Outside the Box: Why Washington’s tax plans for executive compensation are misguided

Tucked into the mammoth tax bills Congress is debating are two provisions that will increase the taxation of executive compensation and undermine related governance practices. Corporate directors and senior managers, take note.

For starters, the Senate bill would virtually eliminate the ability of a company’s employees to defer the taxation of their compensation. Both the House and the Senate bills would severely limit the ability of corporations to deduct awards of performance-based compensation to their top five officers.

My sense is that both provisions are likely to be adopted if Congress passes tax legislation. These two provisions together raise tax revenues of $25.5 billion over the next decade, as compared to a $1.5 trillion deficit the entire tax legislation addresses. But they are viewed as Washington being responsive to popular concerns about income inequality in America.

Read: Here are the winners and losers of the Senate tax plan

Currently, company employees at various levels often defer the receipt of some compensation, which is vested but held by the company for a specified number of years. The employees recognize taxable income in the year when they actually receive this deferred compensation, and the company’s deduction for this deferred compensation is postponed until the same year.

Many public companies require top executives to defer roughly half of their cash bonus as a risk-mitigation measure. Deferred bonuses could be clawed back if the company later determines that the executives had not deserved the bonus, for example, because of aggressive marketing practices, as happened at Wells Fargo WFC, +0.60%  . The deferral of cash bonuses also deters the departure of key executives, who would lose their deferred cash if they moved to a competitor.

Under the Senate bill, employees would be taxed on their compensation as soon as there is no “substantial risk of forfeiture.” According to the staff report on this provision, employees could not defer the taxation of their compensation unless they were required to supply substantial services to the same company during the years of deferral in order to receive that compensation.

This proposal, if adopted, would make it extremely difficult for any company to require top executives to defer receipt of a substantial portion of their cash bonuses. In that event, the executives would have to pay taxes immediately on their deferred bonuses, although the executives would not receive the cash for several years. Since the company would not be holding cash due to its executives, it would have to chase them down or sue them to get back any part of their prior bonuses.

At the same time, Congress would repeal the current exceptions for employee stock options, as well as other for other types of performance-based executive compensation, to the $1 million limit on a public company’s ability to deduct the pay of their top five executives. Other types of performance-based compensation would include awards of cash or company shares that vest only if the company meets pre-specified goals, such as increases in revenues or earnings over several years.

Because of these exceptions, public companies have shifted toward stock options and other forms of performance-based compensation, rather than immediate cash bonuses or stock grants that vest if executives simply continue to be employed by the company for a specified number of years. Corporate governance experts and large shareholders generally approve of this shift because then company executives reap large rewards only if both the company and its shareholders do well.

Nevertheless, the staff report of the House Ways and Means Committee points to this shift as justifying the proposed repeal of the exceptions for performance-based compensation. The report asserts: “This shift has led to perverse consequences as some executives focus on . . . quarterly reports (off of which their compensation is determined) rather than on the long-term success of the company.”

This assertion is plainly wrong. The performance targets for contingent cash payouts and stock grants typically extend for periods of several years. Similarly, stock options usually vest over several years. If Congress really wants to encourage company executives to take a longer-term perspective, it would require them to hold half of their restricted shares after vesting, and half of the shares they acquire through the exercise of their options, for five- to 10 years.

Yet I doubt that most public corporations will substantially reduce the amount of performance-based compensation because it may no longer be tax-deductible. Performance-based compensation is strongly supported by institutional shareholders, who vote each year on advisory resolutions about the total compensation package provided by public companies.

In short, while both of the two proposals may not represent optimal tax or governance policy, they both seem to have significant support in the Senate. The House bill retains the proposal to limit the corporate deductibility of performance-based compensation, though the House recently dropped its proposal to tax deferred compensation. Nevertheless, this proposal may return in the Senate-House conference.

So corporate directors and senior managers should begin to develop strategies to deal with the implications of these two proposals. For example, to eliminate the mismatch between taxes due and cash received, a company might extend vesting periods to end when deferred cash would typically be distributed to employees. If a company wanted its executives to take a longer term approach, it should require that they hold on to half of their shares, acquired by the exercise of their stock options, for five or 10 years after that exercise.

Robert C. Pozen is a senior lecturer at MIT’s Sloan School of Management and chair of the Leadership Council at the Tax Policy Center.

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