To many investors and shareholder activists, tax gross-ups are an element of CEO compensation just about as offensive as the name sounds. Still, they don’t seem to be going away.
Such are the findings of the Corporate Library, which studies the compensation disclosures of nearly 3,300 companies that filed proxy statements from February 2007 to February 2008. Forty-two percent of those companies gave their CEOs gross-up payments, which are used to cover the 20 percent excise tax that applies to golden parachute payments that exceed the limit imposed by the federal tax code.
Corporate Library Senior Research Associate Paul Hodgson, author of the report, says the prevalence of what he calls the “grossest perk” is surprising, given the increased transparency—and scrutiny—of executive pay under expanded compensation disclosure rules the Securities and Exchange Commission imposed in 2006.
“It shows that boards or CEOs, or both, are more thick-skinned than we took them to be,” Hodgson wrote in a March 31 bulletin. He argues that gross-up clauses should be completely removed from employment agreements and change of control severance benefits.
“Many CEOs who lose their position through no fault of their own are eminently employable,” he tells Compliance Week. “And if they’re thrown out for doing a bad job, why pay them more?”
Some investors agree. The American Federation of State, County, and Municipal Employees filed proposals this year at several companies calling for a ban on tax gross-ups. Excise tax gross-ups often raise eyebrows because of the dollars involved. Such payments can be the most costly part of change-in-control payments, since exceeding the IRS limit by even one dollar triggers the 20 percent penalty tax—so even a single extra dollar can translate into gross-up costs of $100,000 or more.
Still, compensation consultants say most companies aren’t likely to eliminate their excise tax gross-ups. “Notwithstanding the criticism, the reasons they have them still exist,” says Paula Todd, a managing principal at consulting firm Towers Perrin. “Most companies are trying to figure out how to make them more efficient and smarter [while accomplishing] the same objectives.”
Steve Van Putten of the compensation consulting practice at Watson Wyatt Worldwide agrees. While there is “some movement” to moderate excise tax gross-ups, “it’s still majority practice to provide them,” he says.
Todd says a common misconception is that an excise tax gross-up means a CEO gets his or her severance payment tax free. Most gross-ups neutralize the sting of the penalty tax, but the executive still owes income tax on the severance package itself, she says. The excise tax gross-up can also negate the uneven impact the excise tax can have on two similarly paid executives at the same company.
Since the limit that triggers the penalty tax is based on a multiple of the executive’s average historical W-2 income, an executive who never exercises any stock options and holds his shares would have a relatively low W-2 base amount and would therefore be more likely to trigger the excise tax, says Van Putten. Meanwhile, a similarly paid executive at the same company who cashes in stock would have a higher base amount and would be less likely to trigger the excise tax.
Observers say gross-ups of excise taxes are likely to stick around because they’re usually negotiated in employment agreements, which aren’t easily changed. “It’s difficult to take it out once it’s in,” Van Putten says.
Still, compensation experts do say boards are trying to manage the cost of change-in-control gross-ups. “Directors are taking a hard look at managing the potential cost … by the design of their programs,” says Mark Rosen, a managing director at compensation consultancy Pearl Meyer & Partners. “It’s not universal, but there’s a lot of discussion among directors and compensation committees about how to manage and reduce the potential cost.”
For instance, some companies are implementing “valley” or “conditional” gross-ups. Such provisions cut back the severance payout if it exceeds the IRS limit by a certain percentage (usually 10 percent) to avoid triggering the excise tax. Experts note, however, that change-in-control payments can easily exceed the limits imposed by those provisions.
Other companies simply cap payments above a certain amount. Rosen says some are providing fewer opportunities for executives to defer compensation, to decrease the likelihood that they’ll exceed the IRS limit. And Van Putten says he’s seen some companies institute cost-sharing arrangements, where the CEO and the company each pay a portion of the excise tax.
Gross-ups in Detail
Companies are also doling out tax gross-ups to cover taxes due on perks—which are often sore points with investors already. According to the Corporate Library study, exactly which perks are covered by gross-ups isn’t always clear; roughly 35 percent of such gross-ups included no explanation. But among those that were tied to specific perks, the most common were insurance (13 percent of all gross-ups), aircraft use (8 percent), relocations (7 percent), car (6 percent), and financial planning (5 percent).
Hodgson says he was surprised at the number of boards providing gross-ups on perks. “It isn’t the amounts, it’s the principle,” he says. “Many of these people are among the most highly compensated in the world. It’s indefensible.”
According to the report, the highest amount paid as a gross-up went to Chad Dreier, CEO of homebuilder The Ryland Group. He received roughly $5.82 million in tax gross-ups for fiscal 2006, on almost $49 million in total compensation. That amount included more than $5.75 million in “tax assistance” on the vesting of $6.5 million of restricted stock, tax gross-ups of $23,202 on life insurance, a $10,641 gross-up on term-life insurance premiums, $3,564 for tax assistance and reimbursement of health and fitness costs, and $32,720 in aircraft usage tax gross-ups for spousal and family travel to corporate functions.
The Ryland Group actually saw its revenue edge downward that year, from $4.8 billion in 2005 to $4.75 billion in 2006. Net income also fell from $447 million to $360 million. And in 2007—a year that has hammered homebuilders of all stripes—the company saw only $3 billion in revenue and swung to a $333 million net loss.
The study also singles out Brunswick Corp. CEO Dustan McCoy, which received tax gross-ups for boats and other Brunswick products; aircraft use; annual physical examinations; home security systems; excess liability insurance; life insurance; spouse travel; and holiday gifts. And executives at Rambus received tax gross-ups on PS3 Entertainment Systems.
Many say gross-ups on perks will all eventually disappear, because most of the perks that give rise to gross-ups are going away. Rosen, who says the number of gross-ups on perks “is pretty small and dropping,” adds that he is “surprised there are that many left.”
Van Putten agrees. With the increased scrutiny of executive pay, companies and compensation committees are “revisiting the issue of perks in general, and gross-ups on perks in particular,” he says. Citing the $12,814 median value for perk gross-ups, “In the context of a $10 million pay package, that’s just not meaningful,” he says. “It’s not worth it.”
Since the amounts involved are usually small, perks are easier to eliminate or renegotiate, he says. Still, Van Putten and others say companies that eliminate perks often replace them with an increase in salary or a one-time lump-sum payment.
“There’s often a quid pro quo since you’re taking something you promised away,” Todd says. “Companies can get to the same place through a different route that won’t bring as much criticism.”