Page 155 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 4. The Stakeholders 141

Year Rate

1944 25.0%
1969 35.0%
1978 28.0%
1981 20.0%
1986 *
1993 28.0%
1997 20.0%
2003 15.0%
2008 15.0
* Taxed at ordinary income rate
Table 4-21. Long-term capital gains tax rates

Dividends were traditionally taxed as ordinary income, but the 2003 Jobs Growth Tax
Relief Reconciliation Act lowered the tax to 15 percent from 2003 through 2008 (unless
changed by law).

Tax Effectiveness. In examining tax impact, it is appropriate to consider what is left after
taxes. This after-tax examination can be done for both the executive’s income and the com-
pany’s (after-tax cost). To the extent the executive’s after-tax value increases or the company’s
after-tax cost decreases, one has improved the after-tax effectiveness.
The company essentially has three situations with regard to a compensation expense: no
expense or a tax credit, tax deductible (fully or partially), and non-tax-deductible. The first
says either there is no out-of-pocket expense or the expense is a tax credit and therefore
reduces dollar for dollar its tax liability (truly a no-cost expense since the federal government
is paying the full charge). If it is tax deductible, it reduces the company income before taxes
dollar for dollar (here the federal government is a partner in paying the expenses). The worst
situation is when the expense is nondeductible for tax purposes. The company therefore
receives no tax assistance and bears the full expense of the payment.
The executive’s income can fall into one of six categories: not taxable; taxable but
100 percent deductible; taxable and deductible if above stated allowance; taxable above a
certain allowance; taxed as long-term capital gains; and taxed as ordinary income or short-
term capital gains. The combination of taxability to executive and tax deductibility to the
company is shown in Table 4-22. The attractiveness to the executive ranges from 1 (best) to
6 (worst) and for the company from A (best) to D (worst).
Table 4-23 shows the 24 possible combinations with examples. Not all combinations neces-
sarily will have possible applications. See combination 1C from Table 4-22, 1 (not taxable to the
executive) and C (partially tax deductible to the company). An additional factor is the timing of
taxation and tax deductibility. Non-tax-qualified deferred compensation cannot be taken as a tax
deduction by the company until the executive receives the income and has a tax liability.
Conversely, tax-qualified pension plans permit the company to take a tax deduction when a
contribution is made to the plan, while the executive is not taxed until the benefit is received.