How Firms Responded to the New Tax Law Limiting the Deductibility of Certain Executive Compensation

January 1, 1997

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Executive Summary In this paper, we provide evidence on factors associated with firms’ decisions to alter their executive compensation plans in response to Internal Revenue Code Section 162(m) added in the Omnibus Budget Reconciliation Act of 1993, which prevents public companies from taking a tax deduction for compensation paid to certain executives that both exceeds $1 million and is not “performance-based.” Affected companies may preserve the deductibility of compensation exceeding $1 million by either qualifying the compensation as “performance-based” or deferring the compensation to a point in time when a deduction can be taken.

In deciding whether to comply with Section 162(m), firms must trade off the costs of increased stakeholder pressure and the higher taxes that result when no action is taken to preserve deductibility against the increased transactions and risk – sharing costs that arise when compensation is restructured to comply with Section 162(m). The influence of stakeholder pressure on the compliance decision is especially important following a November 1993 SEC ruling that required firms to provide Section 162(m) disclosure in their proxy statements, thereby increasing the visibility of their response to the tax law change. Thus, this issue provides a natural laboratory for examining how firms respond to stakeholder pressure to make policy decisions that — in the absence of the stakeholder pressure — may be inefficient.

We offer three hypotheses about the decision to assure deductibility by either qualifying or deferring compensation. In particular, we predict that firms with larger potential tax savings, greater stakeholder pressure, and greater monitoring by shareholders are more apt to take action to preserve deductibility. We also develop four hypotheses about the choice between the two alternatives of qualifying and deferring for those companies that took action. We predict that the greater the shareholder pressure to alter compensation policies, the less the risk imposed on managers by the sensitivity of pay to performance, the lower the cost of reimbursing managers for the transactions costs they incur if compensation is deferred, and the lower the agency costs of debt, the more apt a complying firm is to qualify its plan, as opposed to deferring compensation.

Results from a sample of 266 publicly held U.S. firms with non-qualified compensation in excess of $1 million indicate that 163 (61.3%) took action to preserve deductibility. Of these 163 firms, 129 (79.1%) chose to qualify their plans while 34 (20.9%) deferred compensation to a point in time when the deduction could be taken. With respect to the decision to assure deductibility, we find support for two of our three predictions.

Complying firms face greater political pressure as evidenced by their larger size and higher compensation levels. Complying firms also face greater monitoring by shareholders, as evidenced by the higher percentage of outside blockholders. In contrast, we find no evidence that firms with greater tax savings are more apt to preserve deductibility.

With respect to the decision to assure deductibility by deferring compensation versus qualifying a plan, we find support for three of our four predictions. Qualifying firms face greater pressure from shareholders in the form of shareholder proposals on compensation issues. Qualifying firms also have a higher prior pay-for-performance sensitivity than deferring firms, indicating that less risk is imposed on their managers when pay is made more sensitive to performance. Similarly, CEOs at qualifying firms have a relatively high demand for liquidity, as evidenced by the fact that they are younger than CEOs at deferring firms. Finally, agency costs between bondholders and shareholders do not appear to influence the decision to defer compensation versus qualify a plan.

The remainder of the paper proceeds as follows. In Section 2, we discuss Section 162(m) of the Omnibus Budget Reconciliation Act of 1993. In Section 3, we develop our hypotheses. In Section 4, we describe our sample and present descriptive statistics. We present our models and the results of our empirical tests in Section 5 . In Section 6, we offer a summary and conclusion.


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