Page 160 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

146 The Complete Guide to Executive Compensation

and stock awards are examples. “Moderate” is because it is taxed at more favorable assessment
valuation. “High” is when the item is not taxed or taxed at more favorable rates (e.g., capital
gains). Tax effectiveness is not to be confused with the effective tax rate. The latter is the total
tax paid divided by total income, reflecting the percentage of income paid in taxes. Thus, with
total taxes of $300,000 on a $1,000,000 income, the effective tax rate would be 30 percent.
This in turn is different from the marginal tax rate, which is the tax rate in effect for the next
dollar of income. In a progressive tax structure, this would be ever increasing. Needless to
say, executives look for legal ways to minimize taxes. This is tax avoidance, not to be confused
with tax evasion, which could result in prison time.
The lower the tax effectiveness rating, the more attractive it is to revenue collectors.
Amazingly, some legislators still have not recognized that it is not simply the tax rate levied
on the individual’s income that affects tax revenue. It is the spread between the rates on
taxable income to the individual and the employer. The effect is illustrated in Table 4-27.

Tax Rate
Executive 50% 40% 30% 20%

Employer 35% 35% 35% —
Revenue Gain 15% 5% (5%) 20%
Table 4-27. Tax collector’s net gain

Note that the government is better off with a low 20 percent tax on executive income
when there is no offsetting tax deduction than with a higher 50 percent rate that is tax
deductible to the employer who pays a 35 percent rate. To illustrate, if the executive receives
additional ordinary income of $1 million (taxed at 50 percent), the individual will pay
$500,000 in taxes; however, the employer will take the $1 million as a tax deduction (there-
by lowering the company’s taxable income by a like amount) and save $350,000 in taxes. Net
effect: government tax revenue of $150,000. But if all $1 million were long-term capital gains
(taxed, say, at 20 percent), the tax collector would net $200,000 because the company would
have no tax deductions.
In addition to direct pay (or fair market value for such things as stock awards), executives
must be familiar with several taxable situations described more fully in Chapter 3, especially
constructive receipt, economic benefit, and imputed income. Constructive receipt occurs when
the executive had the right to take the pay currently but chose to defer it or to accept it in
some other form. Simply turning one’s back on the offered compensation is not sufficient to
avoid constructive receipt (i.e., being taxed as if it were received). Economic benefit is closely
allied with the doctrine of constructive receipt, but it is usually invoked when the company
funds a future payment to the executive through an insurance contract or trust. In these sit-
uations, the individual will be taxed on the annual value of the employer contributions, even
though the principle of constructive receipt was not invoked because the risk of forfeiture has
been removed. Imputed income occurs when the value of a service is estimated (e.g., personal
use of corporate aircraft). The value may be the actual cost to the company or, in some
instances, the value of a comparable service through other means (e.g., the cost of first-class
commercial air-fare).