Topics:   Compensation,Strategy

Topics:   Compensation,Strategy

March 19, 2019

What to Do With Pay If Taxes Go Much, Much Higher

March 19, 2019

Regulations and taxes greatly influence executive pay design. While the current “typical” program—salary, annual bonus based on financial results, and an annual equity award dominated by performance-based shares—seems as comfortable as an old shoe, it’s an evolving thing that adapts to meet dual goals of incentives and retention.

As the election cycle begins to heat up for a 2020 showdown, lines are beginning to show in the sand around monetary policy, trade, and income taxes. Compensation committees need be forward-thinking about long-term implications of potential new laws so they can act nimbly and with conviction when changes occur.

Our objective is not to handicap the political environment and discuss what’s “likely” to occur. Guessing right would be simple luck. In broad strokes, the tax ideas floated so far by potential 2020 Democratic presidential candidates focus on raising taxes for the wealthy as a mechanism to close the Federal deficit. That drumbeat will get louder and more polarizing on the road to the 2020 general election and amid mixed economic signals.

The ideas of candidates Bernie Sanders and Elizabeth Warren center on increasing tax revenue from capital gains. Bill Gates approached the notion more directly (albeit in a manner less politically appealing): “The big fortunes, if your goal is to go after those, you have to take the capital gains tax, which is far lower at like 20%, and increase that.”

Both ideas are similar in that they create a more even playing field between ordinary income and capital gains. That disparity is arguably at the heart of inequality of wealth distribution.

Boards first should be thinking and talking about the broader economic implications of the political environment on their business planning and strategy. Compensation committees should consider near-term and long-term implications for pay program design as part of this discussion.

A Dollar Today May Be Worth More Than a Dollar Tomorrow

Material changes to the tax code should not be expected reasonably before 2022, and then only if a Democrat is elected as president. If marginal income rates are certain to rise materially, incentive awards that vest prior to the increase will have a higher after-tax value than those that vest after the increase occurs.

Awards that deliver a higher after-tax value may be desirable, similar to the end of 2017 when the corporate tax rate—and the associated value of tax-deductible compensation—dropped from 35 percent to 21 percent. Many boards took action at the end of 2017 to bring forward compensation-related tax deductions. We would expect similar actions if future individual tax rates are certain to rise.

Maintaining Sound Pay Principles Remains Paramount

The compensation committee has a duty to make rational decisions about pay that align with performance. Pay programs that deliver pay sooner and incentives for long-term strategic execution that benefit the company must remain balanced. This could lead to complexity in pay program design that generates taxable income for recipients but maintains a connection to long-term performance of the company. This could take many forms, such as:

  • Increased stock option usage, giving the recipient control over timing of income.
  • Shorter vesting of share-based awards with material holding requirements.
  • “Banked” awards, to trigger income tax quickly on a portion with future performance requirements for upside attainment.
  • A (short-lived) renaissance in Section 83(b) elections.

Increased Taxes Could Promote “Long-termism”

If wealth, estate, and capital gains tax ideas come to fruition, an opposite and powerful incentive to encourage long-term behavior could become a reality. Executive pay above $1 million in a given year generally is no longer deductible, and if corporate tax rates do not rise with individual rates, companies have less incentive to accelerate pay-related deductions where available.

This should stimulate discussion of much longer-term and estate-oriented pay structures for senior executives. Ideas in this area include the use of various kinds of trusts to encourage a reduction in personal balance sheets to defer wealth or estate tax burdens, and a delay versus acceleration of income recognition.

It is too early to tell how this will shake out. How pay evolves is a result of many complicated interactions. History teaches us that changes in the law are a major driver of that evolution. Reaffirming the principles of the pay system when discussing potential reactions to a new regulatory environment will be the key to having comfort in the next wave of executive pay design.

Margaret Hylas is a consultant and Todd Sirras is a managing director of Semler Brossy Consulting Group. All thoughts expressed here are their own.