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Excessive Compensation: Your Tax Dollars at Work—A Commentary by Aaron Zelinsky ’10

The following commentary was posted on The Huffington Post on October 22, 2009.

Excessive Compensation: Your Tax Dollars at Work
By Aaron Zelinsky ’10

The Obama Administration recently announced limits on CEO salaries at bailed-out corporations, arguing that taxpayer dollars should not fund excessive executive compensation. The American Taxpayer should not kid herself: unless the IRS changes its policies, taxpayers will continue to subsidize unreasonable compensation paid by publicly held corporations.

Every publicly traded corporation is currently given carte blanche by the IRS to deduct an unlimited amount of executive compensation from its corporate taxes. However, the IRS scrutinizes the compensation paid by privately held corporations.

This is wrong. The IRS should not allow taxpayer subsidies of unreasonable compensation via this double standard. Publicly traded business should be treated the same as their privately held counterparts.

Section 162(a)(1) of the Internal Revenue Code declares:

There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including . . . a reasonable allowance for salaries or other compensation for personal services actually rendered.

There is no definition in the law or Treasury Regulations for a "reasonable allowance for salaries." Nevertheless, the IRS has systematically interpreted the "reasonable allowance" provision to apply only to closely held corporations, effectively concluding that a publicly held corporation can deduct an unlimited amount of executive compensation, even though there is no basis in 162(a)(1) for doing so. In contrast, the IRS examines the compensation paid to executives of privately held corporations using at least nine factors, ranging from comparable salaries of other executives to education level.

The IRS allows unlimited compensation deductions for publicly held corporations because, under their reasoning, executives of publicly traded corporations have little control over their compensation, since it is fixed by an "independent board" in an "arms length transaction."

However, recent literature indicates that, in at least some circumstance, this assumption is false. Under the "managerial power" theory, executives exercise influence over the boards which set their compensation in at least four ways:

First, although compensation committees are nominally independent, executives can still have a large amount of say in deciding who sits on the board. Thus, executives stack the deck with individuals who are unlikely to curb future executive compensation.

Second, executives can steer opportunities to board members, such as positions on other boards or positions at the company at a later time. This possibility makes board members less likely to take action which could make the executives unhappy.

Third, board members have little financial interest in the impact of their compensation decisions, since the burden of executive compensation is spread widely over many shareholders.

Fourth, board members often base their compensation decisions on the advice of the HR department, which is employed by the executives.

By exercising managerial power, executives of publicly held corporations may be able to set their compensation unreasonably high, and the corporations can deduct these salaries from their corporate tax returns.

The IRS could rectify this situation in two ways: First, the IRS could treat publicly held corporations the same as privately held companies, and analyze the reasonableness of their compensation using a multifactor test. Second, the IRS could add another factor to its test, and assess the objective traits of the corporation's CEO-board relationship to determine when compensation paid by a publicly held corporation is reasonable.

In this world, publicly held corporations could still pay executives sky-high compensation, they just wouldn't get a corporate tax subsidy from the taxpayers for doing so.

Regardless of the mechanism is chooses, the IRS should do something to end this double standard and stop the taxpayer subsidy of unreasonable compensation. The IRS must recognize that publicly traded corporations have the potential to arrive at equally unreasonable compensation arrangements as their privately held brethren, and treat them equally for tax purposes.