IRS Confirms New Restriction on Performance-Based Compensation

Client Advisory

February 27, 2008

Late last week the Internal Revenue Service issued a ruling that confirms that it will henceforth take a more restrictive position with respect to executive compensation plans providing for “performance-based compensation” pursuant to IRC Section 162(m), but at the same time responds to practitioner requests for a reasonable transition period.

Section 162(m) of the Internal Revenue Code denies public companies a tax deduction for remuneration in excess of $1 million paid in any year to any of their five top executives. There is, however, a frequently utilized exception for certain “performance-based compensation.” Under this exception, if:

  • performance-based compensation goals are established by a properly constituted compensation committee of the company’s board of directors,
  • the material terms of the arrangement are approved by the company’s shareholders, and
  • the compensation committee certifies prior to payment that the goals were attained over an established performance period,

then the remuneration payable on account of the attainment of such goals is not subject to the deduction limit under Section 162(m). The plan must provide for compensation “solely on account of” the attainment of pre-established, objectively determinable performance goals. If under the plan the compensation is payable if the goals are met, but also under other circumstances, then compensation payable under the plan will not be considered to be performance-based. Therefore, compensation paid under such a plan will be subject to the Section 162(m) deduction limit, even if it is paid because the goals were in fact achieved.

Regulations under Section 162(m) provide that notwithstanding the requirement that the plan pay compensation solely on account of the attainment of performance goals, the plan may permit payment to be made on account of death, disability or change of ownership or control prior to the attainment of the stated goals. Such a provision does not preclude the plan from being eligible for the performance-based compensation exception. Any compensation actually paid on account of such events does not escape the Section 162(m) deduction limit, however, since it is not actually performance-based compensation.

The Internal Revenue Service (the “Service”) previously took the position in two private letter rulings that both (i) an involuntary termination of the executive’s employment by the company and (ii) the executive’s voluntary termination for good reason (“termination events”) are sufficiently similar to the events listed in the regulations (i.e., death, disability and change of control), that they should be allowed to trigger payments without preventing the plan itself from qualifying as performance-based. Late last year, however, the Service appeared to reverse itself, and it has now confirmed its new position in Revenue Ruling 2008-13. Consequently, a plan will not qualify as performance-based if it allows for payment on account of the termination events.

The Service was made to understand, however, that as a result of its prior position many performance-based plans were designed to pay out upon the occurrence of the two termination events. Thus, Revenue Ruling 2008-13 provides that an employer will not lose its tax deduction for compensation paid under a plan that otherwise conforms to Section 162(m), but makes payments available on account of the two termination events, as long as --

  • the performance period over which the performance-based compensation is earned begins on or before January 1, 2009, or
  • the compensation is paid under an employment contract as in effect on February 21, 2008 (without regard to future renewals or extensions, including renewals or extensions that occur automatically absent action by the parties).

Public companies should take advantage of this transition period to review the provisions of all their compensation arrangements that rely on the Section 162(m) performance-based exception, including employment agreements, to identify and eliminate the specific payment events that do not qualify as performance-based, if such arrangements do not qualify for either grandfather rule specified above. All new plans and employment agreements will need to be drafted with Revenue Ruling 2008-13 in mind.

Questions regarding this client advisory may be directed to Patricia Matzye at (212-238-8730,, Howard Barnet (212-238-8606, or Dan Pittman (212-238-8854,

Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. © 2020 Carter Ledyard & Milburn LLP.
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