Between 1971 and 1981, average executive compensation grew by 30%. During the 1980s, CEO compensation skyrocketed by 212%. In 1980, Forbes put the average total compensation of top executives at $1.592 million. The Hay Group, a Philadelphia consulting firm specializing in compensation issues, reported that the average 1991 salary of American chief executives had grown to an estimated $1.7 million. In 1992, the average CEO of a large U.S. corporation received $3.5 million, a 50% increase from the previous year. Clearly, executive compensation is rising at an unprecedented rate at a time when corporations are regularly announcing layoffs and cost-cutting measures. As a result, political activists have been clamoring for change.

In response to such activities, in 1992 the SEC adopted new rules for disclosure of executive compensation in proxy and other statements effective January 1, 1993. The new rules could be viewed as an indirect attempt by the SEC to use expanded disclosure requirements to regulate the compensation of corporate officers. Some opponents also view the FASB's proposed statement on stock options as a means to restrict the use of stock options as a vehicle for executive compensation. The most direct attack has come from Congress.

Although the government refused to directly control private sector compensation through the securities laws, it devised a way to do so via the tax code. Critics clamor that the government should not influence private compensation levels, but the tax code has done just that for many decades. Personal income tax levels have historically fluctuated, depending on the economic theories of the administration in power. In 1920, the top tax rate was 73%. By 1925, the top rate had been reduced to 25%. After the 1929 stock market crash and the advent of the New Deal, the top rate increased to 79% by 1936 and then to 91% in the late 1940s. And in the 1960s it settled at about 70% where it remained stable until 1981. During those decades of high tax rates, the average executive earned considerably more than the average worker. However, his proportionally higher tax rate significantly reduced the disparity. Furthermore, the futility of awarding huge salaries only to see them swallowed up by taxes worked to keep salaries lower.

During the 1980s, the highest nominal tax rate dropped from 70% to 28%, significantly increasing the after-tax disparity between worker and executive income by removing the disincentive (tax obstacle) to granting large compensation packages. In the early 1980s, the average pay of a CEO was $624,996, which was 42 times the pay of the average factory worker. By 1990, the average executive's pay, not including stock options, had increased to $1,214,090 which was 85 times the salary of the average factory worker. Many people believe the rich have gotten richer at the expense of factory workers and other lower level employees.

Prior to the enactment of the RRA '93, a corporation was allowed to deduct the amount of compensation paid to an employee, as long as the compensation was reasonable. The unreasonable portion of compensation is nondeductible. If the recipient is a shareholder of the payor- corporation, the unreasonable portion may be treated as a dividend. Reasonable compensation is defined as an amount that would ordinarily be paid for like services by like businesses under like circumstances. However, RRA '93 attempts to apply clearer limits to executive compensation.

The Senate Finance Committee stated its belief that excessive compensation will be reduced ff the deduction for compensation (other than performance-based compensation) paid to the top executives of public corporations is limited to $1 million per year. Therefore, the RRA '93 amended the IRC by adding Sec. 162(m). This amendment is expected to raise $335 million in tax revenue during the period 1994 through 1998.

Effective for tax years beginning after 1993, IRC Sec. 162(m) denies a deduction to any "publicly held corporation" for "applicable employee remuneration" in excess of $1,000,000 per year paid to a "covered employee." The following is an in-depth analysis of IRC Sec. 162(m) in light of the proposed regulation and legislative history.

Publicly Held Corporation

Under IRC Sec. 162 (m)(2), a publicly held corporation is defined as any corporation that issues any class of common equity securities that are required to be registered pursuant to Sec. 12 of the Securities Exchange Act of 1934 (the Exchange Act). However, a corporation will not be treated as publicly held if the registration of its equity securities is voluntary. Therefore, a corporation not required to register its equity securities that nevertheless does so to avail itself of other procedures applicable to public offerings of debt securities will not be considered a publicly held corporation under IRC Sec. 162(m). Whether a corporation was publicly held would be determined solely on whether, as of the last day of the tax year, the corporation is subject to the reporting obligations of Sec. 12 of the Exchange Act. Therefore, a corporation can avoid the limits of IRC Sec. 162(m) for a year if it goes private during that year.

A publicly held corporation also includes all corporations in the affiliated group of the publicly held corporation, whether or not those corporations fried a consolidated return. If a covered employee is paid compensation in a taxable year by more than one member of an affiliated group, compensation paid by each member of the affiliated group is aggregated with compensation paid to the covered employee by all other members of the group. Therefore, if a covered employee receives compensation from an employer that is not itself a publicly held corporation as deemed trader IRC Sec. 162 (m)(2), that compensation would be aggregated with all other compensation paid to the covered employee by any corporation within the affiliated group. The IRC Sec. 162 (m) limitation will apply as if the affiliated group were a single taxpayer. For example, assume a covered employee performs services and receives compensation from an affiliated group of corporations comprised of A, B, and C corporations. If corporation A (publicly-held) and corporations B and C (privately held) pay a total of $3,000,000 to the covered employee for the taxable year, of which A pays $1,500,000, B pays $900,000 and C pays $600,000, $2,000,000 of the total compensation is nondeductible. Furthermore, A, B, and C are treated as having paid a ratable portion of the nondeductible compensation. Therefore, two thirds of each corporation's payment will be nondeductible.

Whether master limited partnerships, whose equity interests must be registered pursuant to the Exchange Act, are considered publicly held corporations under IRC Sec. 162(m) and, if so, how they would qualify for the performance-based exception, has not yet been addressed by the IRS. However, the IRS states in its introductory statement to Proposed Regulation Sec. 1.162-27 that the matter is currently understudy and guidance as to the application of IRC Sec. 162(m) to these entities will be provided in the future.

Covered Employee

Under IRC Sec. 162 (m)(3), a covered employee is deemed as any employee who, on the last day of the taxable year, is 1) the chief executive officer or an individual acting in such capacity, or 2) an employee whose total compensation for the taxable year is required to be reported to shareholders under the Securities Exchange Act of 1934 by reason of such employee being among the four highest compensated officers for the taxable year (other than the chief executive officer)."

While the intent may have been to track the requirements of Item 402 of Regulation S-K with regard to the definition of covered employee, both the law and the proposed regulations are not consistent with S-K. In fact, it could be argued the law and proposed regulations are not consistent with each other. These differences relate to the time period (year end or during the year) covered by such services. The differences were compounded further by an SEC amendment to Regulation S-K made after the passage of RRA '93. The amendment specified that up to two additional individuals may be added if they would have been required to be included as highly compensated employees except for the fact they were not executive officers at the end of the year. Hopefully, some of this confusion TABULAR DATA OMITTED will be eliminated when the regulations are amended. The accompanying table shows the differences.

Applicable Remuneration

The term "applicable remuneration" applies to a covered employee's aggregate compensation (cash or otherwise) for services performed that could otherwise be deducted in a taxable year. However, the $1 million deduction limitation must be reduced (but not below zero) by an amount that would otherwise be treated as deductible remuneration, but for IRC Sec. 280G, which disallows deductions for golden parachute payments. For example, assume that during a taxable year a corporation pays $1,500,000 to a covered employee. Of the $1,500,000, assume $600,000 is an excess parachute payment and is disallowed under IRC Sec. 280G(b)(1). The $600,000 payment will reduce the $1,000,000 limitation so that the corporation may only deduct $400,000 ($1,000,000 - $600,000 parachute payment), and $500,000, which would otherwise be deductible, is nondeductible.

IRC Sec. 162(m) provides that certain types of compensation are not subject to the deduction limitation. They are 1) remuneration payable on a commission basis, 2) any remuneration payable under a written binding contract in effect on February 17, 1993, and which was not modified thereafter in any material respect, 3) qualified plan contributions for employees and amounts excludable from the executive's gross income such as employer-provided health benefits and miscellaneous fringe benefits under IRC Sec. 132, and 4) performance-based compensation subject to specific requirements.

Commission-Based Compensation. For purposes of the $1,000,000 deduction limitation under IRC Sec. 162(m), applicable remuneration does not include commission-based payments so long as the commissions are payable solely on account of income generated directly by the individual performance of the covered employee. For example, compensation that equals a percentage of sales made by the covered employee is treated as commission. However, compensation that equals a percentage of income produced by a business unit is not treated as commission for purposes of IRC Sec. 162(m) because it is not paid with regard to income directly attributable to the covered employee. Nevertheless, this income may qualify for exemption from the $1,000,000 deduction limitation as performance-based compensation. Although compensation that qualifies as performance-based is excluded from the deduction limitation, it is preferable to have it characterized as a commission because the former has more prerequisites that must be met.

Compensation Payable Under a Written Binding Contract in Effect on February 17, 1993. Any remuneration payable to a covered employee under a written binding contract in effect on February 17, 1993, is not considered applicable employee remuneration subject to the $1,000,000 deduction limitation. However, merely because a plan is in existence on February 17, 1993, is not by itself sufficient to qualify payments made pursuant to the plan for the exception for binding contracts. Compensation paid pursuant to a plan qualifies for this exception, provided the right to participate in the plan is part of a written binding contract with the covered employee that is in effect on February 17, 1993. An employee is not required to be a participant in the plan on February 17, 1993, but must have had a right to participate in the plan on or before that date so that his or her compensation is excluded from the deduction limitation.

The deduction limit would apply to compensation paid pursuant to a contract that was renewed or materially modified after February 17, 1993. A material modification occurs when the contract is amended to increase the amount of compensation payable to the employee. However, an increase in the amount of compensation is not a modification, and thus not subject to salary cap, if the increase is equal to or less than a reasonable cost-of-living increase over the payment made in the preceding year pursuant to the qualifying contract.

Contributions to Qualified Retirement Plans and Employer Provided Health Benefits and Other Fringe Benefits. Employer contributions to employee tax-qualified retirement plans are not taken into account in aggregating the compensation paid for purposes of the $1,000,000 deduction limitation. However, the retirement plan must be one of the following: a qualified retirement plan trust that is tax-exempt under IRC Sec. 401(a), a qualified annuity plan set out in IRC Sec. 403(a), a simplified employee pension plan as stipulated in IRC Sec. 408(k)(1), or a qualified annuity contract described in IRC Sec. 403(b).

Nontaxable benefits such as employer provided health insurance and miscellaneous fringe benefits excludable from income under IRC Sec. 132 will not be taken into account for purposes of the $1,000,000 deduction limitation so long as it is reasonable to believe at the time that the benefit is provided that the employee will be able to exclude it from his or her gross income. Because only nontaxable fringe benefits are not taken into account when aggregating compensation for purposes of the $1,000,000 deduction limit, taxable fringe benefits, such as the value of the personal use of employer-provided automobiles, are taken into account and considered applicable employee remuneration.

Performance-based Compensation. Compensation qualifies for the exception for performance-based compensation only if a) it is paid solely on account of the attainment of one or more preestablished, objective performance goals, b) the performance goals are established by a compensation committee consisting solely of two or more outside directors, c) the material terms of the performance goal under which the compensation is to be paid are disclosed to and subsequently approved by shareholders of the publicly held corporation, and d) the compensation committee certifies in writing prior to payment of the compensation that the performance goals and any other material terms were in fact satisfied.

A performance goal is considered preestablished if it is established in writing by the compensation committee prior to the commencement of the services to which the performance goal relates and while the outcome is substantially uncertain. A performance goal is considered objective if a third party with knowledge of the relevant facts is able to calculate the amount to be paid to the executive. Unlike qualified commissions, performance goals can be based on broad business criteria that apply to the individual, a business unit, or the corporation as a whole. For example, criteria could include stock price, market share, sales, or earnings per share. A performance goal need not be based on an increase or a positive result under a business criterion and could include limiting economic losses or maintaining the status quo. A company that lost money but managed to move from fourth to second in market share or a company that lost only five percent, when the industry posted a 25% loss, has had a good year, and the executive is deemed to have performed well.

Compensation via stock options or stock appreciation rights must meet the following requirements to qualify as a preestablished goal: the grant or award is made by the compensation committee; the plan includes a per-employee limit on the number of shares for which options or stock could be granted in a set period; and as a result of owning the stock, stock options, or SARs, the amount of compensation is based solely on an increase in value of the stock after the grant or award date.

Compensation must be contingent upon attainment of a performance goal. For example, if the payment of compensation under a grant or award is not based solely on an increase in the value of the stock after the date of the grant, none of the compensation paid will qualify as performance- based pay. Therefore, restricted stock and options granted with an exercise price less than the fair market value as of the grant date cannot qualify as performance-based compensation. However, if the granting or the vesting of the restricted stock is contingent on the attainment of a performance goal and meets the other requirements, it may qualify as performance-based compensation.

Performance goals must be set by a compensation committee comprised solely of two or more outside directors of the corporation. A director will be considered an outside director only if the director i) is not a current employee of the publicly held corporation, ii) is not a former employee of the publicly held corporation who receives compensation for prior services (other than qualified retirement plan benefits) during the tax year, iii) has not been an officer of the publicly held corporation, and iv) does not receive remuneration, either directly or indirectly, in any capacity other than as a director.

The material terms of a performance-based compensation agreement must be disclosed to the shareholders in a way that permits an objective third party unfamiliar with the compensation arrangement to determine the maximum potential amount of compensation payable trader the plan or the formula under which the performance-based compensation is payable. This requirement that shareholders approve performance goals could result in the disclosure of private information that could place corporations at a competitive disadvantage. Typically, corporations use confidential criteria to establish their top executives' compensation and especially for performance-based compensation. For example, corporations would have to disclose information relating to future corporate plans such as an anticipated merger or plans to increase market share. A corporation would not want such information revealed to its competitors in the process of obtaining shareholder approval for their executives' performance goals.

If stock options are granted as performance-based compensation, then disclosure is considered adequate if shareholders are informed of the following: the maximum number of shares to be awarded to the executive, the option price, the option-exercise period, and any other conditions and restrictions to be placed on the stock subject to the option.

The compensation committee must certify in writing prior to payment of the compensation that the performance goals were indeed satisfied. Certification is not required for compensation solely attributable to the increase in the stock value of the publicly held corporation.

Ways Corporations Can Limit the Effects of IRC Sec. 162(m)

Corporations can structure compensation packages that minimize the effects of the limitation on deductibility. The following are ways corporations may avoid the compensation cap:

* The corporation may have the executive retire prior to the last day of the taxable year. This will preclude him from being a covered employee under IRC Sec. 162(m)(3), thereby exempting his compensation for that year from the $1 million deduction limitation.

* The corporation may defer the payment of nondeductible compensation to an executive until a year in which the executive is not a covered employee under IRC Sec. 162(m)(3).

* The corporation may award performance-based pay to an executive and set performance goals so they are easily attainable.

* The corporation may grant an executive who starts late in the year a sign-on bonus, and still remain within the $1 million cap. The corporation may also accelerate the payment of a sign-on bonus by paying it in the current year for new executives starting in the following year.

Since corporations can ease the burden of the $1 million deductibility limitation via performance-based compensation and the above mentioned tactics, it is unlikely that IRC Sec. 162(m) will cause corporations to lower executive compensation levels. In fact, IRC Sec. 162(m) will cause corporations to seek the advice of compensation consultants to find other ways to get around the cap.

Policy Reasons Against IRC Sec. 162(m)

Limiting the deductibility of CEO and executive compensation has three serious implications.

Salaries Are Set by the Market. Placing a cap on the deductibility of salaries will not deter corporations from paying executives what they have received in the past. For example, a CEO, such as Roberto Goizueta of CocaCola, who causes corporate earnings and share value to increase year after year, will be highly sought after by many large public corporations willing to pay almost any price. Companies will still have to pay what their board determines to be a market value to their executives to compete for and attract a top executive.

IRC Sec. 162(m) Penalizes Shareholders. Placing a limitation on the deductibility of executive compensation would not discourage directors and officers from paying themselves high salaries, because they are not the ones paying the taxes. It is not their money, it is the shareholders'. Therefore, tax disincentives will have little impact on management compensation decisions. Shareholders will ultimately bear the burden of nondeductibility. With higher taxes via IRC Sec. 162(m), the shareholders will be hit twice, once for the pay and again when the higher taxes lead to lower returns and reduced dividends.

Conversely, shareholders who invest in firms that opt to limit their tax liability, will not realize the gains they otherwise would have derived from obtaining the best executive talent.

Will Hurt Small Companies. The deductibility limitation will harm the ability of many small companies to compete for executive talent. This is because smaller companies are usually not in a position to bear the tax consequences of paying market salaries. As a result, they will have a diminished ability to compete for and attract the best executives.

What's Best?

Congress should allow market forces to correct the overcompensation problem. A free working market should be allowed to operate. Shareholders have not had the ability to demand accountability from their corporate directors and officers. Empowering shareholders with the information and authority that reflects their ownership role in American corporations is the key to resolving the executive compensation problem. Therefore, the SEC's new disclosure rules and FASB's proposed accounting standards are steps in the right direction. Unfortunately, the same cannot be said of IRC Sec. 162(m).

George A. Villasana, holds a BS in Accounting from Penn State University and a MAcc from Florida International University. He is a third-year law student at American University, Washington College of Law in Washington, D.C.