Page 158 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

144 The Complete Guide to Executive Compensation

• Contract payments in effect prior to enactment
• Tax-qualified retirement plan contribution
• Employee benefits and perquisites not included in taxable income (e.g., health care)

Individuals leaving prior to the end of the year are not subject to the limit because the
law deals with individuals on the payroll on the last day of the year. Similarly, severance pay-
ments and nonqualified, deferred compensation are not subject to the limit. Not surprising,
Section 162(m) has increased the amount of compensation deferred to retirement age for
affected individuals. It is to the company’s advantage to do so and, therefore, some induce-
ment is provided to executives to make it attractive, such as giving an interest rate equivalent.
As indicated earlier, dividing the executive’s after-tax value by the company’s after-tax
cost gives one a measurement of the tax effectiveness of the form of payment. The higher the
value, the more tax effective the payment. Figure 4-5 illustrates the formula.

• ST Capital Gains or
Ordinary Income
• LT Capital Gains
• Dividends
• 100% Deductible
Executive’s After- • Non-Taxable
Tax = Tax Income
Effectiveness Company’s After-
Tax Cost
• Non-Deductible
• Partially Deductible
• 100% Deductible
• No-Expense

Figure 4-5. Tax effectiveness

The tax effectiveness range is from zero to infinity. A zero is the value when the recipient
is taxed at a rate of 100 percent on the income, resulting in a zero for the numerator. An
infinity value results when the company has no expense.
Table 4-25 allows one to determine tax effectiveness under a wide range of combinations.
This is especially helpful when individual rates may be different. For example, if the
company tax rate (CTR) is 40 percent and income on $200,000 is taxed at 50 percent, but at
$500,000 is taxed at 60 percent, the tax effectiveness (TE) calculations are 0.83 and 0.67,
respectfully. In other words, it is less tax effective at the higher income level.
For the same two executives, the tax effectiveness would be 0.85 for each on stock
dividends since they are taxed at 15 percent to the executive and are not tax deductible to the
company. The importance of salary not being a non-tax-deductible dividend to a small
company executive-shareholder is quite apparent. It must also not be deemed unreasonable
compensation by the IRS, for it would then move from 0.83 or 0.67 in the two examples to
0.50 and 0.40, since unreasonable compensation is not tax deductible to the company while
still taxable as ordinary income to the recipient. The IRS challenge is of concern to privately
held or closely held organizations, since the IRS view is that unreasonable compensation is
really a distribution of profits and, therefore, a dividend—which is not tax deductible.
To generalize, there are three levels of tax effectiveness: low, moderate, and high
(as shown in Table 4-26). “Low” means the full value is taxed at ordinary income rates: cash