Exec Comp: IRS Reverses Rulings Position for Performance-Based Bonuses

Fred Oliphant and Patricia Szoeke

The IRS recently released PLR 200804004 in which it changed its rulings position with regard to whether certain involuntary termination arrangements affect the qualification of performance-based compensation for purposes of Code Section 162(m). The IRS previously had ruled that the presence of a provision that effectively promised payment of performance compensation upon involuntary termination or termination for good cause would not adversely affect the qualification of the performance compensation under Code Section 162(m), except in the event that payment was actually made on involuntary termination or termination for cause. (PLRs 199949014 and 200613012). In contrast to this earlier position, PLR 200804004 reaches the opposite conclusion, holding that because the performance compensation might be paid upon involuntary termination or termination for good reason -- i.e., upon an event other than death, disability, or change of ownership or control -- prior to the attainment of the applicable performance goal, the compensation payable under the performance plan would fail to satisfy the performance goal requirements under Code Section 162(m).

Under the applicable regulations, Treas. Reg. § 1.162-27(e)(2)(v), compensation will not satisfy the performance goal requirement for qualified performance-based compensation if the facts and circumstances, taking into account all plans, arrangements, and agreements, indicate that the employee would receive all or part of the compensation regardless of whether the performance goal is attained. The regulations further specify that compensation does not fail to be qualified performance-based compensation merely because the plan allows the compensation to be payable upon death, disability, or change of control, although any compensation paid on such events will not qualify as performance-based compensation.

Under PLR 200804004, the IRS addressed a situation where a company had established an incentive plan that granted performance share and performance unit awards intended to qualify as performance-based compensation for purposes of Code Section 162(m). Under a separate agreement, the company and one of its executives who was a covered employee under Code Section 162(m) had entered into an employment agreement that provided that in the event the executive's employment was terminated without cause or the executive resigned for good reason, any outstanding performance share or performance unit awards would be deemed to be achieved at target, and the executive would receive a pro rata payout of such awards upon his termination or resignation. In contrast to its holding in prior rulings, the IRS concluded in PLR 200804004 that the compensation payable to this executive under the incentive plan would not qualify as performance-based compensation under Code Section 162(m) because it was also payable upon an individual's involuntary termination or termination for good reason -- regardless of whether or not paid under such circumstances -- because such compensation was not payable solely upon attainment of a performance goal.

However, the holding in PLR 200804004 does not impact the treatment under Code Section 162(m) for performance compensation that may be deemed to be achieved at target upon an individual's termination or resignation but -- unlike the facts under PLR 200804004 -- the payment of which is made only upon attainment of the applicable performance target. In this situation, assuming all other applicable requirements are met, the performance pay would qualify as performance-based compensation under Code Section 162(m) even though there is a special payment provision keyed to the target compensation.

It is our understanding that the holding in PLR 200804004 was not so much attributable to the particular wording of the involuntary termination or termination for good reason provisions in the employment contract, as it was a change in how the Service thinks the exception in the regulations for payment on death, disability, or change of control should be read. In effect, the prior PLRs read the exception as illustrative of situations in which an employee would not be deemed to have a right to the performance compensation if the right were contingent on circumstances beyond his or her control. PLR 200804004 reads the exception merely as a narrow exemption that applies only to those particular enumerated circumstances. Inasmuch as the regulations under Code Section 409A use a similar performance-based compensation standard, also with an exception for payments on death, disability or change of control (Treas. Reg. §  1.409A-1(e)(1)), the Service's interpretation in PLR 200804004 has potential adverse implications for the Service's interpretation of the performance-based compensation rules in the Section 409A regulations.

Taxpayers will want to review their termination plans, employment agreements, and any other side agreements that pertain to the payment of performance compensation to determine the extent to which these arrangements provide for payment of performance pay upon involuntary termination, termination for good reason, or any other event other than satisfaction of the performance condition, death, disability, or change in control. Taxpayers with provisions similar to those in PLR 200804004 will want to consider their position under Code Sections 162(m) and 409A, inasmuch as the Service's change in position in PLR 200804004 could prefigure additional scrutiny of such provisions on audit. In this regard, it is not clear whether the Service was fully aware of the impact that this change in position would have, but we understand that IRS is now hearing from taxpayers on the subject. Whether the Service can be persuaded to alter its position or make it prospective only remains to be seen.

ERISA Litigation: Supreme Court Accepts ERISA Case

Tony Shelley and Susan Relland

The Supreme Court recently granted certiorari on the significant issue of the appropriate standard of review in ERISA cases where the entity who decides claims also is responsible for paying them. In MetLife v. Glenn, MetLife administered Sears' long-term disability plan.  MetLife, who both decided when to award benefits and funded those benefits, initially approved disability claims that were submitted by Glenn, who was on a leave of absence from work due to a cardiac condition.  After initially approving the claim, MetLife reversed its opinion and denied Glenn's disability claim based on conflicting evaluations from Glenn's physician regarding her ability to do sedentary work. Glenn's administrative appeals resulted in affirmance of the denial, and she eventually sued MetLife in federal court. MetLife's decision was upheld by the district court, but the Sixth Circuit reversed and directed the trial court to reinstate Glenn's benefits.  At the court of appeals level, the issue centered on the appropriate standard of review in ERISA benefits cases, with the Sixth Circuit holding that the deference to which MetLife's decision was otherwise entitled was to be lessened because MetLife was both decision-maker on the claim and potential payer of the benefits.

This brings to the Supreme Court the "conflict of interest" issue that has long led to sliding scales of deference in ERISA benefits cases.  The issue is whether benefits decisions under ERISA that are made by claims administrators who also fund the plan benefits involve an inherent conflict of interest, so that courts will afford the decisions only limited deference under Firestone Tire & Rubber v. Bruch, 489 U.S. 101 (1989).  Circuit courts of appeal are split:  the Fourth, Fifth, Sixth, Eighth, Ninth, and Eleventh Circuits require consideration of such dual roles when reviewing an ERISA award, while the First and Seventh do not require consideration of such conflicts.  In addition to this issue, the Supreme Court added to its review the issue of how the conflict should be taken into account on judicial review of a discretionary benefit determination if it is decided that an administrator that both determines and pays claims under an ERISA plan is deemed to be operating under a conflict of interest.

This is a significant issue for all types of ERISA plans.  For example, health plans that insure or administer ERISA health benefits rely on the deferential standard of review to defend their decisions in court actions.  The Supreme Court's determination will affect the standard of review in every one of those cases.  Indeed, this is likely the most significant ERISA issue to be heard by the Supreme Court in at least the last decade.

Health & Welfare / Payroll and Fringe Benefits: Taxation of Employer-Paid Physical Examinations

Lee Spence and Patricia Szoeke

Companies that establish programs whereby executives receive (either on a voluntary or mandatory basis) an annual physical examination, the expenses of which are paid for by the company, must address the proper treatment of such physicals for taxation purposes. A common misconception is that employer-paid physicals qualify as a tax-free working condition fringe benefit. However, despite not qualifying for that tax treatment, the cost of such examination generally nonetheless should be excludible from income as an amount received under an employer-provided health plan.

Code Section 213 provides that expenses related to the diagnosis, cure, mitigation, treatment, or prevention of disease are treated as qualified medical expenses and eligible for deduction. Therefore, annual physical examinations of employees generally are treated as qualified medical expenses under Section 213. However, the Treasury regulations under Code Section 132 specifically provide that a physical examination program provided by an employer is not excludible as a working condition fringe even if the value of such program might be deductible to the employee as a qualified medical expense under Code Section 213 and regardless of whether participation in the program is mandatory for some or all of the employees.

Code Section 105(b) provides that an employee's gross income does not include amounts paid directly or indirectly to the employee to reimburse him for expenses incurred for medical care (as defined under Section 213) of the employee, his spouse, or his dependents. Thus, the value of a physical examination (which is treated as a deductible medical expense under Code Section 213) would be excludible from income under Section 105 as an amount received under an employer-provided health plan.

To the extent employer-sponsored medical plans are self-insured, they are generally subject to nondiscrimination requirements under Code Section 105(h). These requirements may present problems if benefits under a medical plan are limited to highly compensated individuals. However, reimbursements paid under a plan for medical diagnostic procedures for an employee (but not a dependent) are not considered to be part of a medical reimbursement plan that is tested under Code Section 105(h), and are not subject to these nondiscrimination rules. Treas. Reg. § 1.105-11(g)(1).

Qualified Plans: Correction of ADP Failures

Gary Quintiere and Patricia Szoeke

Code Section 401(k)(3) imposes on qualified 401(k) plans an average deferral percentage (ADP) test that these plans must meet in order to maintain their qualified status under the Internal Revenue Code. The ADP test, which is aimed at ensuring that elective deferrals to a qualified 401(k) plan do not discriminate in favor of highly compensated employees (HCEs) over nonhighly compensated employees (NHCEs), is an area where plans frequently make mistakes. Failures timely or properly to apply the ADP test or to correct excess contributions under such test are some of the most commonly submitted under the IRS's Voluntary Correction Program (VCP).

A plan that fails to comply with the requirements of the ADP test has several alternatives in which it may correct such failure -- and thereby be treated as not having failed the ADP test. One alternative is the use of qualified nonelective contributions (QNECs) or qualified matching contributions (QMACs), subject to various restrictions set forth in the 401(k) regulations. Among larger plans, the more common means of correcting a testing failure is to either distribute the excess contributions to the affected HCEs or recharacterize those excess contributions as voluntary after-tax contributions.

Plans that distribute excess contributions to HCEs must do so before the end of the following plan year. The excess contributions distributed to correct an ADP failure are includible in the employee's gross income. If such amounts are distributed no later than 2½ months after the end of the plan year for which the contributions were made, the amounts are includible in gross income on the earliest date any elective contributions during the plan year would have been received by the HCE had he elected to receive them in cash. Alternatively, if the excess contributions are distributed more than 2½ months after the end of the plan year for which the contributions were made, they will be includible in the HCE's gross income for the employee's taxable year in which such distribution is made. Furthermore, if the excess contributions are distributed more than 2½ months after the end of the applicable plan year, a 10% excise tax on the amount of the excess contributions will be assessed against the employer.

When considering the recharacterization method of correcting an ADP failure (i.e., recharacterizing excess contribution amounts as after-tax contributions), plan administrators must keep in mind that "recharacterized" after-tax contributions are themselves subject to discrimination testing under the ACP test. Therefore, for plans that have low NHCE participation rates, this approach may not be an effective way to correct for an ADP failure.

For further information, please contact any of the following lawyers:

Anthony Shelley, ashelley@milchev.com, 202-626-5924

Fred Oliphant*

Gary Quintiere*

Susan Relland*

Lee Spence*

Patricia Szoeke*

*Former Miller & Chevalier attorney

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