IRS wants to tax golden
parachutes
Its proposal would
mean rewriting most pay contracts
February 25, 2008, Financial Week
A tax ruling last week by the Internal Revenue
Service could bring an end to the controversial practice of granting
golden parachutes to top executives who are pushed out amid
corporate failures.
Under a tax rule known as Section 162(m),
compensation of more than $1 million each to the CEO and three next
top-paid executives, excluding the CFO, is not deductible unless it
is performance-based, or tied to a target such as earnings growth.
While it’s not stated in the rule, the IRS for more than a decade
has permitted arrangements to be considered performance-based even
if they had a provision that allows for the payment or vesting of an
award—regardless of achieving a financial goal—upon the firing of an
executive without cause or as the result of a
resignation.
But in a reversal from previous interpretations,
the IRS has now decided that any compensation award—such as an
annual bonus, restricted stock or most other long-term incentive
plans, excluding stock options—that is part of an arrangement with
such a golden good-bye provision fails to qualify as
performance-based, and is therefore subject to the $1 million
deduction limitation for non-performance-
based pay. (The IRS
ruled that payments upon death, disability or change of control of a
company still may qualify as performance-based; retirement, however,
does not.)
“It’s sort of a chicken-and-egg problem here,”
explained Steve Root, managing director at compensation consultancy
Steven Hall & Partners. “The bad termination provision infects
the award before termination. So if you have terms in a contract
that say that in the event a guy gets fired by the company, we’ll
pay it out anyway regardless of performance, they blow the status of
the award being performance-based compensation.”
Had the new
IRS ruling been in effect prior to Stan O’Neal’s forced resignation
from Merrill Lynch last October—just a week after the investment
bank reported its largest-ever quarterly loss of $2.24 billion—the
former CEO might have walked away with significantly less than the
$161.5 million he received. This Thursday, Mr. O’Neal, former
Citigroup CEO Charles Prince and Countrywide Financial chief Angelo
Mozilo are being dragged before the House Committee on Oversight and
Government Reform for a hearing on the retirement and compensation
packages granted to the CEOs during the mortgage crisis.
Treasury Department spokesman Andrew Desouza explained that
older plans are grandfathered, so the new rule applies only to plans
beginning after Jan. 1, 2009.
The guidance from the IRS and
the Treasury Department was not at all what corporate tax lawyers
had hoped for. A coalition of 90 law firms last week sent a letter
to the IRS asking for a formal review of the issue, with the public
invited to comment on whether this new interpretation was
appropriate.
“The bad news is that they didn’t listen to our
arguments about the ruling being misguided,” said Andrew Liazos, a
partner in the law firm of McDermott Will & Emery. “The good
news is that the position will be applied prospectively, meaning
companies will have time to modify their plans.”
Because of
the uncertainties over what exactly constituted performance-based
compensation, lawyers and accountants were worried that the
predicted deductions of their corporate clients’ plans might not
meet the “more likely than not” recognition threshold under the new
FIN 48 accounting rule.
“People were really panicking
because of the impact the new rule would have on financial
accounting for companies that are carrying these tax assets,” said
Regina Olshan, head of compensation and benefits at law firm Skadden
Arps. “Companies that made these awards several years ago are
carrying tax assets that [had the IRS not made the ruling
prospective] couldn’t be counted as deductible. It could have led to
restatements.”
Going forward, it looks as though companies
will have to amend compensation policies and contracts for their
top-paid executives. One option, said Terrence Perris, a partner at
Squire Sanders, is that companies could base severance pay for the
year of an involuntary termination or resignation on the actual
financial results rather than target results. “The executive has to
wait until the end of the year,” he said, “and only receives the
award if the standards have been met.”
Another option,
suggested Mr. Root of Steven Hall, is to draft the employment
agreement to require that some minimal performance benchmark be met
in the year of the executive’s termination. “It can be in any
quarter of the year, and as long as that’s achieved we can go ahead
and pay you out pro rata,” he said. “It’s a special performance goal
attached solely to the severance situation.”
This is not the
IRS’s first revisiting of Section 162(m), which was created in 1993
with the intention of reining in executive pay but has arguably had
the reverse effect, ballooning compensation for top officers through
dramatically expanded use of stock options, stock grants, non-cash
compensation and other tools of the exec-comp trade over the past 15
years.
Last summer, when Section 162(m) was aligned with new
Securities and Exchange Commission compensation-disclosure rules,
the IRS decided that it no longer covers compensation for CFOs. In
theory, that interpretation allows boards to set CFO pay at any
level they choose without worrying about the tax implications. Many
tax experts still believe Congress may amend that ruling (See “New
Tax Loophole May Open Pandora’s Box for Exec Pay,” FW, July
16).
Meanwhile, Charles Grassley, the ranking Republican on
the Senate Finance Committee, has floated the politically appealing
idea of simply eliminating the deduction for compensation in excess
of $1 million.
“You can’t ignore the fact that the IRS is
looking to audit Section 162 much more closely, and so they do see
that they could raise some revenue out of it,” said Mr. Root.
FW
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