Congress May Reduce, Reverse Deduction That Fed Stock-Option Explosion
Revisiting Executive-Pay Law
By CHARLES FORELLE and KARA SCANNELL
September 6, 2006; [WSJ] Page C1
Congress is looking at reducing or even eliminating a lucrative tax deduction that helped feed the explosion in stock options, according to a leading senator.
Under a 1993 law, companies were forced to pay taxes on all compensation for senior executives higher than $1 million apiece annually -- unless the compensation was performance-based, that is, linked in some way to the company's performance. In practice, that exception encouraged companies to tilt compensation toward stock options, since those are tied to a company's stock price and therefore are typically considered performance-based.
But amid a scandal over manipulated options grants, Sen. Charles Grassley, an Iowa Republican who is chairman of the Senate Finance Committee, said the 1993 break has "failed and to some extent it might be creating this options industry."
In an interview, Sen. Grassley, whose committee opens hearings on options and executive compensation today , said doing away with the deduction for performance-based pay entirely is a "possibility," as is "at least tightening it up." Though he said he couldn't give a precise head count of support in Congress, he said "a lot of members are interested" in possibly scaling back executive-pay deductions.
Any proposed curb likely would draw strong opposition from business groups. But the consideration of it by the influential senator is an indication of distaste for high pay packages, especially in light of the options scandal, in which more than 80 companies are under federal investigation for possibly manipulating grants to enhance individual profits. Federal prosecutors have charged five executives from two companies with fraud over backdating practices.
Sen. Grassley said that any action by Congress likely would come as part of a larger tax bill in a future year, though he said there's the possibility of legislation to address the matter in the "lame duck" period after the November elections.
Many in Congress might not want to wade into the matter again. Congress has been criticized widely for the 1993 law -- by business advocates for legislating executive compensation at all, and by investor advocates for allowing what they see as a gaping performance-based pay loophole.
Still, the sometimes-broad gulf between CEO pay and corporate performance, along with the options scandal, has piqued interest on Capitol Hill. In addition to Sen. Grassley's finance committee, the Senate Banking Committee also is holding hearings today on backdating.
Sen. Grassley is expected to question Justice Department and Securities and Exchange Commission officials about the probes and also explore changes to the tax law. He said the original purpose of the 1993 law was "to make sure that there wasn't great deviation between what executives got paid and what people further down the ladder" got paid. "It really hasn't worked at all," Sen. Grassley said. "I want to know what went wrong and how we can fix it."
For most companies, eliminating the deduction would almost assuredly mean higher tax bills, since total compensation over $1 million annually is par for the course for many corporate chiefs. Some companies might moderate executive pay in order to reduce their tax burdens.
For Congress, dumping the deduction may be a palatable way to raise revenue while responding to outcries of dissatisfaction over high levels of executive pay and the options-backdating scandal.
It isn't clear how much eliminating or changing the deduction could raise in tax revenue. The senior-most executives at the roughly 1,800 companies in the Standard & Poor's ExecuComp database -- a small fraction of all publicly traded concerns -- reported $10.8 billion in value realized from exercising options in 2005, S&P says. That figure is off slightly from 2004's total; gains peaked in 2000 at $17.7 billion, according to S&P's figures. Corporations likely took deductions for much of that amount, since option plans are typically structured to comply with the performance criteria in Section 162(m). If the $10.8 billion had been subject to standard tax rates, the government would have raised an additional $3 billion or more last year.
The 1993 law capping deductibility of non-performance-based pay at $1 million applies only to a company's top executives. Compensation of any form to other employees is typically deductible. The $1 million cap is maligned by many tax and compensation specialists, who say that most corporations found ways to get around it.
There are varying views on the wisdom of getting rid of the performance-based-pay loophole completely, or even what solution might patch up its flaws.
"There are better ways [to address CEO pay] than through the tax code," said Nell Minow, editor of Corporate Library, an investor-advocate group. "As long as you have directors picked by the CEO and compensation committees picked by the CEO, the problem is not going to go away."
David Yermack, a finance professor at New York University's Stern School of Business who has published widely on options issues, said dropping the deductions would "at the margins" have a "little bit of an impact on executive pay," but not much, since the market rate for CEOs is "well above" $1 million. Prof. Yermack said such a change might shift the balance of pay away from incentive compensation and toward "straight cash" -- eliminating what he said is a major benefit of the law because he sees incentive pay as good for shareholders.
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