Over 30 years of reporting on Congress, federal agencies and the White House for corporate America as well as national trade and professional associations.

Tightening the Parachute Strings

Human Resource Executive Online, March 11, 2008

The IRS recently acted to tighten the rules affecting executive severance of more than $1 million, requiring companies to review their agreements. And more changes may be in the winds as well, as Congress continues to look into executive comp.

By Stephen Barlas

Companies have some new tax considerations that will force them to rethink many of the performance-based severance packages they have developed for top executives in the past.

It's possible the Internal Revenue Service was responding to prevailing political winds when it tightened its rules dealing with when executive compensation of more than $1 million can be deducted from corporate taxes.

The IRS > action on Feb. 21 may deflate some lucrative exit packages -- known as golden parachutes -- and may be the harbinger of upcoming congressional moves to eliminate the pay deduction entirely.

Steve Seelig, executive compensation counsel at Washington-based Watson Wyatt, says it is not clear whether the < IRS > was primarily motivated by what it learned in recent corporate audits or by the current political climate.

For example, had the new < IRS > ruling been in effect prior to Stan O'Neal's forced resignation from Merrill Lynch in October -- just a week after the investment bank reported its largest-ever quarterly loss of $2.24 billion -- Merrill would have qualified for a much smaller tax deduction.

O'Neal appeared before the House Oversight and Government Reform Committee on March 7, as part of chairman Rep. Henry Waxman's continuing investigation into the "compensation of executives who preside over billion-dollar losses."

Waxman, D-Calif., noted in his opening statement that the hearing was not about "illegality or even ethical breaches. It's a hearing to ... help us understand whether this situation is good for the companies, the shareholders and for America."

O'Neal -- who left Merrill Lynch with a $161 million retirement package -- was joined at the Waxman hearing by other CEOs who had been extremely well compensated by their floundering companies: Angelo R. Mozilo of Countrywide Financial Corporation -- who received more than $120 million in compensation and sales of stock as the company lost $1.6 billion in 2007 and its stock lost 80 percent of its value -- and Charles Prince of Citigroup -- who was awarded a $10 million bonus, $28 million in unvested stock options and $1.5 million in perks when he left the company.

It is congressional dissatisfaction with those kinds of pay packages that has led to talk about further curtailing exceptions to the $1 million pay cap.

A spokesman for Sen. Max Baucus, D-Mont., chairman of the Senate Finance Committee, says Baucus "is reviewing proposals that would affect deferred compensation, as he has been since last January. He remains committed to working with his colleagues, including Sen. [Chuck] Grassley, on this issue."

Grassley, from Iowa, is the top Republican on the committee.

With regard to the new < IRS > policy, Seelig says companies now need to examine severance and retirement packages to make sure they don't simply pay out at target levels.

This raises a couple of possibilities of how companies will seek to amend existing agreements. For example, a plan that pays out at target for a termination one year into a three-year performance might make the executive wait until the actual results come in at the three-year mark before paying out.

Or the company could substitute a severance agreement that entitles an executive to a specific dollar amount if he or she leaves prior to the end of the performance period.

Section 162(m) of the < IRS > Code explains when companies can take more than a $1 million deduction for the pay of any of its top five executives, excepting the chief financial officer. That $1 million cap does not apply to qualified performance-based compensation.

Based on rulings the < IRS > issued in 1999 and 2006, companies could pay, and top executives could receive, a pro-rated share of a performance-based award even if they left the company before the performance period ended, and before it was clear those performance goals had been met, as long as the executive left the company as a result of being terminated without "cause" or if he or she voluntarily terminated his or her employment for "good reason."

In its revenue ruling issued on Feb. 21, the < IRS explained that an employee could leave for "good reason" or be terminated without "cause" simply because that employee missed interim performance targets. Therefore, he or she was not eligible for performance-based pay, nor could the company deduct that pay of more than $1 million.

Seelig says that although 162 (m) explicitly deals with the five highest-paid corporate employees (not including the CFO), companies typically look at pay packages for lower-ranking employees outside the top five.

That is because, if a company, for example, sets a three-year performance period for its top 10 executives, it won't be clear at the start of the period which of those 10 will be in the "top five" three years later.