Executive Compensation: How Much is too Much?

With the SEC requiring greater transparency with regard to executive compensation, many organizations — not just public corporations that are bound by SEC disclosure rules — have begun to rethink

Tax Implications of High Salaries and Benefits

Rather than have perks come under scrutiny by shareholders, or in other public forums, some organizations decide to simply pay higher salaries to executives.

However, different entities must be careful about paying salary and providing benefits that are considered “excessive” by the IRS because it can trigger an audit:

  • Not-for-profit organizations – In recent years, the tax agency has focused auditors on tax-exempt organizations that pay excessive compensation and perks to officers and other insiders.The IRS has also revised its tax form filing procedures to ask more questions about financial arrangements with officers, directors, trustees, highly compensated employees, and highly compensated independent contractors (including certain related parties). The questions, according to the IRS, “capture information about potentially abusive transactions” and help determine whether amounts paid are appropriate and consistent with exempt status under the tax code.When it comes to not-for-profits, the IRS can also evaluate “the independence of the governing body that approved the compensation.”
  • C corporations – If the compensation of shareholder-employees is deemed too high, or not “reasonable” under the circumstances, IRS auditors can make adjustments that result in double taxation. Why? Compensation is fully deductible if it’s considered “reasonable.” But if a salary is deemed too large, Uncle Sam can label part of the payments as “disguised dividends,” which are taxed twice — once at the corporate level and again at the personal level.In the course of an audit, fringe benefits are also inspected. In guidance to its auditors, the IRS states there are income and employment tax considerations with fringe benefits such as: Is the expense deductible by the business? Is the amount excluded from the executive’s gross income? Does the executive benefit personally? Do the benefits exceed tax code limitations?
  • Twelve benefits that IRS auditors scrutinize include:
Athletic skyboxes/entertainment suites Wealth management orretirement planning services
Awards/ bonuses Private jet use
Club memberships Relocation expenses
Corporate credit cards Spousal travel
Employer-paid vacations Transportation/ chauffeurs
Executive dining rooms Loans

the issue. Shifting public expectations are causing organizations to redefine how, and to what extent, executive initiative and leadership is rewarded.

At most organizations, base salary is merely the starting point of a compensation package. And as the executive compensation debate has raged on, two of the most noteworthy issues that have been brought under a microscope are severance pay and executive perks. There are numerous examples of excess when it comes to each type of compensation.

Executive Perks: A Bygone Cliché?

When the public learned of the many alleged transgressions of former Tyco CEO Dennis Kozlowski, one of the excesses that became symbolic of his reign was a video of his wife’s million-dollar, company-paid birthday party. Even Jack Welch, a public figure with a good reputation as an executive, came under public scrutiny when his perks from G.E. were revealed as a result of his divorce battle.

The public debate that has ensued since that time — along with SEC Disclosure Rules requiring certain types of benefits be declared as a form of compensation by public corporations — has caused many organizations to re-evaluate the breadth and depth of their policies.

The reconsideration of fringe benefits has been true for public corporations, private companies and not-for-profit organizations. The re-evaluation has run the gamut from considerable perks, such as private planes, to moderate perks, like country club memberships and company cars. It has even extended to a re-evaluation of mini-perks as well. For example, according to a proxy filed with the SEC in 2007, Cigna Corp. eliminated paying for executive memberships in a book-of-the-month club.

Executive Severance Packages: Going, Going, Gone?

Another compensation issue that has come under scrutiny — particularly with regard to public companies — is the escalation of executive severance packages.

When Bob Nardelli was ousted from The Home Depot, for example, he left with a severance package in excess of $200 million. Hank McKinnell of Pfizer received a payout of approximately $200 million.

These payouts are often negotiated as part of a benefits package prior to a CEO being hired. The above instances not only raised eyebrows, they raised the attention of the SEC, which now requires that potential severance packages for corporate executives to be detailed in proxy reports as a part of executive compensation disclosure.

In a letter to Berkshire Hathaway, Inc. shareholders, Chairman of the Board Warren Buffett made the following criticism:

“Getting fired can produce a particularly bountiful payday for a CEO…Forget the old maxim about nothing succeeding like success: Today, in the executive suite, the all too-prevalent rule is that nothing succeeds like failure.”

Such criticism may result in a trend toward downsizing severance packages.

Creating a Balanced Approach

When deciding what works best for your organization, keep in mind these examples of excess and try to strike a balance between rewarding leadership and having an executive compensation policy that will satisfy shareholders and/or the public at large.

An executive compensation policy should both attract the best talent possible while remaining defensible and rational.

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