IRS rules on the "commission-based" exception to sec. 162(m).

In Letter Ruling 200541033, the Service held that certain compensation is exempt from the Sec. 162(m) $1 million deduction limit under the commission-based exception of Sec. 162(m)(4)(B). This is the first ruling to consider this exception; thus, it provides insight into a rule that had previously existed without guidance.

Background

In general, Sec. 162(m)(1) limits the deduction for "applicable employee remuneration" (i.e., compensation) paid by a publicly held corporation to a "covered employee" to $1 million per year. Under Sec. 162(m)(3), "covered employee" refers to the chief executive officer and the four other most highly paid corporate officers listed on the proxy for Securities and Exchange Commission purposes, and who are serving as officers on the last day of the tax year.

However, there are a number of exceptions to the Sec. 162(m) limit. The most-used exception is for "performance-based" compensation, which is available for compensation paid only on the attainment of certain pre-established, objective performance goals; see Sec. 162(m)(4)(C). Regs. Sec. 1.16227(e) provides an extensive and detailed list of requirements to qualify.

Compensation paid on a commission basis is also exempt, under Sec. 162(m)(4)(B). However, the statute does not define commission-based payment for this purpose, nor does the regulation offer guidance on a "commission." Regs. Sec. 1.162-27(d) simply states:

The deduction limit ... shall not apply to any compensation paid on a commission basis. For this purpose, compensation is paid on a commission basis if the facts and circumstances show that it is paid solely on account of income generated directly by the individual performance of the individual to whom the compensation is paid. Compensation does not fail to be attributable directly to the individual merely because support services, such as secretarial or research services, are utilized in generating the income. However, if compensation is paid on account of broader performance standards, such as income produced by a business unit of the corporation, the compensation does not qualify for the [commission-based] exception.... (Emphasis added.)

Since the enactment of Sec. 162(m) in 1993, and the promulgation of final regulations in December 1995, there has been no court decision or authoritative IRS guidance further interpreting or elaborating on any aspect of Sec. 162(m). In addition, although the IRS has issued many letter rulings under Sec. 162(m), none has ever addressed the commission-based exception.

Ruling

Facts: In Letter Ruling 200541033, an employee worked for a publicly traded executive placement firm. The firm received fees for conducting executive searches for clients. As described in the ruling, the firm received a cash fee and, in some cases, was also entitled to an "equity fee" which typically consisted of warrants on a client company's stock. The executive searches were performed by a group of consultants working together as a team. If the firm received an equity fee, it converted it to cash as soon as possible, then paid it out to the consultants on the team. Each member's share of the equity fee was allocated according to a pre-determined formula.

According to the ruling, as a direct result of one of the employee's efforts, a client hired the search firm to fill an executive position. The employee was a member of the placement team for the client. The search was successful and resulted in the payment of a cash fee and an equity fee in the form of warrants on the client's stock. When the warrant was exercised, the employee received his share of the equity fee under the predetermined formula. By the time this fee was received, the employee was a covered employee for Sec. 162(m) purposes.

Holding: The Service ruled that the portion of the equity fee payable to the employee qualified for the Sec. 162(m)(4)(B) commission-based exception.

Significance

In addition to being the first of its kind, the ruling shows it is possible for compensation to qualify for the commission-based exception when team performance is involved. Regs. Sec. 1.162-27(d) indicates that the commission-based exception applies only if compensation is paid based on the executive's individual performance. By contrast, compensation payable as a result of company-wide performance or the overall performance of a defined business unit does not qualify for the exception. The ruling does note that there were "individual efforts" on the part of the executive in question, even though there was a project team, thus implying that the commission-based exception can apply when compensation is paid to team members for a discrete project, when there are clearly delineated roles (although the ruling is not explicit on this point).

The ruling does not specify the executive's "individual efforts." Sufficient individual efforts in a particular situation might consist of making a sale or creating a relationship. If these efforts are viewed as individual performance, an employer might be able to design a structure that provides executive compensation measured by revenues generated from relationships created. The ruling shows that it might be possible to compensate executives for their individual roles in generating business, and to use the commission-based exception to do so. This exception has not typically received serious consideration by most publicly held companies.

The commission-based exception may be easier to qualify for than the more commonly used Sec. 162(m) (4) (C) performance-based exception. Regs. Sec. 1.162-27(e) contains numerous requirements, making planning and monitoring important to protect against inadvertent failures. Although the commission-based exception is narrower than the performance-based exception, it does not require compliance with myriad procedural rules.

Recommendation

A letter ruling applies only to the taxpayer requesting it. Given the relative lack of guidance on the commission-based exception, a publicly held corporation should seek its own ruling if it believes this exception applies.

FROM THOMAS R. PEVARNIK, JR., J.D., LL.M., AND MICHAEL A. HABERMAN, J.D., LL.M., WASHINGTON, DC