What a job I used to have when I was working as an executive compensation consultant. My clients taught me all sorts of things, and I got to send them bills for my time.
I'll never forget a meeting I had with the chief financial officer of Bethlehem Steel Corp. back in the late 1970s or early 1980s. I was reviewing my recommendations concerning the design of a new incentive compensation plan and when I got to the subject of offering a participating executive the opportunity to defer all or part of his bonus, I told the CFO: "Bethlehem could offer the executive a rate of interest on his deferred income equal to the prime rate. After all, Bethlehem gets to keep the money in the business during the deferral period, and if it had borrowed the money from, say, Citicorp, it would have had to pay the prime rate in any event."
The CFO looked at me curiously and said something like: "That's an interesting analogy, but you're dead wrong." My stunned glance told him that I was going to require a bit of an explanation.
"Let's assume," he said, "that we are about to award an executive a bonus of $100,000. Now if we pay him the bonus right away, we can take an immediate corporate tax deduction. Given a corporate marginal tax rate of 35% (the current level), Bethlehem is out-of-pocket, not $100,000, but $65,000. So it follows that if the executive defers his $100,000, we cannot be in-the-pocket by $100,000; we can only be in-the-pocket by $65,000. We'll eventually get a tax deduction on that $100,000 bonus, but only when we finally pay it out to the executive.
"In the meantime," the CFO continued, "if I understand your proposal, you would have Bethlehem credit the executive with prime rate interest on his $100,000 nominal bonus. Thus, if the prime rate is 6.5%, you would have us credit him with $6,500 in interest the first year. But $6,500 interest on a cash inflow of $65,000 turns out to represent a true interest rate of 10%.
"Alternatively, were we to pay out the bonus to the executive, sustain a net cash outflow of $65,000 and then restore that outflow by borrowing $65,000 form Citicorp, our interest bill would only be 6.5% of $65,000, or $4,225. In other words, your proposal looks to offer us the same cost for an executive deferral as for a bank loan, but we actually end up having our true interest rate raised by 54% (10% vs. 6.5%). Got any other brilliant ideas?"
I never forgot the lesson he taught me - especially when I read an opinion recently issued by a panel of judges on the 9th U.S. Circuit Court of Appeals in San Francisco. It seems Albertson's Inc., the large Boise, Idaho, supermarket chain, had an executive deferral program that offered the participant a rate of interest during the deferral period equal to the weighted average of Albertson's long-term borrowing rate for that current year.
There has for many years been a dichotomy in the tax law concerning the interest paid on a true bank loan and the interest paid on deferred compensation. Interest owed on a true bank loan is immediately deductible to the corporation as an accrued expense, even if the interest is carried forward and compounded. But interest paid on deferred compensation has been considered simply to be more compensation, and not really interest, and has remained non-deductible until it actually was paid out to the executive.
Sniffing a potential tax benefit, Albertson's asked the Internal Revenue Service in 1982 for permission to deduct the interest on deferred compensation as true interest, i.e., to deduct it right away. Amazingly, the IRS agreed, at least at first. But it quickly rethought its position and reversed itself. That didn't please Albertson's. As a result, the company sued the IRS. It lost in U.S. Tax Court, but the panel of appellate judges reversed the decision and held for Albertson's.
In coming to this startling decision, the Court of Appeals noted, "The additional amounts specified in [Albertson's deferred compensation agreements] were a direct reflection of what Albertson's would have paid on the open market in order to borrow such amounts." In a footnote, the court added: "Of course, a taxpayer's characterization of what is 'interest' is subject to a rule of reason. Otherwise, most of a taxpayer's obligations under a [deferred compensation agreement] could be characterized as 'interest.' We conclude that the interest component in this case is not unreasonable."
Well, based on what I learned from my teacher at Bethlehem Steel, the Court of Appeals has fallen into the same trap I did. They forgot that if the executive defers, the company does not have available for use in the business the nominal amount of the deferral; rather, it has available only the after-tax amount of the deferral, an amount that, under current tax law, is 35% lower. On that basis, therefore, the interest being paid is not, as the court put it,"a direct reflection of what Albertson's would have paid on the open market in order to borrow such amounts." And on the same basis, the amount being paid, rather than being "not unreasonable," is plain unreasonable.
The appellate court's decision so totally unnerved the Department of the Treasury that it asked for, and has been granted, a rehearing by the same court June 29. The Treasury calculates that if companies are permitted to deduct the cost of interest on deferred compensation as the interest is accrued, it will sustain a cash outflow of $7 billion during the next five years.
In all probability, the Treasury has underestimated the cash outflow for at least three reasons.
First, the court decision itself lowers the cost of deferred compensation to a company and thus makes it more likely the company will engage in more deferred compensation deals.
Second, the Clinton administration has raised the top individual income tax rate to 39.6% from 31%. As history shows when marginal tax rates rise, executives begin to consider seriously whether they would be better off deferring income, rather than taking it currently. So the increase in marginal tax rates almost assuredly will spur yet another increase in deferred compensation transactions.
Finally, the Clinton administration also initiated the new law that now denies a company its tax deduction on compensation that is payable to any of its top five executive officers and that is in excess of $1 million per year. Compensation consultants are telling companies all over the country that one way to bypass the $1 million pay cap is to defer compensation above $1 million one day past the executive's retirement. At that moment, the executive no longer will be one of the five highest-paid executive officers, and anything paid to him will become fully deductible. So for all these reasons, the cash drain to the Treasury, if the court does not reverse itself, could be much larger than it currently estimates.
So why do I care whether the Court of Appeals sustains its original opinion or reverses itself? After all, it's not my tax deductions at stake. Well, I figure, purely pragmatically, that if the Treasury loses, and if the U.S. budget deficit thereby widens, it won't be long before President Clinton acts to rebalance the deficit by increasing still more the income taxes paid by higher-income taxpayers. The way I see it, Albertson's has deeper pockets than I do.