In a recent case, Freedman vs. Adams, a shareholder filed a claim alleging the Board paid out $130M in discretionary bonuses without consideration to maximizing tax deduction, according to IRC 162(m), specifically referring to a provision that deems performance-based compensation qualifies for a full deduction in the compensation expense (for more detail, see Executive Pay and Loyalty).
Let’s review the rule and see its application in an example.
Essentially, the IRC 162(m) rule denies tax deduction for any annual compensation exceeding $1 million paid to the “covered” executives, who are the CEO and the three most highly compensated executives as of the last day of the company’s tax year. Prior to 2007, the CFO position was covered; however, under the current rule, the CFO is not considered a covered employee.
Most companies have replaced discretionary bonus plans, yet they disclose in their filings retaining right to have discretion in adjusting these payouts in the event that the intended results of a compensation plan are not achieved or are unexpected (e.g., windfall or punitive). If a discretionary payment is made beyond the cap of an IRC 162(m) compliant incentive plan, then that discretionary portion is not tax deductible and is disclosed in the bonus column of the Summary Compensation Table.
Here is an example applying this rule.
A covered employee receives a $900,000 base salary and a $600,000 discretionary bonus. Also included in the compensation package are a $1.5 million performance-based cash incentive and a $3 million dollar payout for nonqualified stock option tied to achieving a market based performance condition , 10% total shareholder return (TSR).
According to IRC 162(m), the $1 million deduction cap would apply to the base salary and the discretionary bonus. Only $1 million would be deductible and the extra $500,000 would not be deductible. The $1.5 million performance bonus and the $3 million earnings on the non-qualified stock options do qualify for the tax deduction, so the company will report a total of $5.5 million tax deduction ($1M allowable plus $4.5M performance-based compensation).
For more information about these executive compensation data, regulations, research, and related analysis, contact ERI. See www.executiveloyalty.org for more infomation on this case and other topics regarding executive compensation law.