Wednesday, April 6, 2011

Executive Compensation and the Tax Code -- the Knot that Won't Untie

Do you remember when a company could pay an executive what it wanted to? Do you remember when the market decided how much a company would pay its executives? It wasn't that long ago. There weren't a lot of rules.

So, what happened? Things got out of hand. You can place the blame where you like. You can put it with executive compensation consultants, and surely, there is a group of them (not all of them) that deserve a lot of the blame, as everyone in the industry knew that a key to getting a new engagement was promising a company's management that you could get them more. You can blame it on Compensation Committees, as they didn't seem to care how much their company's executives got so long as a consultant could support it. You could even choose to blame it on me, although that would be misguided.

And, then what happened? Congress found a new whipping boy so to speak. The first key change was when they decided that deferred compensation should be subject to FICA tax. In a vacuum, this is probably the correct thing to do within the context of public policy. Your wages should be subject to a payroll tax (taking the broad leap of faith here that a payroll tax is appropriate) in the year that you earn them to some reasonable degree of certainty. What was the problem with that? I don't think that Congress actually knew what they intended. Did they really mean to FICA tax company-provided nonqualified plans? I bet they didn't know. In 1983, it probably didn't matter. The Social Security Wage Base applied equally to the OASDI (old age, survivor, and disability) portion of FICA and to the HI (Medicare) portion. It wasn't until much later that they pay cap on HI taxes was removed.

Then came Code Section 162(m). Congress decided that no disqualified individual (that's a fancy term for the people they are targeting) should earn more than $1 million in a year. But, wait, suppose an executive performed really well. That might merit more pay. So, performance-based compensation was exempted from Section 162(m), so long as whoever crafted the plan got the design just right. Companies found ways to skirt this one pretty easily.

And, then came the nightmare before Christmas, Code Section 409A. I've written about it here many times before. The worst thing is that it was part of a jobs bill, the American Jobs Creation Act of 2004. If you don't work in this area or if you have been living under a rock, I'll give you the brief summary of how Section 409A creates jobs.


It places additional 20% income taxes on nonqualified deferred compensation that doesn't meet some of the most convoluted rules that even the Treasury Department has ever come up with. And, what is worse, the more time that passes, the more problems that are uncovered with respect to plans subject to 409A ... all in the name of creating jobs.

Well, I have done a detailed statistical analysis (remember, I'm an actuary and I have training in this area), and I have determined with a particularly high confidence level exactly how many jobs were created (outside of government jobs to regulate and enforce this mess and attorneys to find ways around it) by Section 409A.

Zero. Zilch. Nada.

But, it has taken some perfectly innocent plan designs and made them seem like they were created by scoundrels the likes of which even Gordon Gekko has never seen. Imagine this: suppose that an employer provides its CEO with restricted stock units (RSUs). And, further, suppose that the restrictions lapse (the units vest) after 10 years, or after bona fide retirement on or after age 65. Lots of critics think that this is a desirable design of an executive compensation program. It ties executive compensation both to company stock performance and to the executive staying with the company.

Oops, the fact that the RSUs could vest upon retirement (seems innocent enough to me) makes the plan subject to Section 409A, and as often as not, nobody worked this out in advance, so the plan fails to comply with Section 409A and there are draconian tax penalties on the executive ... all because the company thought it was fair that he or she should have access to his or her earnings upon retirement from the company. The nerve of the CEO!

Excuse me, the nerve of Congress.


  1. Then imagine your deferred compensation plan is also subject to 457(f) and the IRS hasn't determined how the two sections will relate to each other.

  2. Ron, note that this blog hasn't tackled that one either. It's a good thing that Congress has infinite wisdom because the rest of us sure don't.