Should Congress Limit Executive Compensation?

Stephen D Kirkland
September 2, 2008 — 1,588 views  
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Should Congress Limit Executive Compensation?

 

By Stephen D. Kirkland, CPA, CMC, CFC

Compensation of executives is one of the most controversial topics in American business today.  It is also one of the most complicated topics due to the broad nature of executive responsibilities and the difficulties involved in measuring one person's achievements. 

For example, many people feel that CEOs at publicly-traded companies have the opportunity to enjoy upside potential without risking the downside.  This means that they get big bonuses and large gains on stock options when business is good, but they do not have to reimburse any losses when their businesses perform poorly.  In fact, you may believe some CEOs get their biggest paychecks with poor performance, in the form of generous severance packages - in effect, getting paid millions of dollars without even having to work.

Although Congress has focused considerable attention on this controversy, they still have not limited the amount of executives' pay.

However, Congress has created a number of tax laws which limit deductions for executive pay under certain circumstances.  For example, under Internal Revenue Code section 162, companies are allowed to deduct only "ordinary and necessary" business expenses.  Unreasonably high compensation can be considered unnecessary and therefore non-deductible.  This issue usually comes up at closely-held businesses, where the IRS can convert unreasonable compensation into non-deductible dividends to the executives/shareholders.

At charitable organizations, Code section 4958 allows the IRS to impose a 25% excise tax on an employee or independent contractor receiving unreasonable compensation.  They can also impose a 10% excise tax on the directors or officers who permitted the overpayment.

At publicly-traded companies, Code section 162(m) limits the tax deduction for an executive's pay at $1,000,000 per year unless certain requirements are met.  However, there are significant exceptions.  One type of compensation exempt from this limitation is performance goal remuneration.  An executive can achieve performance goals set by the Board and be paid almost unlimited amounts which the company can deduct.  Examples of goals would be increasing the company's revenue to a pre-determined level and increasing one division's profits by a certain percentage during the year.  

There is another deduction limitation for publicly-traded companies.  Code section 280G limits a company's tax deduction for excessive severance payments.  These payments are often referred to as golden parachutes.  In essence, the executive enters into an agreement between the company and himself.  It provides that he will receive a substantial cash bonus if he loses his job due to a change in the company's ownership.  The idea is that if the company is acquired, in a hostile takeover for example, and the executive is terminated, he gets a generous severance package.  The rules are complex, but the Code basically says that an "excess parachute" is one that exceeds three times the executive's average pay for the preceding five years.  If the parachute exceeds that three-year average by even one dollar, section 280G states that the company cannot deduct most of the parachute payment.  Also, Code section 4999 imposes a 20% penalty on the executive who receives an excess parachute, in addition to all the regular taxes due on that income.

Numerous other Code sections impose limits on retirement plan contributions and other benefits.

Another powerful federal agency, the Securities and Exchange Commission, has long required publicly-traded companies to disclose compensation paid to top executives each year.  In 2006, the SEC began asking for publication of more details.  For example, they want disclosure of the specific performance goals that are set for these key officers, so investors can see more clearly what is expected of the executives and how they earn their paychecks. 

The U.S. House of Representative's Oversight and Government Reform Committee has looked into the role of compensation consultants in setting officer pay.  It would not be surprising to eventually see legislation prohibiting a company from using a compensation consultant whose firm provides other services for the company.  It is not difficult to see that a consultant could be tempted to recommend big bonuses for the officers who just paid his or her consulting firm millions of dollars.

Even with these deduction limitations, disclosure requirements and Congressional inquiries, CEO pay levels have reached new heights.  So, should the federal government set a maximum wage the way it has set a minimum wage?  Each company's Board of Directors is charged with governance of the company.  Managing executive compensation is part of that responsibility.  The Directors, and the shareholders, need to be the ones to control executive compensation and to ensure that the company gets a good return on that investment.  To do so, they must pay for performance which means setting goals which can be measured in the short term and correlating compensation to achievements.  Base pay, otherwise known as show-up pay, generally should be minimized.  The bulk of executive compensation should be incentive pay, which ensures that if the company does not get great leadership, it does not pay great bonuses.

Setting appropriate compensation levels for employees is complicated indeed, but it is part of managing a business. 

Stephen D Kirkland

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Stephen D. Kirkland, CPA, CMC, CFC is a compensation consultant with Atlantic Executive Consulting Group, LLC, based in Columbia, South Carolina. He helps businesses and tax-exempt organizations structure compensation plans for their executives. He also serves as an expert witness in U.S. Tax Court cases involving the reasonableness of executive compensation across the United States. He can be reached through www.ReasonableComp.biz .