Section 162(m): the Bonus Break (May 10)

Mike & Co. —

April showers in May provides an excuse for a tax focus this week.  How many know that the federal tax code had a provision allowing large firms to write off the bulk of their executives’ wages?  Section 162(m) of the Code has a loophole letting “performance-based” compensation to be claimed as business expenses, costing U.S. taxpayers $5 billion per year (per the JCT).

Half the Senate Democratic caucus has now supported a legislative effort to close the “Bonus Break,” which is easier to grasp than the carried interest loophole and twice as expensive.  

More below.  More on carried interest tomorrow. 

Best,

Dana

———

Performance Incentive or Tax Dodge?

Large companies able to take advantage of Section 162(m) and deduct all “performance-based” compensation packages from a business’ tax liability as a business expense.  That same section of the Code limits the tax deductions for regular salaries to $1 million, but only for the CEO and the next four highest paid officers.  These are the “covered” employees comprising the beneficiaries of the loophole.

Instead of putting an end to galloping CEO salaries, as it was intended to do, Section 162(m) set a floor for executive compensation at $1 million annually, plus any and all bonuses, stock options, or other “performance based” payments a CEO could desire.  While 162(m) does contain four statutory requirements for compensation to qualify as performance based, Congress has already declared that any stock option given to a CEO must be performance based per se.

The massive increase in executive pay seen in the past two decades is probably not a coincidence.   Between 1978 and 2013 CEO compensation has increased by 937 percent; in 1995 the CEO-to-worker compensation ratio was 122.6-to-1 (up from 30-to-1 in 1978) and by 2013 was 296-to-1.

The Current Criteria

A performance-based compensation package needs to meet four criteria to qualify for 162(m) treatment:

•   Performance Goals:  the compensation must be contingent on meeting one of more “pre-established” and quantifiable performance goals

•   Compensation Committee:  the goals must be set by the corporation’s compensation committee

•   Shareholder approval:  shareholders must hold a separate vote to approve the compensation terms, including the applicable goals and the total maximum amount payable to a covered employee, before the compensation package is paid

•   Committee Certification:  before any payment, the compensation committee must certify, in writing, that the performance goals were met

In theory, these requirements set out a minimum level of due diligence for companies to follow when assigning CEOs a performance-based compensation package, but in practice little of it matters.  Since stock options are considered performance-based per se, the simplest solution is to make a sizable amount of any executive’s performance-based pay based on that form — a loophole built into a loophole.

Ending the Corporate Bonus Break

The break had faced criticism from both sides of the aisle.  Sens. Reed and Blumenthal introduced the Stop Subsidizing Multimillion Dollar Corporate Bonuses Act in 2013.  Rep. Lloyd Doggett introduced the companion House bill the next year.  These bills would have recovered the full $50 billion which is lost over 10 years to the loophole.  Former GOP Ways and Means chairman Dave Camp targeted the break in his 2014 tax reform proposal, indicating Section 162(m)’s legislative vulnerability.

The loophole has long been a point of contention in government.  In 2007 the SEC announced it would issue a rule concerning executive pay disclosure, pay if an attempt to shame companies into lowering pay packages. Some expected a democratic surge after Bush left office to take care of the matter once and for all, but 162(m) has survived, due to defense by beneficiary firms.

Criticisms Fall Flat

Lobbyists for these firms have long said that the government has no right to dictate how much firms pay their executives. This argument is not a serious one.  The proposals to deal with the performance-based pay loophole don’t limit firms’ ability to pay CEOs, or any other covered executives.

Will the best executives have less incentive to work if companies lower their pay in the face of higher taxes?   This relies on the (idle) speculation that companies will punish executives for the closing of the bonus loophole.

Chances in Congress Today

Not high.  But the proposal scores many pinball points, hitting on several of the most resonant issues in the political campaign — big corporations (sounds kinda like Wall Street) profiting off a special bonus break for rewarding their top bosses…. Voters oppose this section of the Code by nearly 2 to 1 (63-34) when asked about it.  Corporations should be free to pay their CEOs whatever they choose but asking taxpayers to subsidize those salaries is a non-starter in 2016.  It may be history by next year.

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