The IRS issued a Private Letter Ruling (PLR) on January 25, 2008, that indicates a change in its position on the deductibility of certain forms of executive compensation. The PLR may have financial reporting implications for both year-end and first-quarter financial statements (for calendar-year-end entities).

Background

Under Section 162(m) of the Internal Revenue Code (IRC), a public entity’s tax deduction on compensation to covered employees¹ is limited to $1 million. However, the IRC provides an exception to the $1 million limitation for performance-based compensation (e.g., compensation tied to an earnings target and that satisfies other applicable requirements). Some entities may have incorporated provisions into their compensation arrangements that allowed for payment in certain defined circumstances even when specified performance targets were not achieved. The arrangements may have allowed for payment or vesting of the award upon termination without cause (involuntary termination), termination (by employee) for good reason, or retirement. ² An entity may have concluded that the existence of these clauses would not result in its compensation arrangements failing to qualify for the performance-based compensation exception under the IRC. That is, an entity might have concluded that the full deductibility of its compensation arrangements would meet the more-likely-than-not recognition threshold under FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes.

The PLR reverses the IRS’s position on events that permit acceleration of payment or vesting under the exception for performance-based compensation. Specifically, the mere existence of a provision that compensation would be paid or vested on an involuntary termination or a termination for good reason (i.e., without regard to achievement of the performance goals) may cause that compensation arrangement to fail to qualify as performance based. Similarly, a clause that allows for payment on retirement, without regard to performance, also may cause the compensation arrangement to fail to qualify as performance based. Thus, compensation that was or is paid out (or vested or vests) upon achievement of performance targets under an arrangement that includes a provision permitting acceleration of payment or vesting upon involuntary termination, termination for good cause, or retirement may now fail to qualify as performance-based compensation and, if so, would be subject to the $1 million deductibility limitation.

Pursuant to the PLR, an entity that has taken (or expects to take) a tax deduction for a compensation arrangement that includes a provision that may cause the compensation to fail to qualify as performance based should reanalyze its tax positions under Interpretation 48’s more-likely-than-not recognition threshold. That analysis should be performed for both (1) deferred tax assets for such arrangements currently recognized on the balance sheet and (2) deductions taken in prior tax years related to such arrangements. Under the PLR and in accordance with paragraph 12 of Interpretation 48, any changes in recognition or measurement of an entity’s tax positions should be recorded in the reporting period in which the new information became available (no adjustment would be recorded in financial statements for periods ending on or before January 24, 2008).

Compensation Affected

The PLR could affect compensation such as cash, restricted stock, and restricted stock units. Tax professionals should be consulted to determine whether the PLR affects the deductibility of payments (or vesting) under an entity’s compensation arrangements.

Financial Reporting Implications

The PLR may affect an entity’s previous conclusions about the recognition or measurement of past and current tax positions related to compensation arrangements. That is, an entity may determine that a tax position no longer meets the more-likely-than-not threshold in Interpretation 48. Accordingly, an entity that previously recognized a tax benefit for a deduction for all or a portion of compensation paid or vested (or compensation that will be paid or vested) under an arrangement that provides for accelerated payment or vesting upon retirement, involuntary termination, or termination for good reason may be required to:

1. Record an Interpretation 48 liability (or reduce a deferred tax asset) in the reporting period the new information becomes known or knowable.
2. Include the uncertain tax position in its Interpretation 48 disclosures in the reporting period the new information becomes known or knowable.

The effect of a change in an Interpretation 48 liability (or reduction in a deferred tax asset) related to a tax deduction for cash compensation is generally recorded as a component of income tax expense. Similarly, the effect of a change in an Interpretation 48 liability (or reduction in a deferred tax asset) related to the grant-date fair value of an equity award is generally recorded as a component of income tax expense. However, the appropriate accounting is less straightforward for the effect of a change in an Interpretation 48 liability related to an excess tax benefit³ of an equity award that was recorded directly to additional paid-in capital in a prior period. Questions also exist about whether an adjustment may be required to an entity’s pool of excess tax benefits (i.e., its APIC pool). These matters will be discussed in a forthcoming communication. (Refer to the "Financial Reporting Implications of an Entity’s Share-Based Payment Awards" section below.)

If the new information became available to the entity after the end of its reporting period, but before issuance of its financial statements, and the impact is expected to be significant, the entity should consider disclosing the expected impact of the new information as a material subsequent event. In determining the appropriate information to be disclosed related to this subsequent event, the entity should refer to the requirements of paragraph 21(d) of Interpretation 48.

Update — Financial Reporting Implications of an Entity’s Share-Based Payment Awards (added February 19, 2008)

This section discusses the interaction between establishing an Interpretation 48 liability and any portion of a previously recognized tax benefit recorded as an increase to APIC related to a share-based payment award. As discussed above, an Interpretation 48 liability may need to be established for a tax benefit that was previously recognized upon a tax deduction of a share-based payment award. The portion of the previously recognized tax benefit that relates to the amount of compensation expense recorded for book purposes (i.e., the grant-date fair value) would have originally been recorded as a reduction to income tax expense, and the corresponding liability that is now recorded pursuant to Interpretation 48 is recorded as an increase to income tax expense. The portion of the previously recognized tax benefit that was in excess of the amount of compensation expense recorded for book purposes would have originally been recorded as an increase to APIC. 

Questions have arisen about the appropriate accounting for an Interpretation 48 liability that is recorded for this piece of the previously recognized tax benefit (i.e., the “excess” tax benefit). The accounting literature does not explicitly address this issue. We believe that there is a reasonable basis for an entity to record a change in the Interpretation 48 liability related to an excess tax benefit as either of the following:⁴

1. A reduction to APIC.
2. A component of current-period income tax expense.

While we believe that the first alternative is acceptable, the amounts credited to APIC in prior periods may have already been used to absorb deficiencies related to award exercises for which the recorded deferred tax asset exceeded the deduction received for income tax purposes. If so, it may be overly burdensome to reevaluate historical additions to, and subtractions from, an entity’s pool of excess tax benefits (i.e., its “APIC pool”). EITF Issue No. 06-11, “Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards,” addresses a similar scenario, and provides a practical mechanism that obviates the need to perform retrospective computations. By analogy to Issue 06-11, we believe it would be reasonable to limit the APIC reduction to the current APIC pool balance as of the date the adjustment is made (i.e., as a result of the issuance of the PLR). Any adjustment to APIC would reduce the entity’s APIC pool by a corresponding amount. Any adjustment required that is in excess of the current APIC pool balance would be recorded as a component of current-period income tax expense. 

In computing the Interpretation 48 liability related to an excess tax benefit, an entity must also consider footnote 82 of FASB Statement No. 123(R), Share-Based Payment. Footnote 82 prohibits recognition of the excess tax benefit and a credit to APIC until the excess tax benefit reduces taxes payable.

Example

An entity took a deduction on its tax return (and increased its net operating loss carryforward) for an equity award but did not recognize the excess tax benefit for financial reporting purposes because the excess deduction did not lower taxes payable. Therefore, pursuant to footnote 82, the entity did not record a net operating loss deferred tax asset and credit APIC for the excess tax deduction. In this case, no Interpretation 48 entry is required for that excess tax deduction because the change in the related uncertain tax position would not result in either a reduction in the net operating loss deferred tax asset or an increase in an Interpretation 48 liability recorded on the balance sheet. The entity would need to separately track the portion of the net operating loss related to the uncertain tax benefit and record an Interpretation 48 liability when this net operating loss is used and reduces income taxes payable on the tax return.

Update — Possible Grandfathering Guidance From the IRS (added February 19, 2008)

Recent press reports have speculated that guidance may be forthcoming that would permit only prospective application of the PLR guidance or that would allow entities to “cure” the award provisions described. However, if an entity has otherwise determined that an Interpretation 48 liability is necessary because of the issuance of the PLR on January 25, 2008, it would not be appropriate for the entity to delay recognition of that liability in financial statements for periods ending on or after that date solely because of this speculation. Any new guidance would be reflected in the entity’s more-likely-than-not assessment in the period in which the new information becomes known or knowable.

We will continue to monitor these developments closely and publish updates as appropriate.

Update — Revenue Ruling 2008-13 (added February 27, 2008)

The IRS issued a Revenue Ruling on February 21, 2008, that provides guidance on the applicability of the qualified performance-based compensation exception under IRC Section 162(m) and related regulations. The Revenue Ruling reaffirms the IRS’s position in the PLR issued on January 25, 2008, but provides transition relief in the form of prospective application for certain plans, agreements, or contracts. As a result, entities may need to reconsider their uncertain tax positions under Interpretation 48 in light of both the PLR and the Revenue Ruling.

Revenue Ruling 2008-13 involves a publicly held corporation that maintains a bonus plan that pays cash awards to employees if the corporation’s earnings per share do not decrease during the calendar year. Although the plan meets the other requirements of qualified performance-based compensation, it permits payment even if the goal is not attained if (1) the employee is terminated without cause or if the employee voluntarily terminates employment for good reason or (2) the employee voluntarily retires during the performance period.  The IRS concluded that because of the permissible payment in these circumstances, the compensation would not be qualified performance-based compensation and that compensation paid under the plan would be subject to IRC Section 162(m) disallowance (the same conclusion that was reached in the January 25, 2008, PLR discussed above).

This ruling not only clarifies the positions of the IRS and U.S. Treasury on permissible payments, but also provides transition relief for many existing arrangements. That is, Revenue Ruling 2008-13 will not be applied to disallow a deduction for any compensation that otherwise satisfies the performance-based compensation exception and that is paid under a plan, agreement, or contract that has payment terms similar to those described in the ruling if either of the following conditions exist:

Under paragraph 12 of Interpretation 48, the Revenue Ruling is treated as “new information.” Therefore, entities whose reporting periods begin on or before the issuance of the PLR (January 25, 2008) but end on or after the issuance of the Revenue Ruling (February 21, 2008) should account for both pieces of new information in that period (e.g., first quarter ended March 31, 2008, for a calendar-year-end entity). 

If this new information (i.e., Revenue Ruling) became available to an entity before the issuance of its financial statements for a reporting period that ended before issuance of the PLR (e.g., calendar year ended December 31, 2007), and the entity had previously decided to disclose the expected impact of the PLR as a material subsequent event, the entity should consider revising that disclosure for this new information.

In contrast, entities whose reporting periods ended on or after the issuance of the PLR (January 25, 2008) but before the issuance of the Revenue Ruling (February 21, 2008) are required to account for the two pieces of new information in the respective periods in which each was issued. For example, if the PLR caused an entity with a January 31 year-end to conclude that the more-likely-than-not recognition threshold was not met, an Interpretation 48 liability or reduction in deferred tax asset would be recorded as of January 31 without consideration of the Revenue Ruling issued after the reporting date. These entities will be required to account for the new information in the Revenue Ruling in the first reporting period that includes February 21, 2008.

If the new information (i.e., the Revenue Ruling) became available to an entity after the end of its reporting period, but before issuance of its financial statements, and its impact is expected to be significant, the entity should consider disclosing the expected impact of the new information as a material subsequent event.

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¹  The IRC defines a covered employee as the chief executive officer and the three highest-paid officers or, in prior years, the four highest-paid officers of the entity (as specified in the entity’s required SEC disclosures).

²  For example, these provisions may have been included in an entity’s compensation plans, in the documents outlining the terms of grants to individual employees, or in employment agreements.

³  As defined in FASB Statement No. 123(R), Share-Based Payment.

⁴  An entity’s accounting policies should be applied consistently and disclosed if material to the financial statements in accordance with APB Opinion No. 22, Disclosure of Accounting Policies.

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