Is There a Role for Tax Law in Policing Executive Compensation?
Stabile, Susan J., St. John's Law Review
SUSAN J. STABILE*
The public often complains that executives of public corporations in the United States are overpaid.l Reports of average chief executive officer ("CEO") compensation in major American industrial companies exceeding $3.5 million2 and of individual CEOs earning compensation of $45 million or more' are met with the response that no one could be worth that much.4 While attention has primarily been focused on CEO compensation, the pay packages of other senior executive officers have not gone unnoticed.5
When Americans have a complaint, they generally think something should be done to address that complaint. Frequently, they think the government should be the one to solve the problem. One of the ways in which the federal government has been involved in the area of executive compensation is through the Internal Revenue Code (the "Code"), which imposes limits on the deductibility of both ordinary compensation and compensation contingent on a change in corporate control. Several months ago, the Internal Revenue Service (the "IRS") initiated a case in the United States Tax Court in Washington D.C. against Columbia/HCA Healthcare Corp., alleging that the company owed $190 million in back taxes for "unreasonable compensation" and "excess parachute payments.' So rarely has the IRS attacked a major public company's deductions for executive pay,7 that some believe the case telegraphs the IRS's "intent to open a new chapter in their policing of compensation in public companies."8 In addition to whatever actions the IRS takes under current law, there have also been proposals made in the last several years to use the Code more extensively to alter corporate decisions on executive compensation.9
This Essay examines whether there is a role for the Code in the policing of compensation paid to executives of public corporationslo in the United States. Part I examines attempts under current law to use the Code as a means of addressing perceived abuses in executive compensation. Part II examines whether the Code should be used as a vehicle for policing executive compensation. The conclusion of this Essay is that the Code should not be used as a means of attempting to influence the amount or type of compensation a company pays its executives in absolute terms or in relation to the compensation a company pays its rank and file employees. Unless Congress and the IRS are able to articulate and defend a different goal in relation to executive compensation, there is no role for the Code in this area.
I. CURRENT ATTEMPTS TO USE THE CODE AS A MEANS OF POLICING EXECUTIVE COMPENSATION
Section 162(a)(1) of the Internal Revenue Code permits a taxpayer to take a deduction for "ordinary and necessary" business expenses, including "a reasonable allowance for salaries or other compensation for personal services actually rendered."ll Treasury Regulations promulgated under section 162 expand the statutory language by providing that the "test of deductibility in the case of compensation payments is whether they are reasonable and are in fact payments purely for services."la Although the Regulations seem on their face to envision a two-part test, in reality, the primary inquiry is whether the amount of compensation in question is reasonable, since courts will infer from that conclusion the existence of a compensatory purpose. 13
Section 162(a)(1) appears to operate as a restriction on the amounts that may be paid to executives. The language of the statute and the regulations certainly gives the IRS the authority to disallow deductions for compensation that is viewed to be unreasonable. The IRS, however, has not aggressively utilized this authority. There are few cases, none of them recent (with the exception of the recently initiated action against Columbia/HCA Healthcare Corp.), in which the IRS has challenged compensation paid to executives of publicly-held companies.l4 IRS efforts to disallow deductions for compensation have generally been targeted at close corporations, where the executive is essentially setting her own salary and the allegation is that the amounts paid are unreasonable or are really disguised dividends and not compensation. …