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  From last wks



Executive Compensation Reform and the Limits of Tax Policy

Michael Doran

Published: November 23, 2004
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The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.

Note: This report is available in its entirety in the Portable Document Format (PDF).

Executive Compensation Reform and the Limits of Tax Policy

Congress recently enacted its most significant effort in decades to reform executive deferred compensation. The new legislation rewrites the tax rules for billions of dollars that corporate managers defer outside the tax-qualified pension, 401(k), and other retirement plans that cover rank-and-file employees. But the legislation misses the mark for effective reform. It does little to address the long-standing improper tax subsidy for certain deferred compensation arrangements. Compounding matters, the legislation follows previous misguided efforts to regulate corporate governance through the tax code, almost certainly leaving shareholders worse off for the effort. In short, Congress not only let slip away an opportunity for meaningful tax policy reform, but it also took a large step backward on corporate-governance policy.

Corporate scandals over the past several years apparently jarred legislators out of the complacency that had prevailed among them since 1978, when they imposed an indefinite moratorium on deferred compensation rule-making by the Treasury Department and effectively froze the law for executive pensions, long-term incentive plans, and other types of nonqualified deferred compensation.1 Suddenly aware of the aggressive arrangements that many corporations and their managers developed under the protection of the moratorium, Congress passed the new rules for deferred compensation as part of the American Jobs Creation Act of 2004 (AJCA).2

The new rules likely will trigger structural changes to most (if not all) deferred compensation arrangements in the United States. Additionally, the effective date will present very complex transition issues, potentially resulting in high adjustment costs.3 However, among the most intriguing aspects of the legislation are the tax consequences of not complying with the new rules. Those consequences can be separated into two distinct parts. First, the new legislation imposes accrual-based taxation on corporate managers whose deferred compensation arrangements fail any of the new rules. Second, it imposes a flat 20 percent surtax on managers covered by such arrangements. The legislation makes no change to the tax treatment of companies providing deferred compensation, generally allowing them to deduct currently the amounts included by the managers.

This two-part scheme represents an ineffective and misguided approach to deferred compensation reform. Rather than pursue the proper tax policy goal of strict neutrality between current and deferred compensation, the legislation attempts to discourage particular forms of deferred compensation by shifting taxation of investment earnings on the deferred compensation from the company to the manager. The result is only weakly related to appropriate tax policy objectives. More important, managers in many cases are likely to reallocate the cost of accrual-based taxation back to their companies, making the after-tax costs to shareholders of providing deferred compensation no less than under prior law. Similar reallocation from managers to their companies may also occur for the 20 percent surtax, potentially resulting in higher after-tax costs to shareholders.

A better tax policy approach would have been to eliminate any preferences and dispreferences for deferred compensation by enacting straight accrual-based taxation of corporate managers. That approach would close gaps in the law that confer a tax subsidy on certain deferred compensation arrangements and would provide more straightforward and transparent results than will the new legislation. For arrangements that do not currently exploit the gaps in the law, this approach would not increase shareholder costs. Any broader reform of deferred compensation would require basic changes in corporate governance outside the tax law.

Notes from this section

1. Section 132 of the Revenue Act of 1978. Nonqualified deferred compensation does not include taxqualified retirement vehicles, such as 401(k) plans.

2. The new deferred compensation rules are set out in section 885 of AJCA and generally are codified at new section 409A of the Internal Revenue Code (the Code).

3. The deferred compensation rules in AJCA generally apply to amounts deferred after December 31, 2004 [AJCA § 885(d)(1)]. Amounts deferred before January 1, 2005, will be subject to the new rules if the plan providing for those deferrals is "materially modified" after October 3, 2004 [AJCA § 885(d)(2)(B)]. Hill staff have suggested that the grandfather for amounts deferred before January 1, 2005, was intended to apply to certain of the new rules but not to others—a result plainly at odds with the statute that Congress enacted.

Note: This report is available in its entirety in the Portable Document Format (PDF).