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Much of the material below is used, with permission, from the updated and revised edition of Ellig's best sellerThe Complete Guide to Executive Compensation.
While some may think that executive pay is unchecked, limited only by what greedy executives can extract from their employers, such is not the case. First and foremost, pay of the company’s top executives is set by a committee of the board of directors. For publicly traded companies that is not a nicety; it is a requirement. Additionally, several regulatory bodies impact the form and level of executive pay significantly.
At the federal level the Securities and Exchange Commission (SEC) defines what executive pay items must be disclosed to shareholders and/or filed with the SEC. The SEC also has oversight responsibility for financial accounting, currently more directly controlled by the Financial Accounting Standards Board (FASB), a privately funded organization that promulgates rules on financial accounting to be followed by organizations and independent financial auditors. And of course, there is the Internal Revenue Service (IRS), which interprets the Internal Revenue Code (IRC) laws passed by Congress. Let’s review some of the key points.
A few key SEC rules worth remembering are:
• 16(a) defines company “insiders” and electronic filing requirements to the SEC.Form 3—Beneficial ownership filed within 10 days upon attaining insider status.Form 4—Changes in beneficial ownership filed within two business days of the event.Form 5—Annual statement of changes in beneficial ownership not reported on Form 4 or correction to Form 4, filed within 45 days of the end of the fiscal year.
• 16(b) covers profits from purchase and sale.
• 16(b)3 covers exemptions. May 1991 ruling defined grant (not exercise) of a stock option as a purchase thereby making “cashless” exercises available, a significant advantage to execution.
• 10(b)5 other “insiders” defined.
The proxy statement requires detailed disclosure on the principal executive officer (PEO), principal financial officer (PFO) and next three highest paid executive officers, including tables for:
• Compensation—three year history of salary, bonus, stock awards, stock options, non-equity awards, change in pension and other deferred pay, all other compensation and a total of these items.
• Grants of plan-based awards including date of grant, estimated future payments of equity, number of shares and price for non-equity and all other awards and non-equity awards, as well as the number of shares/units of each along with the purchase price.
• Outstanding equity awards at fiscal year-end including number of options unexercised (separately for exercisable and non-exercisable along with the option price and expiration date of each). Similar information is required for stock awards.
• Option exercises and stock vested requires reporting the number of shares acquired upon exercise for the most recent fiscal year and similar information on stock awards received upon vesting.
• Pension benefits requires the name of each separate defined benefit pension plan, the number of credited years of service, the actual present value of such benefits and the dollar payments if any during the year to the executive.
• Non-qualified deferred compensation for the past year requires total contributions by the executive and separately for the company in addition to the aggregate earnings on the contributions, aggregate withdrawals, and aggregate balance.
Additionally, a compensation discussion and analysis (CD&A) report is to be filed with the SEC and included in the proxy. The SEC stated the report is to be in plain English and emphasize principles rather than process. It is expected to answer the following questions:
1. What are the objectives of the company’s compensation program?
2. What is the compensation program designed to reward?
3. What is each element of compensation?
4. Why does the company choose to pay each element?
5. How does the company determine the amount (and, where applicable the formula) for each element?
6. How does each element and the company’s decisions regarding that amount fit into the company’s overall compensation objectives and affect decisions regarding other elements?
Pay to executives, whether in cash or stock, is an expense to the company and is reflected on the income statement on the “general and administration” line in the “Operating Expense” section.
Until late 2004 not all stock plans were charged to the income statement. APB 25 and FASB Statement No. 123 permitted the exclusion of any income to the individual as an expense if the option price was the same as market price on date of grant and the number of shares optioned was known on that date. FASB Statement No. 123R changed that. It expanded on FASB Statement No. 123 and repealed the earlier Accounting Principles Board (APB) Opinion No. 25.
Using a present value model (such as Black-Scholes) the value of a stock option or stock appreciation right must be spread over the period of vesting (prior to becoming exercisable) as a charge to earnings. Stock awards would have the value of such awards on date of grant similarly spread over the period of vesting before the stock was released.
Most everyone is familiar with the ordinary income tax: It is the tax paid at the end of the year on cash compensation (or its equivalent). For most this includes salary and bonus. However, it also includes imputed income, income the executive receives that is not in cash or stock. Most of this falls in the category of executive benefits and includes the value of such things as personal use of company car, financial counseling and membership fees to airline clubs and other places.This progressive rate increases to a current maximum of 35 percent a year.
Additionally, the executive may be subject to tax preference income using an alternative minimum tax of 28 percent. Tax preference income is adjusted gross income plus non-taxed gains on incentive stock option (ISOs) exercises, non-taxed income from shelters and certain otherwise deductible items (such as medical expenses and state income taxes). Taxpayers must pay whichever is greater, the ordinary income tax or the AMT.
A more favorable tax to highly paid executives is the long-term capital gains tax. It is a flat tax of 15 percent a year on dividends and property held for more than 12 months. That held for less time is considered short-term capital gains and taxed as if ordinary income. Company stock meets the definition of “property”.
The company receives a tax deduction at time of, and the amount of, ordinary income to the executive. However, while companies get tax deductions on ordinary income paid and short-term capital gains on company stock, they do not get a tax deduction on dividends paid or long-term capital gains tax paid by the executive. For that reason, companies do not favor long-term capital gains opportunities for executives.
A further limitation on the amount of the company tax deduction is section 162(m) of the Internal Revenue Code. It states that a maximum of $1 million a year is allowable for each of those executives named in the proxy unless the payment is performance based, approved by shareholders, and administered by at least two independent members of the board of directors. If carefully done, all forms of equity (options and awards) in addition to cash compensation can meet the “performance based” definition and be tax deductible to the company. One of the more creative forms is the negative discretion formula. It is a commission plan (typically expressed as a percent of sales or net income) that will be payable to each proxy-based executive and is expensed at the maximum that will be paid. The compensation committee can pay less (but not more)—hence the term negative discretion.
If executives are deferring a portion of their income it is important they be aware of constructive receipt and economic benefit. Constructive receipt is when the IRS believes the executive pretty much knew the amount of payout before deciding to make a deferral. In this case the IRS will require the deferred amount be taxed currently even though received at a later time. Constructive receipt applies only to voluntary deferrals, not those mandated by the company.
Section 409A was introduced to the Internal Revenue Code in 2004 defining coverage for non-qualified deferred compensation plans. Final regulations are effective Jan. 1, 2008. Deferral decisions for covered plans are in compliance if the election to defer is made in the year before the year in which services are performed, or within 30 days after first becoming eligible or within six months prior to the end of a performance-based compensation plan of at least 12 months. Distributions can be made only for: separation from service, disability, death, date specified on election date, change in company ownership, unforeseen emergency causing financial hardship (with amount limited to the amount of the emergency need) or termination of the plan.
If the executive has successfully avoided constructive receipt the next test is economic benefit. This is when the IRS rules the executive stands ahead of general creditors on the unpaid amount. This would happen if the company placed the money in a trust, purchased an insurance contract, or in some other way assured the payment of the deferred amount. If so the IRS will determine an amount to be taxable currently.
To avoid having to take the employer to court for failure to pay the deferred amount, some opt to establish a rabbi trust. This is an unsecured promise to pay but it will be the trustee who will enforce the provision of the trust should there be a “change of heart” by the employer.
When the deferred amount is received it will be taxed as ordinary income. An exception would be if the deferral were in shares of stock and the executive made an83b election (section of the IRC) within 30 days of being informed of the award. In this situation, the person should be taxed at time of deferral at the current value of the stock and long-term capital gains tax on the increase in stock value when received. However, the person forfeits the paid tax if unable to collect the deferral. Furthermore, companies are not required to allow executives to make an 83b election or even to defer income.
The 20th century saw the introduction of personal income taxes (1913) and the SEC (1934) with responsibility to ensure that investors had sufficient information to make an informed decision to buy, hold or sell a company’s stock. This responsibility has been manifested in disclosure requirements for at least the PEO, PFO and three other named executives in the proxy, as well as a level playing field on financial reporting. What lies ahead in this century is unknown but almost assuredly it will mean more, not less, regulations dealing with executive pay.
It is therefore critical to engage appropriate professionals to stay abreast of developments. This article is not intended to provide legal, accounting or other professional service. For such service appropriate professionals should be sought out.
Bruce Ellig is the noted author of over 90 articles and 7 books including his most recent, the updated and revised edition of the classic best seller,The Complete Guide to Executive Compensation. Ellig served as worldwide head of HR for Pfizer Inc. for the last 11 years of his 35 years with the company. He is a member of the National Academy of Human Resources and the recipient of many lifetime achievement awards including those from SHRM and WorldatWork.
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