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

• Author: Pevarnik, Thomas R., Jr.

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)...