tax policy

Reconciling U.S. Tax Policy on Executive Equity with the Public Interest

Posted by Jeff McCutcheon on March 28, 2013  /   Posted in Compensation Committees

taxesThere is substantial agreement between academics, policy makers and behavioral experts that executive ownership of company shares, particularly when those shares are held for an entire career (e.g., retirement plus 2 years for successor transition), is good for investors and the public.  Long-term equity ownership on the part of executives is viewed as a mitigant for excessive risk taking, providing financial accountability for risks taken over the course of a career that may not be reflected in annual bonus or salary decisions.  However, current tax law does not effectively extend to executives the same tax treatment afforded investors, nor does it encourage the type of ownership that can retard events such as those leading up to the recent financial crisis.

Gaps and inconsistencies in tax policy have contributed to much of the complication, obfuscation and negative unintended consequences in current executive pay arrangements.  Companies seek, often through overly-complex arrangements, to provide executives with the same tax treatment afforded investors.

The IRS Code has provided some opportunity for alignment between tax policy and good governance dating back to 1964 through employee stock purchase plans (ESPP’s)[1] and since 1981 with Incentive Stock Options (ISO’s)[2].  These provisions allowed, in certain circumstances, for employee equity to be treated consistent with investors with respect to capital gains treatment.  An Incentive Stock Option (ISO), established in 1981, provides employees with capital gains treatment for the gain on any qualifying option award under certain exercise and holding period requirements.  Unfortunately, the original $100,000 award limitation remains unchanged from 1981.  On a pay-inflation-adjusted basis alone, this limit would need to be over $1M in 2013[3].

We propose that through minor modification to the existing tax code we can increase the transparency of executive equity/compensation arrangements, provide greater alignment of executive rewards with societal goals of balanced risk taking, and increase the actual net revenue to Treasury.  We propose the following simple changes to existing tax code:

  • Eliminate the $100,000 limit on Incentive Stock Option awards.  The definition of a qualified award would include full-value shares as well as stock options.
  • Where there is a discount element (e.g., restricted or performance shares), the discount at grant would be treated as ordinary income to the executive, taxed upon sale of the shares. The corresponding employer tax deduction would also be deferred until sale.
  • To qualify for capital gains treatment, shares must be held for the longer of ten years from the date of grant 2 years following termination of employment.  Shares sold prior to the time limit would be disqualified and subject to immediate ordinary income taxation of the entire amount.

These proposed tax rules create a strong incentive for executives and Boards to design equity plans utilizing hold–till-retirement provisions.  This will result in more net shares remaining in the hands of executives, presumably providing a more significant incentive for delivering long-term results for investors and the public at large.

Curiously, although the executive would receive favorable tax treatment, the tax revenue gains to the government would actually increase.  Currently, upon share vesting or option exercise, income tax paid by the executive is generally offset by the compensation deduction of the employer.  On a net basis, the only revenue received by Treasury now is the capital gains tax received upon sale of the shares.  Under our scenario, the employer loses the tax deduction for gains from grant through exercise/vesting (further delineating between income and investment), leaving the government with effective taxation, albeit at a lower rate, of a greater portion of the award.

Under our proposed approach[4], the executive’s capital gains would be measured from the grant date price – as is the case with an investor purchase – with no offsetting tax deduction by the corporation for subsequent gains. While this results in a lower tax rate for the executive, the effective Treasury revenue is increased by elimination of the employer’s tax deduction. Furthermore, the combination of hold-till-retirement covenants and supporting tax policy better aligns the executive performance incentive with the interests of investors and the public over time, rather than allowing an executive group to be rewarded for short term results.  With a broad definition of equity incentive plans (i.e., including nonpublic company equity and equity-like vehicles), this approach can successfully apply regardless of company size or ownership structure (e.g., small businesses, joint ventures, subsidiaries, private equity and start-ups).

The individual & corporate taxation, as well as federal revenue, can be summarized in the following example where an executive is granted 3,000 restricted shares at $10 per share, vesting in entirety at the end of three years, with the shares eventually sold at the end of 10 years, assuming a constant 10% CAGR in share price.

 

Treating executive pay consistent with investors is good public policy.  Creating an effective tax penalty for executives choosing to liquidate shares prior to retirement achieves a sensible balance for executive risk-taking and provides greater long-term skin-in-the-game that provides additional accountability for executives and corporations within our economy.  We believe this is an easily-achievable step toward aligning federal tax policy with public policy interests, and can immediately provide increased federal tax revenues through improved public policy.  Lastly, it would eliminate the need for complex plans, where any benefits to investors or the public are negligible at best.

Jeff McCutcheon is  a Managing Director of Board Advisory, LLC, an independent consulting firm exclusively serving boards of directors, their compensation committees, and investor groups.


[1] The Revenue Act of 1964 provided the tax treatment for options contained in ESPPs through IRC Section 421(a)(1), providing that “no income shall result at the time of the transfer of such share to the individual upon his exercise of the option with respect to such share.”

[2] The Economic Recovery Tax Act of 1981 established ISOs. P.L. 97-34. Senate Report 97-144 states the intended tax treatment for ISOs: The bill provides for “incentive stock options” where there are no tax consequences when an incentive stock option is granted or when the option is exercised, and the employee will be taxed at capital gains rates when the stock received on exercise of the option is sold. Similarly, no business expense deduction will be allowed to the employer with respect to an incentive stock option.

[3] IRC Section 422(d)(1).  The $100,000 limit on ISO value was established in 1981 and has not changed.  Based on compound growth rate of executive pay for S&P 500 CEOs from the period 1989 through 2011, the $100,000 limit established in 1981 would need to be over $1M for 2013 based on the average growth rate in S&P 500 CEO compensation of roughly 7.5% per year.

[4] See Aligning Tax Policy with Sound Executive Pay Practices, Board Advisory, LLC, (Issue 3, 2009).

Aligning Tax Policy with Sound Executive Compensation Practices

Posted by Paul McConnell on May 26, 2009  /   Posted in Compensation Committees

If we want executives to act and be rewarded like investors, we should tax them like investors.

As the chorus of public outrage over executive compensation rises to a new crescendo, it is understandable why the populist approach to “solve” executive pay is through regulatory pay limits. However, executive compensation experts and investor representatives alike agree that rather than limiting pay, the best thinking on the subject is focused on creating plans where executive wealth is tied to that of long-term investors – where they are unable to profit (or limit losses) from short-term changes in company performance or company stock price. There is much agreement that this linkage is best accomplished through executive equity arrangements with provisions such as “hold-till-retirement” requirements. However, in implementing these provisions boards of directors are now finding that federal tax policy is not aligned with what is arguably in the best interest of the public, not to mention shareholders.

We believe that minor changes to the tax code could facilitate these ownership provisions, thus providing greater alignment of executive pay with public interests. Further, these changes will also increase federal revenues by increasing the effective tax on executive pay without the adverse economic effect of broad rate increases. Simply put, we recommend that the tax code cease treating certain long-term executive equity incentives as annual “compensation”, and instead treat it like an investment.

Current Tax Law Rewards an Early Exit

The table below shows the current taxation of various popular executive equity compensation vehicles:

Vehicle Form of Income Timing
Restricted Stock or Performance Shares Full value is Compensation Vesting
Nonqualified Stock Option (NQSO) Gain is Compensation Exercise
Incentive Stock Option (ISO) Gain is Capital Gains Sale of shares

Any compensation value from an executive equity grant is also deductible to the employer (subject to the limits and performance rules of section 162(m)) and is subject to Medicare taxes (1.45% rate) from both the executive and the employer.

The net effect of this approach is that today’s executives have a powerful incentive to exercise stock options during favorable market cycles, then liquidate their positions to provide cash flow to execute the exercise, including withholding taxes. Since there is no further tax liability and typically little obligation beyond perhaps modest stock holding requirements, a rational executive/investor would clearly sell their ownership position and interests to diversify their overall portfolio. The existing tax treatment does not encourage long-term executive ownership nor penalize sale of stock during the executive’s career.

Alternative Tax Approach Creates Value from Holding to Retirement

An alternative approach is to treat executive equity awards as a sale of company stock on the date of grant, similar to any other investor purchasing shares for cash. Where there is a discount element (e.g., restricted stock or performance shares), the discount at grant would be treated as compensation to the executive and deductible to the company (subject to 162(m)). However, the tax on this compensation would not be due until it was both vested and sold. Thus a company could create a very favorable tax situation for its executives (and an incentive benefiting investors and the public alike) by requiring that they hold the stock until after they leave the company. Like other investors, any post-grant gain (or loss) would be taxed as a capital gain at the time of sale. Similarly, any dividends paid would be taxed at the 15% rate (under current law).

Vehicle Form of Income Timing
Restricted Stock or Performance Shares Value at grant is Compensation, any post-grant change is Capital Gain (Loss) Sale of Shares
Stock Options [1] Gain is Capital Gains Sale of shares

These proposed tax rules create a strong incentive for executives and Boards to design equity plans utilizing hold–till-retirement provisions. For example, without a hold-till-retirement provision a performance share grant would trigger immediate taxation for the full value at vesting. The executive would typically then sell shares to satisfy the withholding tax. With the benefit of a hold-till-retirement provision, the executive would not be liable for any tax until the shares were sold – at some point after retirement. This will result in more net shares remaining in the hands of executives, presumably providing a more significant incentive for delivering long-term results for investors and the public at large.

Curiously, although the executive would receive favorable tax treatment, the tax revenue gains to the government would be significant. Currently, the executive’s ordinary income tax and the corporate deduction largely offset each other. As a result, the executive’s basis in the stock is stepped up to the price at the date of vesting (for full value shares) or exercise (in the case of an option). Thus the net tax received by the federal government is limited to the capital gains tax calculated on any stock appreciation subsequent to vesting/exercise – and there is little incentive for executives to hold shares after vesting/exercise.

Under the proposed approach, the executive’s capital gains would be measured from the grant date price – as is the case with an investor purchase – with no offsetting tax deduction by the corporation. While this results in a lower tax rate for the executive, the effective taxation is increased by eliminating the employer’s tax deduction. Furthermore, the combination of hold-till-retirement covenants and supporting tax policy better aligns the executive performance incentive with the interests of investors and the public over time, rather than allowing an executive group to be rewarded for short term results. With a broad definition of equity incentive plans (i.e., including non-public company equity and equity-like vehicles), this approach can successfully apply regardless of company size or ownership structure (e.g., small businesses, joint ventures, subsidiaries, private equity and start-ups).

We believe this is an easily achievable first step toward aligning federal tax policy with public policy interests regarding executive compensation and corporation accountability. If we want executives to act and be rewarded like investors, we should tax them like investors.

– Paul McConnell

Paul McConnell works with a number of Board Advisory clients within the banking and related financial services arena on executive pay alignment, performance measurement, and executive performance issues. You can view Mr. McConnell’s bio here. If you have any question or comments on this article, or want to speak with Paul about any executive rewards, performance, or succession issue, he can be reached at pmcconnell@board-advisory.com, or at (407)876-7249.

[1] The tax code changes proposed in this article could be achieved by simply modifying existing ISO provisions in IRC sections 421 through 424, to reflect contemporary executive pay programs and hold-till-retirement obligations.

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