Executive Compensation: Last Chance to Fix Bonus Plans and Severance/Employment Agreements

Anne Batter

For those companies who have not yet revised their bonus plans or severance/employment agreements to comply with the IRS interpretation of Internal Revenue Code (Code) section 162(m) in Rev. Rul. 2008-13, 2008-10 IRB 518, now would be the time to do that in order to avoid a deduction disallowance for the 2010 annual bonus (and for long-term bonuses with a performance period beginning January 1, 2010). For taxpayers with calendar year performance periods, the grandfather provisions in Rev. Rul. 2008-13 generally will only protect annual bonuses through the 2009 performance period. Bonus plans and severance/employment agreements impacting the bonus paid for the 2010 performance period generally will need to be compliant with Rev. Rul. 2008-13 in order to avoid deduction disallowance under Code section 162(m). The same is true for long-term bonuses with performance periods beginning after January 1, 2009.

As background, Rev. Rul. 2008-13 sets forth the IRS’s position that a bonus program does not meet the requirements for deductibility as performance-based compensation exempt from section 162(m) if the plan and/or other arrangements provide for payment of a bonus without regard to attainment of performance goals on the employer’s involuntary termination of the employee without cause, or the employee’s termination for good reason or by retirement. Thus, for example, under the ruling, if a performance plan (or a separate severance or employment agreement) contains a provision specifying that the target level bonus will be paid upon the executive’s involuntary termination, or termination for good reason, or retirement, whether or not the performance goals are met, then all payments under the performance plan, even those that are made upon meeting the performance goal, will be treated as failing the Code section 162(m) exception.

Thus, the ruling applies a strict interpretation of Treas. Reg. § 1.162-27(e)(2)(v), so that a plan can only be assured continued exemption from Code section 162(m) as qualified performance-based compensation if the plan and associated arrangements provide for payment of a target bonus without regard to attainment of goals only on death, disability, or change in control. As has always been the case, bonus payments actually made without regard to attainment of goals in these circumstances (i.e., death, disability, or change in control) are non-deductible but the inclusion of provisions for such payments will not disqualify the entire plan from satisfying the section 162(m) exception for performance-based compensation.

This new strict interpretation of the Code section 162(m) regulations was first announced in PLR 200804004 (January 25, 2008), which signaled the IRS’s disagreement with its prior ruling position in PLR 200613012 (March 31, 2006) and PLR 199949014 (December 10, 1999). Due to taxpayers’ vocal concerns regarding the financial accounting consequences of this new position, the IRS issued Rev. Rul. 2008-13 and made it prospective in effect.

Rev. Rul. 2008-13 was made effective prospectively for plans and arrangements that otherwise satisfy the rules for performance-based compensation exempt from Code section 162(m) and contain payments terms similar to those in the ruling. Thus, the ruling does not apply to bonus programs for (i) performance periods beginning on or before January 1, 2009, and (ii) compensation paid under employment contracts in effect on February 21, 2008. Although the wording of Rev. Rul. 2008-13 is not as clear as it could be, it would appear the IRS meant to grandfather contracts in effect as of February 21, 2008, only for the stated term thereof, but not where the employment contract has been extended or renewed since February 21, 2008, even under a provision for automatic renewal.

To the extent not covered by the grandfather rule for employment contracts in effect on February 21, 2008, the last performance period that is grandfathered for annual bonus plans is the 2009 calendar year performance period. Consequently, in such a case, the grandfather will not apply to the 2010 performance period and the plan and other arrangements (such as associated employment agreements and severance plans) need to be revised to comply with Rev. Rul. 2008-13 in order to be assured a deduction for the 2010 bonus (and bonuses relating to longer periods beginning January 1, 2010).

Note that companies need to review, not only their annual bonus plans and long-term performance-based compensation programs, but also any severance or employment agreements that might separately provide whether a bonus (or a bonus substitute) is paid in the year of termination. How the severance programs and employment agreements can be designed such that they do not clearly make up for the target bonus that cannot be paid on termination pursuant to Rev. Rul. 2008-13 is an open issue that must be given serious consideration.

Fringe Benefits and Payroll Tax: IRS to Increase Employment Tax Audits

Thomas Cryan, Jr.

Earlier this year, we alerted our clients that the IRS has been conducting its largest hiring initiative in decades. We suspected, based on both statements from the IRS and because employment taxes are “recession proof,” i.e. taxes that can be collected even when a company is in a net operating loss position, that a primary focus of this increase in manpower would be employment taxes. A recent announcement from the IRS has confirmed this.

On September 18, 2009, the IRS announced that it will audit 6,000 U.S. companies to determine whether they pay all their required employment taxes to fund Social Security and Medicare benefits. The IRS indicated that the primary focus of these examinations will be worker classification (i.e., whether service providers are being properly classified as independent contractors) and the tax treatment of fringe benefits. John Tuzynski, chief of employment tax operations at the IRS, also noted that the IRS will focus in particular on fringe benefits such as company cars and the personal use of corporate-owned vacation property. The audits will occur over a three-year period, beginning in February 2010, and the companies will be chosen at random. These examinations will enable the IRS to collect data to identify additional issues and to prepare a broader national audit program.

The IRS will consider a taxpayer’s prior efforts to correct plan issues or withholding procedures in assessing whether penalties are appropriate for back years. Therefore, we strongly recommend that our clients take steps now to comply with IRS requirements prior to the IRS discovering the issue on audit. We have been working with our clients to conduct internal audits of both their plans and withholding procedures in an effort to both discover and correct any plan or procedure deficiencies. Please let us know if we can be of assistance.

There are two additional developments on the audit front. First, taxpayers have reported that the IRS has begun auditing (i) Code section 409A compliance and (ii) claims for the COBRA subsidy (see article below). Second, taxpayers also have reported that their audit teams have indicated that the returns of corporate officers will be reviewed in conjunctions with the corporate income tax return audit as part of the Global High Wealth Industry initiative within LMSB. This initiative will be described in more detail in a separate, upcoming alert. In summary, a new industry, the Global High Wealth Industry, has been added to LMSB and we expect this could result in more sophisticated audits of corporate officers’ tax returns as well as better coordination of the examination of the corporate return and the individual officers’ returns.

Qualified Plans: IRS Releases COLA-Adjusted Amounts for 2010

Elizabeth Drake, Garrett Fenton

On October 15, the IRS released the 2010 annual cost-of-living adjustments (COLAs) to qualified plan limitations. There had been some speculation that at least some of the COLA-adjusted amounts could actually decrease from their 2009 levels, since the relevant cost-of-living index had declined from a year ago. But the IRS interpreted the Internal Revenue Code’s COLA provisions to prevent a year-to-year reduction in the relevant limitations, and thus maintained the amounts at their 2009 levels:

The 2010 Social Security taxable wage base is also unchanged from its 2009 level of $106,800.

Health and Welfare: IRS Rapidly Begins COBRA Subsidy Audits

Michael Lloyd

When Congress provided a 65% subsidy for involuntarily terminated workers in the American Recovery and Reinvestment Act of 2009, many questioned whether the IRS could adequately ensure compliance of claims for the subsidy. M&C has learned that the IRS has already begun audits of employers and insurers claiming the subsidy on their 2009 Forms 941 (Employer Quarterly Federal Tax Return). The IRS information document request asks for the identity of all individuals represented on line 12b of the Form 941, each individual’s request for the COBRA subsidy, and a copy of the insurance premium invoice to the employer with proof that the employee paid the premium. Although IRS guidance instructs employers/ insurers to maintain this information in their files [IR-2009-15, Feb. 26, 2009], the speed with which the IRS has initiated enforcement action (6 months) is surprising. Employers and insurers should make sure that they have their COBRA subsidy documentation in order.

Health and Welfare: Senate Finance Committee Proposes Excise Tax on High Cost Health Plans

Susan Relland, Garrett Fenton 

On October 13, the Senate Finance Committee voted to approve its version of the health reform bill, which includes as its primary funding source a controversial excise tax on high cost health plans. The funding provisions included in the eventual Senate health reform bill will likely be based in large part on the Finance Committee’s provisions. Thus, employers, insurers, and plan administrators should be aware of the excise tax, as well as how it could potentially affect them in the near future.

The proposal calls for the imposition of a 40% non-deductible excise tax, beginning in 2013, imposed on the excess of the aggregate value of employer-sponsored health coverage over a threshold amount. The “value” of coverage provided under a self-funded plan is determined based on COBRA premiums. In calculating the value of retiree coverage, pre-65 and post-65 retiree plans may be combined at the employer’s election.

The threshold amount is generally $8,000 for individual coverage and $21,000 for family coverage (although several Senators are interested in increasing those amounts). For retirees over age 55 and individuals in high-risk professions, however, the thresholds are $9,850 and $26,000, respectively. A three year transition rule would implement higher thresholds in the 17 states with the most expensive health care as of the end of 2012, as determined each year. The thresholds are indexed to CPI-U + 1%, which is usually a much lower rate than actual medical cost inflation. Thus, an increasing number of plans will likely begin to exceed the relevant thresholds over time.

Employer and employee contributions made on a pre-tax or after-tax basis are taken into account in determining the value of coverage for purposes of the excise tax. In addition, the threshold includes all contributions to medical, dental, vision, health Flexible Spending Arrangements (FSAs), Health Reimbursement Arrangements (HRAs), and Health Savings Accounts (HSAs) (if made by the employer or the employee through a cafeteria plan) for the year. All long-term care and disability benefits, as well as indemnity and specified-disease insurance purchased with after-tax contributions, are excluded from the value of coverage for purposes of the excise tax.

The excise tax will be imposed upon the insurance company in the case of an insured plan, and the plan administrator in the case of a self-funded plan. The tax will be allocated to the insurers and administrators in proportion to the value of the health plans. An employer will need to calculate the total value of health coverage on a per-employee basis, determine the allocation of the tax for each plan, and report the resulting amount to each insurer and plan administrator, and to the Secretary of Treasury, in accordance with regulations. The employer will be subject to a penalty for underreporting, although the penalty may be waived if the employer can show that the failure was due to reasonable cause and not willful neglect.

Several revisions to the excise tax provisions have been suggested, and could be made before the full Senate votes on its health reform bill. For example, the bill could index the thresholds to a higher percentage (e.g., CPI-U + 3%, or CPI-medical) that more accurately reflects medical cost inflation; exempt retiree medical coverage and employee-pay-all plans; carve out employee after-tax (and even pre-tax) contributions; increase the threshold for family coverage from $21,000 to, for example, $25,000; maintain the increased thresholds under the transition rule for high-cost states indefinitely; or eliminate the threshold completely and, instead, beginning with the value of coverage provided in 2013, impose an excise tax on plans that increase at a rate greater than medical inflation for the year. It remains to be seen which, if any, of these suggestions will garner enough support to be either included in the final Senate health reform bill or adopted as part of a conference to reconcile House and Senate-passed versions of health reform. 

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