This article is reprinted with permission from the
March 27, 2008
edition of
New York Law Journal.
2008 NLP IP Company.

Severance Benefits May Risk 'Performance-Based' Status

Section 162(m) of the Internal Revenue Code (the Code) provides a $1 million "cap" on deductibility of certain compensation paid to "covered employees" of publicly traded companies.

For this purpose (and as used in this column), "covered employees" refer to the chief executive officer and the three other highest-paid executive officers of the company (but excluding the chief financial officer).1 Exception to this "cap" is made for "performance-based" compensation such as annual bonuses and long-term incentive arrangements that, in each case, are tied to performance targets and meet certain criteria in that respect. Code §162(m)(4)(C); Treas. Reg. §1.162-27(e).

It has been generally assumed that an incentive plan will not fail the "performance-based" test just because it provides that incentive awards will be payable, regardless of achievement of performance targets, as severance in the case of terminations of covered employees without cause or terminations for "good reason." This conclusion was supported in two private letter rulings, discussed below (private letter rulings, of course, can only be relied on by the taxpayer receiving the ruling).

New Position

The purpose of this column is to examine the new position of the Internal Revenue Service (IRS) that guaranteeing bonus and other incentive awards upon terminations without cause and terminations for good reason can disqualify the incentive compensation as to the performance-based plan exception under Code §162(m).

This new position is reflected in a recently published Revenue Ruling and an earlier Private Letter Ruling, both of which are discussed below. (It is important to note that the tax status of severance amounts paid following terminations without cause or terminations for good reason is not in question (they are not themselves subject to Code §162(m); because they are payable after the employee is no longer a covered employee they would be deductible without reference to §162(m)).

The issue involves the impact of (A) a provision to make such severance payments in the future (to the extent they "look like" guaranteed incentive awards) upon (B) the qualification of current incentive compensation as performance-based compensation under Code §162(m).)

Treasury Regulation §1.162-27(e). Pursuant to Code §162(m)(4)(C), this regulation, adopted Dec. 19, 1995, sets forth requirements for meeting the performance-based compensation exception. Treasury Regulation §1.162-27(e)(2)(i) provides that "[q]ualified performance-based compensation must be paid solely on account of the attainment of one or more pre-established, objective performance goals." Treasury Regulation §1.162-27(e)(2)(v) provides, however, that compensation payable upon "death, disability, or change of ownership or control" does not violate the "paid solely" test just quoted from Treasury Regulation §1.162-27(e)(2)(i). This provision of Treasury Regulation §1.162-27(e)(2)(v), together with the two private letter rulings noted above and discussed in the next paragraph, led public corporations and their tax advisers to conclude that providing severance based upon incentives such as annual bonuses would not deprive the incentive compensation arrangement of the performance-based exception from the §162(m) cap.

1999 and 2006 PLRs. In two private letter rulings, PLR 199949014 and PLR 200613012, the IRS ruled that compensation that otherwise represented performance-based compensation would not fail to qualify for the exception simply because its payment was guaranteed (without regard to attainment of performance targets) upon a termination by the employer without cause or by the covered employee for good reason (and, in the case of PLR 200613012, upon retirement as well.)

PLR 200804004. On Jan. 25, 2008, the IRS released PLR 200804004 (date issued to taxpayer: Sept. 21, 2007). In this ruling, the IRS adopted the position that an employment agreement which provided that upon termination without cause or for good reason, performance targets for the employee's outstanding stock awards were deemed satisfied and hence the stock awards became vested would disqualify all such awards made to the employee for purposes of the Code §162(m) exception for performance-based compensation. Shortly following the release of PLR 200804004, many public corporations and their advisers expressed concern to the IRS that, among other things, PLR 200804004 created immediate problems for them in reporting on the deductibility of performance-based compensation that had related severance provisions (As noted above, a private letter ruling is applicable only to the taxpayer receiving it but this did not alleviate the concern of public companies and their advisers).2 Shortly after the release of PLR 200804004, the IRS published Revenue Ruling 2008-13 on this same subject.

Revenue Ruling

Revenue Ruling 2008-13, 2008-10 IRB 518 (March 10, 2008). This Revenue Ruling (originally issued Feb. 21, 2008) deals with the same basic issue as PLR 200804004 (in a situation involving different facts) and is applicable to publicly traded corporations generally. As noted below, it provides transition protection to the corporations affected.

The Ruling involves a bonus plan that pays a cash award to the covered employee if the employer's earnings per share do not decrease during the calendar year. The plan provides that the compensation will be paid to the covered employee, without regard to whether the performance goal is achieved, if either of the following situations applies:

(i) the covered employee's employment is involuntarily terminated by the corporation without cause or the covered employee terminates his or her employment for good reason, or

(ii) the covered employee retires.[3]

The Ruling holds that the guarantee of payments under the circumstances described in clauses (i) and (ii), quoted above, disqualified all incentive payments to the covered employee under the plan for purposes of the performance-based exception from Code §162(m).

Grandfathering of Revenue Ruling 2008-13. Revenue Ruling 2008-13 provides for grandfathering from its holding in the following two situations:

(i) if "the performance period for such compensation begins on or before Jan. 1, 2009" or

(ii) "the compensation is paid pursuant to the terms of an employment contract as in effect (without respect to future renewals or extensions, including renewals or extensions that occur automatically absent further action of one or more of the parties to the contract) on Feb. 21, 2008."

In respect of clause (i), the Ruling provides that "the performance period for such compensation is the period of service to which the performance goal applicable to such compensation relates." While the Ruling provides performance-based plans a transition period (that is, for performance periods up to and including those beginning on Jan. 1, 2009) within which they may be brought into compliance, the entering into (or renewing or extending) of employment or severance agreements, that may relate to them, after Feb. 21, 2008 may have disqualifying impacts on incentive plans with performance periods commencing after Jan. 1, 2009. Careful attention must be given to the entering into or renewing of such severance or employment agreements occurring after Feb. 21, 2008.[4]

Language, Documentation

What type of language and/or documentation can be used to avoid a severance provision's causing incentive compensation to which it relates from being disqualified for purposes of the "performance-based" exception under Code §162(m)?

The following are some alternative forms of severance covered employees might receive upon termination of employment without cause or for good reason:

(i) Two times salary and two times target bonus (sometimes expressed as 24 months of salary and target bonus).

(ii) Four times salary (if, for example, target bonus had been 100 percent of salary, this would produce the same result as Alternative (i)).

(iii) a lump-sum payment of "X" (intended to produce the same result as in (i)).

Revenue Ruling 2008-13 does not consider this issue and, thus far, IRS representatives speaking at conferences have not been clear as to what kind of severance language can be used without "tainting" the performance-based arrangement as to which the severance payment relates.

The IRS point of view, as expressed informally thus far, appears to be that if the severance is another way of paying incentives without requiring attainment of performance targets, it disqualifies the related incentive plan. Thus, for example, the provisions for guaranteed payments of bonus under the bonus plan covered by Revenue Ruling 2008-13 describe the bonus payment as being paid "even if" the "Performance Goal" under the plan is not attained if the employee is terminated without cause or terminates for good reason. The "nomenclature" of severance is not used in the plan. Likewise, in the PLR 200804004, the employment agreement provided that upon a termination without cause or for good reason the targets would be "deemed" achieved - again, without describing the payment to be made on termination as "severance."


The question is: under what circumstances will the IRS be comfortable with treating a severance payment as separate from the incentive compensation by which it is measured? Various positions have been expressed by practitioners on this issue, at conferences and in commentaries. None of these viewpoints reflects any official position yet taken by the IRS. Following are three of them.

Viewpoint 1 (from a taxpayer's standpoint, the most aggressive of the three). Any severance stated clearly as severance (even if stated, for example, as two times "target" incentive award) should be treated as a payment outside the incentive plan which it merely uses as a measure of severance and, therefore, should not disqualify the plan for purposes of the §162(m) exception for "performance-based" compensation. Under Viewpoint 1, severance is severance, separate and apart from the bonus or other award by which it is measured, and under no circumstances should it "taint" for this purpose the incentive plan to which it relates (just as payments upon disability and death do not taint the incentive compensation to which they relate). This should be the case whether severance is pursuant to a severance provision in the incentive plan or pursuant to a severance provision in a separate contract or other arrangement. On the other hand, if the IRS ends up agreeing with this viewpoint, one would wonder why the IRS issued the Ruling in the first place. It would be allowing choice of words (i.e., the use of the term "severance") and/or structuring (placing the severance clearly in a provision/agreement/plan or other document separate from the incentive award) to dictate the treatment. This viewpoint leaves little real substance to Revenue Ruling 2008-13.

Viewpoint 2. Some practitioners suggest modifying severance provisions to read as in clauses (ii) and (iii) above, making no reference to a bonus payment as part of severance, but, economically, providing the equivalent of clause (i). If the IRS rejects Viewpoint 1 (as well as a modified version of that viewpoint as presented in Viewpoint 3) it becomes uncertain whether "clothing" bonus-related severance in a nonbonus formula (i.e., an enhanced multiple of salary or a single stated amount) will avoid the problem raised by Revenue Ruling 2008-13. By the same token, if the IRS does not accept Viewpoint 1 (or Viewpoint 3), it may find itself facing numerous "stealth" formulas (such as in clauses (ii) and (iii) above) posing a challenge to the IRS in trying to pierce opaque formulations.

Viewpoint 3. Provide a pro rata award for the performance period in which termination without cause or for good reason occurs, thereby "insulating" the severance payments from the incentive compensation. For example, if the termination occurred exactly half way through the year for an annual bonus, provide a 50 percent bonus based on actual results for the year. That, conceptually, takes care of the bonus for the period of actual employment. Then, arguably, severance (which is really reimbursement for being forced into the position of not working in the future) can be based on a formula like that in the incentive plan without tainting the §162(m) exception.

At least that is the argument. In fact, there has been a suggestion in conferences attended by IRS representatives that the pro rata bonus in the example given might in fact insulate severance payments, as just described, from tainting the incentive plan exception. It must be emphasized, however, that nothing has been stated formally by the IRS on this point at the time this column was written.


In light of the numerous issues raised by Revenue Ruling 2008-13 (and its PLR predecessor, PLR 200804004), such as those discussed above, it is hoped that the IRS will issue a ruling soon giving its interpretation as to such issues. In the meantime, public corporations and their advisers should give close attention to what is being said at conferences (in person and by video) being held on Code §162(m) around the country, including comments made by IRS representatives attending those conferences.


1. Reflecting changes in SEC proxy statement rules for reporting compensation of Named Executive Officers, in Notice 2007-49, 2007-25 IRB 1429, the IRS reduced the number of executives other than the chief executive officer that are covered employees to the three highest paid other than the chief executive officer and the chief financial officer, the latter being excluded, in any event, from covered employee status. (Notice 2007-49 refers to the chief executive officer and the chief financial officer as the principal executive officer and the principal financial officer, following SEC nomenclature in this respect.)

2. Among other concerns, public corporations and their advisers expressed concern as to correct reporting under Financial Accounting Standards Board Interpretation No. 48 (FIN 48). FIN 48 requires a "more likely than not" conclusion as to the tax position taken by a corporation in its financial statements. See letter dated Feb. 13, 2008 addressed to the IRS Acting Commissioner Linda Stiff from Dennis B. Drapkin of Jones Day and Susan P. Serota of Pillsbury Winthrop Shaw Pittman; see also letter dated Feb. 19, 2008 addressed to Acting Commissioner Stiff signed by 90 law firms.

3. The plan that is the subject of Revenue Ruling 2008-13 also provides for guaranteed payment in the event of a termination if the covered employee dies or becomes disabled or if a change of ownership or control of the employer occurs. The Ruling, consistent with Treasury Regulation §1.162-27(e)(2)(v), notes that the presence of a guaranteed payment in any one of these three types of terminations does not cause a loss of the exception. The Ruling cites Treasury Regulation §1.162-27(e)(2)(i) which, as noted in the text, provides, in part, that to qualify for the §162(m) performance-based exception, compensation "must be paid solely on account of one or more preestablished, objective performance goals." The Ruling also cites Treasury Regulation §1.162-27(e)(2)(v) which provides that determination as to whether the performance-based exception applies must take into account the "facts and circumstances" relevant to the performance issue including "all plans, arrangements and agreements that provide compensation for the employee."

4. Thus far, IRS representatives have suggested that amending an otherwise grandfathered agreement does not take away grandfathered status under Revenue Ruling 2008-13 provided the amendment does not affect the performance-based issue addressed by Revenue Ruling 2008-13. However, nothing is said in this regard in the Revenue Ruling. This is a point on which further discussion by the IRS would be helpful.