The Brave New World

The 1986 Tax Reform Act has raised new questions about virtually every compensation tool a company has

Tweet

TIME WAS WHEN EXECUTIVE COMPENSATION WAS A walk in the park. You paid your key people a competitive salary, threw in a merit raise once a year, and went about your business. Everybody was happy.

My, how times change. In recent years, executive compensation has more nearly resembled Mr. Toad's wild ride: just when you think you know where you're headed, something comes along and sideswipes you, spinning you around and sending you off in another direction. First it was persistently high inflation, which made 10% cost-of-living raises an accepted annual ritual. Then inflation abated, competition intensified, and the hot issue became "pay for performance" -- that is, compensation tied to the achievement of clear goals. Scarcely had that concept taken hold than we found ourselves in the Age of the Entrepreneur, with hundreds of new companies being started every day, and the challenge of retaining key people became tougher than ever.

But all that, it turns out, was a mere taste of things to come, most of which came in 1987. It is no exaggeration to say that this year has brought more change to the world of executive compensation than any since the dawn of modern management. Granted, companies are still searching for ways to be more competitive, still looking for formulas to motivate and keep their best and brightest people. But whether you are aware of it or not, the context in which you sort through your options has been utterly transformed. No matter what business you're in, the 1986 Tax Reform Act has -- to one degree or another -- raised new questions about virtually every compensation tool you have.

This is not to suggest that companies are rushing to revamp their pay systems for top managers. Judging from the results of INC.'s ninth annual survey of executive compensation, most business owners are taking a wait-and-see attitude. Just 18% of the survey respondents have adjusted any of their executive compensation practices during the past year, and only 37% say they are actively considering making such changes in the coming year.

Nor do the majority appear to worry much in general about the effect of the tax laws on compensation. As in years past, respondents say that they have the most difficulty in determining the worth of a job and setting pay levels (58%), developing annual incentives and bonuses (51%), and coming up with appropriate long-term incentives or equity-participation plans (43%). Developing tax-effective compensation plans was listed as a concern by only 37% of the respondents -- a higher percentage than in previous surveys, but still a distinct minority.

There is, indeed, a good argument to be made against tailoring reward systems to fit the tax laws. Moreover, companies should be cautious in restructuring something as important as compensation. But caution is not the same as ignorance, and no company owner can afford to remain in the dark about the implications of tax reform. They are simply too far-reaching. They affect everything you do in the area of compensation.

Take, for example, the most basic ingredient of compensation: cash. Under the old tax code, it wasn't that difficult to convince a highly paid, middle-aged executive to defer some of his annual compensation into his retirement years. By then, after all, his income would probably be lower, and so would the tax liability on the money in question. As it was, he was getting only half of each incremental dollar paid out currently (assuming he was in the 50% tax bracket). So he had a strong economic motive for setting aside a chunk of his salary or bonus and investing it on a tax-deferred basis. As for his employer, deferring compensation meant improving cash flow.

Under the new tax law, however, deferred compensation has lost its luster. It's a matter of simple math. As corporate tax rates fall from 46% to 40% to 34%, companies are faced with increasing aftertax costs of compensation and benefits in general. Meanwhile, executives find that the value of that extra dollar of current income is rising. At today's top individual tax rate, it's worth 62.5?, rather than the 50? of a year ago, and it will be worth 9.5? more in 1988, when the rate drops to 28%. Small wonder that top executives are beginning to clamor for cash on the barrelhead. And if Congress is as likely to raise individual tax rates as many believe, there is all the more reason for executives to worry about the future value of a deferred bonus, and to push for getting their money now.

So cash has a lot more appeal now than it did a year ago. What about equity? There, too, tax reform has had a major impact. Only yesterday, it seems, executives and ambitious employees all over the country were demanding stock in their companies, and -- to some extent -- the rationale was economic. Equity, after all, offered the opportunity to build personal wealth through the increasing value of the shares, and the appreciation would be taxed at no more than 20%, the maximum tax rate on long-term capital gains. For an executive in the 50% bracket, the prospect of big gains and low taxes was hard to resist.

Tax reform has certainly not eliminated the appeal of capital appreciation. (Has there ever been a better way to build a nest egg than to have the value of your company's stock soar from $5 to $50?) But, starting next year, the appreciation will be taxed at the same rate as ordinary income. That change removes a significant part of the economic incentive for owning real shares of stock, and correspondingly strengthens the case for nonequity alternatives -- such as phantom stock and performance bonuses -- which can be structured to give employees a chance to reap the upside rewards of growth without actually becoming owners. From the company's perspective, moreover, such alternatives are often easier to administer than real equity, in that they are not subject to securities regulations. Granted, employees may still want ownership. "But there are many ways a private company can foster a feeling of ownership without giving away actual shares," notes Donald T. Sagolla, a principal in charge of management consulting with Peat Marwick Main & Co., in Hartford. Some of those other ways are more appealing than ever.

 1 | 2 | 3 | 4 | 5  NEXT