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Performance-based pay tax credit needs work

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Since the credit crisis in 2008, several bills have been passed to modify the financial system and instill safeguards like the Dodd-Frank Act.

But despite persistent pushback from academics, an aspect of the IRS tax code remains for more than two decades. It is known as 162(m).

The original intent of said tax code was to rein in what a publicly traded company can deduct from its taxes. One of the major components involves additional compensation to an executive’s salaries.

The deductions in 162(m) have created a framework for how executives have been paid ever since.

A company can deduct up to $1 million in non-performance-based pay for an executive’s salary and $500,000 for employers that participated in the Troubled Asset Relief Program. The “covered executives” are generally the CEO and the highest-three compensated officers.

Aside from the executives’ hair-raising salaries and bonuses, the most alarming aspect is the performance-based pay. This, which includes stock options and non-equity incentive plans, are fully deductible

In many cases, the deductibles can exceed the $1 million cap on other forms of compensation, making them a hotbed for tax aversion.

Performance-based pay emphasizes the increasing of a stock price by any means in the short-term. An executive can cash in on the difference between their personal exercise price of an option and the share price that the stock trades for on the public market. This practice often leads excessive risk-taking and earnings manipulation.

Executives tend to gain the most from doing these. If the company’s goals aren’t attained and the share price falls below the exercise price, the loss in value doesn’t penalize them.

There is definitely more transparency since the credit crisis, including the requirement to allow shareholders cast an “advisory” vote concerning executive compensation. A study has shown this being an effective monitoring mechanism when the U.K. passed similar provisions.

In addition to the “say on pay” provision, a pay ratio disclosure was finalized in 2012, which shows the median annual total compensation of all employees, except the CEO, in comparison to the CEO’s total compensation.

Despite these provisions’ good intentions, they appear to be cosmetic. Unless stated otherwise by the company, the votes from shareholders are non-binding, and the disclosures are buried in a mountain of financial statements.

Executives and firms, then, can still deduct large sums of money from their taxes. These measures are merely a Band-Aid on a bullet wound.

The U.S. has suffered two major recessions since the implementation of this tax code in 1993.

According to a paper from Columbia University, excessive risk-taking from compensation schemes, whether it was due to executive hubris, lack of proper monitoring or the exploitation of limited liability, were a factor in the practices that led to the recession.

Opinion columnist Nicholas Bell is an MBA graduate student and can be reached at [email protected]

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