The options mess
DURING HIS FIRST YEAR AS PRESIDENT, Bill Clinton persuaded Congress to reduce the federal deficit by raising taxes and limiting spending. At the time, higher rates and a 10% surcharge on taxpayers who earned more than $250,000 a year attracted most of the attention. But a less publicized increase in corporate taxes has turned out to have had unexpected consequences -- which Congress is still addressing.
The provision capped the amount of executive pay that a publicly held company could deduct from its taxable income. Beginning in 1994, only $1 million of the annual salary and benefits paid to a top executive could be deducted as a business expense. This wasn’t a wage control so much as a surtax on compensation; the deduction amounted to a subsidy, and capping the deduction eliminated the subsidy for paychecks greater than that amount.
The Congressional Budget Office thought so little of the provision that it made only a passing reference to it in a 72-page analysis of the legislation’s changes to tax law. Nor was any mention made of the loophole lawmakers created: The provision did not apply to compensation tied to performance goals, pensions, commissions or pre-existing contracts. The result: Numerous companies reduced top executives’ salaries to below $1 million and made up the difference with stock options. The latter could still be deducted because they were theoretically tied to a company’s performance -- the better a company did, the more its share price should rise, increasing the value of the options.
The shift to options paid off handsomely for many executives during the dot-com boom. But outfits with gyrating or falling share prices were at a disadvantage because their options didn’t have a predictable payout. To keep valuable employees happy, dozens of companies appear to have manipulated the timing of the option awards surreptitiously -- and illegally -- to maximize the payoff. Federal investigators are now examining the records of more than 100 firms.
The Sarbanes-Oxley Act of 2002 has already put a crimp in options manipulation by requiring companies to tell the public who has been granted options within two days. Still, enough possibilities for mischief remain that some lawmakers are rethinking the change made in 1993. One possibility is to eliminate the exemption for performance-based pay; another is to raise the cap on deductible compensation.
Either way, the shenanigans have already taken their toll on investors in scores of firms whose shares slumped after the wrongdoing was alleged. These companies may have avoided some taxes by awarding options instead of paying higher salaries. But their savings are a drop in the bucket compared to the losses faced by shareholders.
