The Advisors' Blog

After the IRS’s recent and unanticipated 162(m) PLR (200804004) and Revenue Ruling 2008-13 on bonus payments in a termination context, a new (more normal) ruling dealing with “officer” status came as a bit of a relief. As most compensation practitioners know, Section 162(m) of the IRC is a provision that provides for a $1 million limit on non-performance based compensation that a public company can deduct for its named executive officers.

The goal then is to structure covered executive compensation agreements to provide for “good” performance based compensation. That was the problem with the IRS’s recent 162(m) foray – which took the position that full bonus payments made upon an involuntary termination were not performance based. Of course, Section 162(m) also has strict “procedural” requirements, apart from tying “good” compensation to performance. One such requirement is the provision mandating that objective performance goals be established by a committee of two or more independent “outside” directors.

Dealing With “Interim” Officer Status

In Revenue Ruling 2008-32, dated June 16, 2008, the IRS addressed the issue of who qualifies as an “outside” director. The facts of the ruling are as follows: Public Company X’s chief executive officer (CEO) unexpectedly resigned in January 2008. In response, the Board of Directors of Company X appointed Director A to serve as “interim CEO” while the Board conducted a search for a permanent replacement CEO. The service agreement between Company X and Director A did not limit Director A’s authority as interim CEO, was for an indefinite duration, and provided for termination of service upon selection of a permanent CEO. On February 1, 2008, the Compensation Committee of Company X approved, and the Board of Directors ratified, a compensation plan for the period during which Director A served as interim CEO.

The plan provided for a base salary of $1 million, as well as participation in Company X’s executive bonus plan. On December 11, 2008, after Director A served as an interim CEO for almost a year, Company X announced that Employee F was selected as Company X’s new CEO. Director A received final, prorated compensation for services as interim CEO on December 29, 2008. Following December 29, 2008, Director A did not receive compensation from Company X, directly or indirectly, in any capacity other than as a director. In January 2009, Director A was appointed to the Compensation Committee of Company X. Director A had not served on the Compensation Committee before.

162(m) and “Outside” Director Status: The Ground Rules

The issue before the IRS was whether Director A would qualify as an “outside” director for 2009 and subsequent years under Section 162(m)(4)(C)(i), after having served as an “interim CEO.” Under Section 1.162-27(e)(3)(i) of the 162(m) regulations, an individual is an outside director if the director:

– Is not a current employee of the publicly held corporation;
– Is not a former employee of the publicly held corporation who receives compensation for prior services (other than benefits under a tax-qualified retirement plan) during the taxable year;
– Has not been an officer of the publicly held corporation; and
– Does not receive remuneration from the publicly held corporation, either directly or indirectly, in any capacity other than as a director.

In This Case: Disqualifying “Regular and Continued” Officer Status

Not surprisingly, in the ruling, the IRS relied on the definition of “officer” in the 162(m) regulations. That provision provides that “officer means an administrative executive who is or was in regular and continued service . . . The determination of whether an individual is or was an officer is based on all of the facts and circumstances in the particular case, including without limitation the source of the individual’s authority, the term for which the individual is elected or appointed, and the nature and extent of the individual’s duties.”

In this case, the IRS highlighted certain facts:
– Director A was not employed as CEO for a special and single transaction;
– Director A was in regular and continued service from January 7, 2008 through December 11, 2008;
– Director A was hired for an indefinite period; and
– Director A did not merely have the title of officer, but had full authority to serve as CEO.

Under the facts before it, the IRS determined that Director A was an officer of Company X and thus not an “outside” director for purposes of Section 162(m). Thus, Director A’s officership status tainted any chance of subsequent appointment to the Compensation Committee. He may as well wear a scarlet letter on his chest, at least for compensation purposes. The bottom line is that once a bona fide officer of the issuer, the individual is forever barred from qualifying as an “outside” director, absent a successor situation (of the sort described below).

Planning Around Disqualifying “Officer” Status

Is there any good news in this revenue ruling? Consistent with the 162(m) regulations that define “officer,” a one-time, short-term, limited role as officer should not taint the individual in question. Section 1.162-27(e)(3)(vii) provides that an “officer” means an “administrative executive who is or was in regular and continued service.” So there is some wiggle room in structuring interim officership status so as not to constitute regular and continued service. Working off the factors in the revenue ruling and regulations – what if we structured the interim CEO position for a finite period, to handle specific matters and with limited authority?

On a related note, practitioners should also remember that there is a well developed line of private letter rulings that say officership in one entity does not necessarily disqualify the individual from “outside” director status in the new entity. For example, in PLR 200423012, Director served as secretary of Corporation Y from Year a to Year c. In Year d, Corporation Y merged into Corporation X. Director served on the Board of Directors of Corporation X. Director received no remuneration from Corporation X except in his capacity as director. The IRS ruled that Director qualified as an “outside” director of Corporation X, notwithstanding prior offcership status at Corporation Y.

There are also situations where the individual in question served as officer, but only in a limited ministerial capacity. These facts alone did not preclude the IRS from ruling that the individual qualified as an “outside” director. For example, in PLR 9732011, Corporation A proposed that Director B serve as the second “outside” director on its Compensation Committee. Corporation A had been a publicly held corporation since Year Y. Director B was not a current or former employee of Corporation A and did not receive any compensation from Corporation A other than in his capacity as a board member. Director B had served as the corporate secretary for Corporation A since Year Z. Corporation A represented that Director B’s functions as corporate secretary were limited to attendance at board and shareholder meetings and that Director B’s duties were ministerial in nature, with secretarial duties performed by the assistant secretaries.

As stated above, Section 1.162-27(e)(3)(vii) of the 162(m) regulations provides that the determination of whether an individual is or was an officer is based on all the “facts and circumstances” in the particular case, including the “nature and extent of the individual’s duties.” Therefore, in this case, the IRS ruled that Director B qualified as an “outside” director because the nature and extent of his duties as an officer were strictly ministerial and “ceremonial” in nature.

Finally, a “tainted” former officer who continues to serve as a director may still be able to observe Compensation Committee activity in the context of a non-voting role. In PLR 9811029, the IRS allowed a stock option plan approved by a Compensation Committee which included “inside” directors, as well as two “outside” directors, to qualify for “good” 162(m) treatment, based on the fact that the “inside” directors would abstain or recuse themselves. The IRS ruled that after giving effect to the abstention or recusal of the “inside” directors, the corporation had a subcommittee of, at a minimum, two “outside” directors, and complied with Section 162(m).

– Michael Album, Partner, Proskauer Rose; Morgan Gold, a summer associate from Fordham University School of Law assisted on this blog posting.