Executive Compensation—“ordinary and necessary”

Executive Compensation—“ordinary and necessary”

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  § 162(m)—Certain excessive employee remuneration
  
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    disallows compensation over $1M to CEO and next four highly compensated employees in publically traded companies
    
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    in addition to reasonableness exception—outlines what performance-based compensation is
    
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    What does this section do?
    
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      Implicit tax rate
      
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      Incentive for companies to give performance-based compensation rather than pure compensation
      
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      Problem: In practice this is a way for CEOs and Boards to get around performance-based criteria—can set criteria wherever they want and be OK
      
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      Performance-based compensation is supposed to align the interests of management with the shareholders’
      
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      Effectively nothing—anyone can get around it
      
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  Hypothetical—Privately held company—CEO Willa gets a $2M salary
  
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    Was the $1M over performance-based? (doesn’t matter--§ 162(m) doesn’t apply b/c private)
    
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    What is the internal rate of return on the stock?
    
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    Is she a majority shareholder? (More likely to have salary be disguised dividend)
    
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    Is she related to any other shareholders?
    
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    Is the success of the company tied to the CEO’s work? Or did they stumble upon oil and the company suddenly (and accidently) significantly increased their rate of return?
    
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    Has the company paid dividends?
    
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      Could be more likely that they’re just hiding them? Or is that indicative that shareholders just want to reinvest their earnings?
      
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  Take-aways
  
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    Disguised dividends—we’re trying to preserve double taxation
    
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    If we don’t like the corporate tax this isn’t an issue—disguised dividends are self-help mechanisms used to circumvent the tax code
    
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    Major problem: agency costs—CEOs and Board take advantage of power to squeeze out funds
    
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      One of a variety of types of market failures (i.e. externalities, information asymmetries)
      

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  Language in code: “reasonable allowance for salaries and other compensation”
  
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  Exacto incentives for high salary—disguise income as salary; disguise (taxable) dividends as salary
  
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  Decision:
  
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    Reject 7-factor test; instead implement “INDEPENDENT INVESTOR TEST”—returns inquiry to basics
    
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    Links manager’s generation of returns to salary—greater returns, greater allowable salary
    
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  Class Notes
  
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    Corporate taxes for dividends from c-corps—
    
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      Exacto Spring wants this to be a dividend
      
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      C Corporations are subject to the corporate income tax
      
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        if this were a partnership the income would pass through the entity to the partners
        
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      Dividend tax is a double-tax—Bush tax cuts tried to get a credit for corporate tax paid distributed to dividend receivers so that
      
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    What if Exact Springs were a publically traded company?
    
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      Less likely to be a dividend in disguise as salary
      
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    Independent Investor Test—
    
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      Would an investor accept the rate of return adjusted for risk?
      
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      usually expect 13% return; getting 20%  salary ok
      
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      Should the IRS get to be this far into corporate governance?
      
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      Can the CEO be held accountable for returns?
      
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    What is the best way to decide if salary is reasonable?
    
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      Comparables—assumes market competitiveness
      
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        But disguised dividends could be consistent across companies
        
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    When is this a problem?
    
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      When CEO is a majority shareholder
      

Tellier charged with securities fraud—spent $22,964.20 on defense—tried deduction as business expense—ordinary and necessary?

“No public policy is offended when a man faced with serious criminal charges employs a lawyer to help in his defense.”

Decision: “There can be no serious question that the payments deducted by the respondent were expenses of his securities business under the decisions of this Court, and the Commissioner does not contend otherwise.”

Problem Set #9: Business Expenses

1. 
   Vic runs a moonshine business in a dry county. His costs include corn, barrels and bottles. Are these expenses deductible? Are the following expenses deductible?
   

Issues to think through:

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  capital expenditures,
  
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  make sure moonshine is not a controlled substance under § 280E (which it’s not because this is a local restriction),
  
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  ordinary and necessary (really more about being non-personal and not a capital expense),
  
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  whether or not this was a trade to generate income (vs. for personal consumption)
  
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  § 212 is generally more about investment income; this would be more likely deductible under § 162
  
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  Particular provisions barring deduction for being contrary to public policy
  
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    § 162(c)(2)—would these be illegal payments? Corn and bottles would probably be ok
    
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    § 1.162-1(a)—unless we enumerate this as something we’re disallowing, if it’s a business expense he should be able to deduct it.
    

1. 
   He pays a revenue agent a bribe to ignore the illegal business.
   

2. 
   He pays someone to make the revenue agent “disappear.”
   

3. 
   He is caught and has to pay a fine of $10,000.
   

4. 
   He pays an attorney to defend him when he is charged with running a moonshine operation. Does it matter if he is convicted?
   

Does it matter if he’s convicted? No—as long as it’s a business crime it’s deductible

5. 
   He advocates for changing the law by lobbying his local legislators and state representatives, and by paying for advertisements in the county newspaper.
   

 can deduct expenses to lobby local legislatures

Prospectively thinking about entering the moonshine business: § 162(e)(2)(b)—if he’s not in the moonshine business he cannot deduct for lobbying for his moonshine business

Does he have any recourse in terms of the state legislatures? § 62—in-house lobbying expenses as long as it’s less than $2,000 he can deduct them as a de minimus expense

What about advertisements in the county newspaper? Not deductible—doesn’t fit within the Code allowances § 162(e)(1)(c)—not deductible for elections, legislatures, or referendum; § 1.162-20 not deductible unless it’s a good will advertisement

6. 
   Would any of your answers change if he sold illegal drugs instead of moonshine?
   

CAN deduct the COGS, but not the ancillary expenses