The “Hidden” Tax Cost of Executive Compensation

Kobi Kastiel is Assistant Professor of Law at Tel-Aviv University; and Noam Noked is Assistant Professor of Law at The Chinese University of Hong Kong. This post is based on their recent essay, published in the Stanford Law Review Online.

Related research from the Program on Corporate Governance includes Executive Compensation at Fannie Mae: A Case Study of Perverse Incentives, Nonperformance Pay, and Camouflage, and Stealth Compensation Via Retirement Benefits, both by Lucian Bebchuk and Jesse Fried; and Executive Pensions by Lucian Bebchuk and Robert J. Jackson.

The sweeping tax reform enacted in December 2017 will significantly increase the tax cost of executive compensation in many publicly held corporations where the compensation for each of the top five executives exceeds $1 million. Nonetheless, it is unlikely that these corporations will reduce the executive compensation to offset the increased tax cost, which will likely be shifted to public shareholders.

In our Essay, The ‘Hidden’ Tax Cost of Executive Compensation (forthcoming in the Stanford Law Review Online) we show that this significant tax cost is not transparent to shareholders. Our analysis of a hand-collected dataset of relevant proxy statements that were filed in the first fifty days after the enactment of the tax reform reveals that companies do not provide their shareholders with sufficient information about the tax cost of executive compensation. Therefore, there is a need for a prompt regulatory response. To make the tax cost of executive compensation fully transparent, we propose that the Securities and Exchange Commission (SEC) should adopt new disclosure requirements, outlined in this Essay, as soon as practicable. The disclosure of the tax cost of executive compensation would significantly improve the accuracy of investor information regarding the overall cost of executive compensation, and it could enhance shareholders’ ability to scrutinize compensation practices, all while imposing minimal compliance costs upon companies.

Below we provide a more detailed account of our analysis:

Under section 162(m) of the Internal Revenue Code, a publicly held corporation cannot deduct from its taxable income executive compensation exceeding $1 million to the chief executive officer (CEO), chief financial officer, or the other three highest-paid executive officers. Although the $1 million deduction cap was originally enacted by Congress back in 1993, it was easily avoided by structuring remuneration as performance-based compensation or deferred post-employment compensation, which were exempted from the deduction limitation under the old section 162(m). For example, although the median pay for CEOs of public companies included in the S&P 500 was $10,817,000, the base salary of these CEOs constituted only 11.3% of their overall compensation in 2016, and therefore the tax cost under the old section 162(m) was relatively small. The Tax Cuts and Jobs Act of 2017 (TCJA) repealed these widely used exemptions and is expected to significantly increase the tax cost of executive compensation in a large number of public companies.

Theoretically, public companies could reduce or completely avoid the tax cost under section 162(m) by reducing executive compensation in excess of $1 million. However, it is unlikely that companies will voluntarily adopt this approach. Many of them will likely argue that to attract and retain top managerial talent, they must incur the higher tax cost without reducing compensation levels. Indeed, partners from the leading law firm Wachtell, Lipton, Rosen & Katz expressed in a recent article their thoughts about companies’ expected reactions to the amended section 162(m): “This change will result in a significant increase in disallowed tax deductions. Nevertheless, we expect that companies will accept this result as a necessary consequence of the competitive marketplace for talent.”

Under the current SEC disclosure rules, shareholders will not be able to learn the actual cost of the disallowed deductions under section 162(m). This is because companies are not obligated to report the magnitude, or quantify the actual costs, of the disallowed deductions. All that is required of companies is to disclose “[t]he impact of the accounting and tax treatments of the particular form of compensation.” To meet this requirement, companies could verbally describe in very general and broad terms the rules under section 162(m) and their potential implications, without providing any quantification of the disallowed deductions. Of course, this does not necessarily have to be the case. Companies could go beyond the minimal disclosure requirements and provide a detailed account of the disallowed deductions under the amended section 162(m).

To ascertain what information companies have furnished to their shareholders in the first fifty days following the enactment of the TCJA, we analyzed a hand-collected dataset of all proxy statements with disclosures regarding the amended §162(m) that were filed with the SEC by companies that paid one or more of their executives more than $1 million in 2017. Our dataset comprises fifty-eight companies, including some high-profile ones, such as Apple, Tesla, Disney and Viacom.

Our analysis shows that none of the companies that had disallowed deductions in 2017 disclosed information about the quantum of their disallowed deductions. Notably, companies only provided a verbal description of the rules of §162(m), and whether specific compensation schemes were designed to qualify for the exceptions of the old §162(m). Most companies (86%) stated that they might grant nondeductible compensation if doing so is in the best interest of the company and its shareholders. These companies typically noted that the nondeductibility of the compensation is only one of the factors taken into consideration. Equally important, none of the companies indicated that it would consider decreasing the executive compensation because of the increased tax cost.

As the tax cost becomes more significant under the amended section 162(m), the information concerning the quantum of this cost will become more important for shareholders. Nonetheless, as our analysis reveals, companies will likely continue the current practice of providing only a verbal discussion of the rules under section 162(m).

In the last part of our Essay, we discuss the implications of our findings for policymakers, and present the case for making the tax cost of executive compensation more transparent. In particular, we explain why shareholders are unlikely to be able to estimate the tax cost of executive compensation by themselves and why it is more efficient for the company to disclose this information. As companies know the exact disallowed deduction and the tax that would have been saved if the expenses were deductible, disclosing this information would entail no additional costs. We also note that disclosure rules already require companies to disclose the amounts of tax reimbursements and gross-ups concerning golden parachutes and other personal benefits. Similar to the disclosure of tax-reimbursements and gross-ups, the tax cost of disallowed deductions under section 162(m) should also be fully transparent.

As outlined in the Essay, the disclosure should be made in two parts of the proxy statement: in a new column in the Summary Compensation Table, and in the part of the proxy statement that currently discloses the impact of the accounting and tax treatments of the particular form of compensation. The SEC may also consider making it obligatory for firms to disclose the increase in the overall tax cost from disallowed deductions under section 162(m) in comparison to 2017.

It is important to note that our proposal is not merely a technical amendment to the company’s proxy statement. The exclusion of tax cost from the analysis of executive pay might lead shareholders to underestimate the actual costs of executive compensation. By correcting such misconceptions, these disclosure requirements might enable shareholders to scrutinize compensation arrangements more effectively, and, if necessary, press companies to reduce their compensation levels or adopt other arrangements that are better aligned with the interests of shareholders.

The case for requiring the disclosure of the tax cost of executive compensation is compelling, and there is no reasonable basis to oppose such disclosure requirements. The SEC should consider amending the disclosure rules in 2018 so that the proxy statements filed in 2019 will include this information.

The complete Essay is available for download here.

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