Page 157 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 4. The Stakeholders 143

Table 4-24 shows possible tax rates on company income. A tax rate of zero is equivalent
to a nondeductible item since the government underwrites no portion of the expenditure.
Conversely, a tax rate of 100 percent will be comparable to a full reimbursement by the
government, only because all the income is turned over to the government. In more typical
situations, if the federal tax were 40 percent, the after-tax or net cost to the company would
be 60 percent of the expenditure. As company taxes increase, it is less expensive to make tax-
deductible expenditures, and the reverse is also true. As taxes on company income decrease,
it becomes more expensive for such outlays. Conversely, as individual tax rates increase on
ordinary income, executives seek alternative forms of pay taxed at lower rates.
Company

Tax rate 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Net cost 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

Executive

Tax rate 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Net income 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

Table 4-24. Tax rate effect (net income vs. net cost)
The executive’s after-tax value is dependent on the manner in which the expense is taxed.
In the best situation, it either is not taxed or, if taxable, is fully tax deductible and therefore
cancels itself out (i.e., the amount is entered as income, but income is then reduced by the same
amount). The next best situation is long-term capital gains (i.e., property held longer than a
year), where the gain is taxed at a rate lower than the tax on ordinary income. In addition to the
capital gains tax, which may lower the tax paid (because it usually is less than the ordinary
income tax), there are several situations that will affect tax effectiveness. First is the earlier
described alternative minimum tax (AMT), which increases the individual’s tax rate (thereby
lowering his or her net income). The second is capital gains, which increases the recipient’s
after-tax value (as it is taxed at a lower rate) but is not deductible to the company. The third
is a limit on the amount of compensation that is tax deductible to the company. It thereby
increases the after-tax cost to the company. One such limitation is described in Section 162(m)
of the IRC. Enacted in 1993, it imposes a $1 million limit on tax-deductible compensation to
the chief executive and the next four highest-paid officers of a publicly held company.
Excluded from the $1 million limit are:
• Commissions
• A shareholder-approved stock option plan that specifies individual grant limits and is
administered by a committee of independent directors
• Performance-based compensation when:
– the compensation committee of the board of directors establishes objective
performance goals
– the performance goals and other material terms are approved by shareholders
– the compensation committee certifies that the performance goals and other
material terms have been met before payment is made