Davis Polk & Wardwell Newsflash

IRS Ruling Reflects Changed Position on Application of $1M Deduction Limit on Annual Compensation to Top Executives Under Internal Revenue Code Section 162(m)

January 31, 2008

A recently released private letter ruling (200804004) appears to reverse a position taken by the IRS in several prior rulings. At issue was whether compensation meets the performance-based requirement of Section 162(m) for an executive whose employment agreement provides that, in the event his employment is terminated by the employer without cause or by him with good reason, the executive is entitled to receive an amount based on the target performance level without regard to the actual performance results. In this circumstance, the ruling holds that any compensation paid to the executive under an award covered by the special payment provision will not qualify as performance-based, including compensation paid under any such award in years in which the executive did not terminate employment and the performance targets were achieved.

The language in the letter ruling applies only to the compensation paid to the executive with the special payment provision in his employment agreement. However, some practitioners have extrapolated from the facts in the letter ruling that a similar provision in a Section 162(m) plan would “taint” all awards under the plan covered by such a provision.

Although the precise scope of the IRS’s intended application of the ruling is at this time unclear, it would be advisable for companies to identify provisions of this nature in plans intended to qualify as performance-based under Section 162(m), as well as in employment contracts and award documents for individuals likely to be covered by Section 162(m).

If you have any questions regarding this newsflash, please call your Davis Polk contact.

Davis Polk & Wardwell