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No Fix Needed for Deferred Com p
Off-and-on for the past 20 years, the federal government has set off
on a crusade to eliminate some alleged evil in executive compensation
programs. Just as regularly, those attempts have backfired .Yet, Congress
and the IRS are now at it again, setting their sights on curbing any flexibility in deferred compensation programs .
Like some other recent bad ideas, the story begins with Enron .
Included in the Joint Committee on Taxation's 2,700 page report on the
tax and compensation issues supposedly raised by Enron, is a criticism
of deferred compensation. Basically, Enron offered its executives a tra ditional, "plain vanilla" deferred compensation program like those used
at thousands of companies, which allowed executives to postpone
taxes on certain bonuses and equity compensation . Deferred compensation programs exist because low maximums and discrimination rules
severely limit higher-earning employees' participation in qualified 401k
and savings plans. Enron's deferred compensation program was pretty
standard-the company did not employ any particularly aggressive
deferral practices, such as questionable "sales" to family limited partnerships to avoid executives' being taxed on stock option exercise, or the
creation of off shore trusts to evade creditors.
However, simply because Enron offered deferred compensation pro grams, some in Congress have decided that there is something wrong
with even the most common, tried and true deferral practices .They are
questioning whether executives should be allowed to maintain investment control over their hypothetical deferred compensation accounts,
to make second deferral elections at least a year prior to the scheduled
payout, and to override their deferral election and take immediate payment, less a haircut of 10 percent or so .
At the same time, the IRS has announced an initiative to start auditing deferred compensation programs . The Service will focus on
whether executives should be considered in constructive receipt of
their deferrals, on the basis that they maintain too much control over
the funds.
Deferred compensation last came under serious attack in early 1977,
when the IRS went on a virtual rampage . Ignoring half a century of judicial precedent, the IRS attempted to immediately tax all elective
deferred compensation outside of a qualified plan . The philosophical
underpinning of the attack was the dominion and control theory-that
once an executive has any control over his or her compensation,
including whether to defer payment, that compensation should be sub ject to immediate taxation .
The business community revolted and Congress, wisely, stepped in
to call a lengthy time out . Section 132 of the Revenue Act of 197 8
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"This art icle was republished with permission from Benefits Law Jou rnal, Vol . 16, No . 2, Summer 2003), Copyright 2003, Aspen Publishers, Inc . All rights rese rv ed. For more information on
this or any other Aspen publication, please call 800 .638-8437 or visit www.asoenoublishers.com ."
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ordered the IRS not to tamper with its pre-dominion and control posi tion on deferred compensation until further notice . Tax-exempt organizations, however, were not so lucky-they were not protected from
the IRS and, under Section 457, executives of tax-exempt organizations
were subjected to immediate taxation of virtually all vested deferred
compensation . This led to some creative and complex strategies to
postpone the tax, such as options to acquire mutual fluids and split-dol lar life insurance. Since then, aside from the occasional constructive
receipt challenge, which the IRS invariably has lost (see the Tax Court's
1991 Martin decision), the government has not tampered with
deferred compensation .
Until now. Both Congress and the IRS are attacking deferred compensation armed with a virulent new strain of the dominion and control theory. Congress now wants to turn the IRS loose on tax deferred
compensation over which the executive maintains even a vestige of
control. Gone would be hypothetical investments, haircuts, and the
ability to ever modify a deferral election. It is possible that even the
most basic deferral programs-in which an executive makes an irrevocable election before the compensation is earned, the deferred
amounts grow based on a pre-established investment factor, and there
is zero flexibility to change anything-will be eliminated .
The first question the compensation zealots in Congress should ask
themselves is, "What's wrong with deferred compensation in the first
place?"After all, deferral is simply that-a postponement of receipt. Just
as the company defers its tax deduction on the payment, so the execu tive defers his or her taxable income .With corporate and individual tax
rates approaching parity, the postponed deduction more or less cancels
out the deferred taxes . And, depending on whether and how the deferrals are funded, the Government may actually enjoy some double taxation of investment income-for example, first on earnings from a rabbi
trust's investments, and again when those earnings are distributed to
the executive.
Although executives may be in a lower tax bracket when the deferral is paid out, it's equally possible that they may be wealthy enough or
rates will have risen sufficiently, to put them in an even higher brack et . The net result is that eventually everything comes home to roost :
The compensation is paid out, a corporate tax deduction is taken and
the executive is taxed on the income. As several recent private letter
rulings under Section 457 have observed, deferred compensation in
the for-profit world does not hurt the Treasury's bottom line or any
other governmental interest .
Moreover, during the course of the deferral period, the executive
takes a real credit risk. If the executive experiences an unexpected
cash crunch that required early payment, he pays a 10 percent or s o
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haircut .Who is hurt by allowing the executive early access to his or her
money? Not shareholders, who see the company's compensation costs
reduced. Not the government, which should experience little revenue
gain or loss .
To be sure, there are legitimate questions of fairness and abuse raised
when executives bail out just before their companies go broke, thereby short changing both creditors and shareholders . But these situations
are a matter of bankruptcy law, not tax law. Such hurried distributions
should be captured as preferential transfers-if not, then it is the bankruptcy code that needs fixing.
Deferred compensation-the so-called "rich person's" 401(k)-is
neither an exotic tax shelter nor a lavish executive perk . Personally, I
would rather not put my money at risk in a nonqualified deferred com pensation program, having seen too many seemingly rock-solid firms
explode. I also prefer to maintain total control over my investments,
including the ability to earn long-term capital gains or tax-free interest
on municipal bonds. But given the appeal-tax deferral, forced savings,
or other reasons-many executives are willing to accept the risks and
limitations of deferring a portion of their earnings . There is no reason
the government should care .
Congress should be mindful of its previous attempts to remedy exec utive compensation abuses . First, in 1984, Section 280G targeted the
large golden parachute arrangements that proliferated during the
1980's M&A boom . Executives at target companies were enjoying
accelerated bonuses and vesting, as well as generous severance benefits, while redundant rank and filers were being laid off en masse in
post acquisition downsizings . Deeming those executive payments too
high, Congress stepped in with a draconian fix : a 20 percent excise tax
and corporate nondeductibility on any parachute payments over the
executive's average compensation, provided the total parachute payments exceeded three times average compensation .
That makes Section 280G the only tax provision for which just $1 in
additional income (putting an executive above the three times test)
could yield millions in tax liability. As a direct result, many companies
actually increased golden parachutes, either because the three times
limit was viewed as a reasonable safe harbor, or to gross up the 20 percent excise tax . Other companies retained armies of accountants, actuaries, and lawyers to ferret out loopholes in the rules . The only thing
Section 280G did not do was reduce parachute payments .
Several years later, Congress again decided that something needed to
be done about over-paid executives . Section 162(m) limits the tax
deduction for compensation above $1 million, with the exception of
performance-based compensation. Guess what? Stock options and
other equity based awards swiftly proliferated because they were con sidered performance based.The net result was an executive compensaBENEFITS LAW JOURNAL
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VOL. 16, NO . 2, SUMMER 2003
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tion bonanza that made even investment bankers jealous and helped
fuel the greed, corruption, and financial shenanigans that lead to-you
guessed it-Enron.
The lesson from Sections 280G and 162(m) is that Congress cannot
fix perceived abuses in executive compensation by fiddling with the
tax laws . Dealing with these issues is the responsibility of corporate
boards and shareholders, some of whom have done better at it than
others . Past experience shows that legislatively straight-jacketing the
use of deferred compensation won't lead to more appropriate executive pay packages or better corporate governance . Leave it alone .
David E. Morse
Editor-in-Chief
Kirkpatrick & Lockhart LLP
New York, NY
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