Tax Penalties on Executive Compensation: Is the Cure Worse than the Disease?

• Author: Joy Sabino Mullane
• Position: Associate Professor, Villanova University School of Law
• Pages: 15-18

B u s i n e s s L a w B r i e f | S p r i n g / S u m m e r 2 0 1 0 1 5

For the past year or so the media has been focusing its atten-

tion on executive compensation packages, as it is wont

to do during times of economic turmoil.

1

The focused

media attention inevitably gives rise to public resentment, which

prompts government officials to decry the lavish pay and benefits

executives receive and to threaten legislative action to curb such

excesses. These days, the threatened action usually involves the

use of Congress’s power to tax.

The tax code is frequently used as a vehicle for influencing

non-tax behavior.

2

In the executive compensation context, the

goal is to discourage companies from offering, and executives

from receiving, certain types or levels of compensation. Congress

does this by altering what would otherwise be the normal operat-

ing tax rules to increase the after-tax cost of engaging in certain

executive compensation practices.

3

In other words, Congress

wants to make the targeted compensation cost-prohibitive for the

company and the executive. The two primary methods Congress

uses to accomplish this are disallowing or limiting a deduction

that would otherwise be allowed, and imposing additional taxes.

4

At first blush, imposing tax penalties on executive com-

pensation certainly seems like a good way for Congress to “do

something.” The penalties appear to target executives, and their

compensation, rather precisely. The reality, though, is that they

are ineffective and cause indiscriminate injuries to a wide swath

of Americans, as will be shown below.

TAX PENALTIES AND GOLDEN PARACHUTES: A

CASE STUDY

Take, for example, Congress’s first attempt to directly

regulate executive compensation via tax penalties: the golden

parachute provisions.

5

Golden parachute agreements became a

very popular component of an executive’s compensation package

during the early 1980s as a by-product of heightened takeover

activity.

6

Congress, however, viewed large golden parachutes as

an undesirable business practice that should be “strongly dis-

couraged.”

7

In particular, Congress was concerned that sizeable

golden parachutes would (1) result in a target’s shareholders

being paid less for their stock in a takeover, (2) discourage poten-

tial buyers, and (3) encourage management to pursue a transac-

tion that was not in the best interest of the shareholders in order

to reap the financial rewards of a parachute.

8

To protect shareholders from these direct and indirect costs,

Congress enacted two tax penalty provisions: section 280G,

which applies to companies, and section 4999, which applies to

individuals.

9

In short, section 280G prohibits companies from

deducting a significant portion of any parachute payment if it is

greater than or equal to three times a base amount that is deter-

mined with reference to the executive’s annual taxable compensa-

tion.

10

The nondeductible portion is the amount of the payment

in excess of the base amount.

11

For example, suppose a corpora-

tion makes a parachute payment of $30 million to an executive

whose average annual taxable compensation is $10 million. In

that case, the excess parachute payment is $20 million and that

amount is not deductible by the corporation.

12

The cost to the company, here, is more than just the direct

costs of the parachute payment. The foregone tax savings that a

deduction would have produced implicitly makes the payment

more costly to the company than a payment that can be fully

deducted. Assuming the company is subject to a marginal tax rate

of 35%, a $20 million deductible payment would have reduced

the company’s tax liability by $7 million.

13

Because the excess

parachute payment is instead nondeductible, the amount of taxes

the company will owe will be increased. That, in turn, reduces

the company’s after-tax profits.

14

Section 4999, on the other hand, focuses on the employee

by imposing a nondeductible 20% tax on those who receive an

excess parachute payment.

15

Thus, if an executive receives a $20

million excess parachute payment, the tax due would be $4 mil-

lion. This amount is in addition to other taxes that are normally

due on compensation payments, such as income and payroll

taxes.

As contemporaneously predicted, companies wasted no

time in crafting arrangements around these new rules.

16

Some

companies increased executives’ annual taxable compensation,

17

which has the effect of raising the level at which section 280G

applies. Others provided additional compensation in lieu of the

protection traditionally offered by a golden parachute. Many

companies chose to purposely forego a deduction in order to

offer a golden parachute in excess of the 280G limit.

18

Signifi-

cantly, each of these alternatives ultimately increases the compa-

ny’s costs in providing the desired level of compensation. Of the

companies that choose to incur the 280G tax penalty, many agree

to reimburse an executive for the concomitant 20% penalty tax

Tax Penalties on Executive Compensation:

Is the Cure Worse than the Disease?

By: Joy Sabino Mullane†