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The practices of Enron make clear that executive pay is about more than just tax policy. Executive pay is an issue of corporate governance and accountability, and an issue of fiscal responsibility and fairness. However, it is important to distinguish matters of tax policy from matters of corporate governance and accountability, and the fiduciary responsibilities related to good corporate governance and accountability.
In considering the practices of Enron regarding executive pay and the tax policies related to nonqualified deferred compensation, it is important to understand the tax rules for executive compensation and how the rules factored into the compensation practices of Enron. The tax law does not specifically encourage executive compensation arrangements. In contrast to qualified retirement plans, Congress has not enacted incentives for companies to maintain executive pay arrangements. The rules on executive compensation generally have focused on three policy goals, first, to prevent tax avoidance, second, to protect the qualified plan system, and third, to promote good corporate governance.
First, the rules on executive compensation generally are intended to prevent tax avoidance. The general tax principles allow an executive to defer tax on compensation only if the executive accepts the risk that the compensation may never be paid if the company becomes insolvent or bankrupt. Executives typically do not enjoy this risk and seek greater security and control in their deferred compensation arrangements. Second, other rules are intended to protect the integrity of the qualified plan system. To ensure the retirement security of most workers, the tax code provides substantial tax incentives for companies to establish and maintain qualified plans. Allowing executive pay plans to provide the same tax benefits that qualified plans can provide would undermine the qualified plan system. Therefore, the tax code ensures that executive pay arrangements do not inappropriately compete with qualified plans. Third, certain tax rules are intended to promote good corporate governance and accountability. Congress has enacted rules that impose tax penalties unless companies satisfy certain shareholder-protection standards.
Nonqualified deferred compensation arrangements, including both executive bonus plans and executive retirement plans, constitute a significant element of executive pay. The objective of these arrangements is to provide tax deferral for a specified period of time on either an elective or non-elective basis. If structured correctly, the tax treatment of a nonqualified deferred compensation arrangement is as follows. The executive does not include the deferred amount in gross income until it is actually paid out to the executive. The company cannot claim a deduction for the deferred amount until the executive includes it in gross income. During the deferral period, earnings on the deferred amount generally remain taxable to the company. Therefore, the law imposes a "tax tension" between the executive and the company because every dollar for which the executive defers income is a dollar for which the company must defer its deduction.
The rules for a deduction for the deferred amount are found in Section 404(a) of the Internal Revenue Code (the Code). Section 404(a) of the Code provides additional guidance regarding the requirements for a deduction for that amount. Under that section, the compensation paid under a plan deferring the receipt of compensation will be deductible only if the compensation otherwise satisfies the requirements for reasonable compensation pursuant to Section 162 of the Code. The potential loss
of a significant tax deduction provides, therefore, a significant incentive to companies to provide only "reasonable" compensation. In addition, the boards of directors of companies have fiduciary obligations under the business judgment rule, a feature of the corporation laws of every state, that require them to assure that deferred compensation pay levels and those for whom such pay levels are established are not abusive to shareholders.
Deferred compensation arrangements must also satisfy certain requirements. First, the executive cannot be in "constructive receipt" of any deferred amount. Income is "constructively received" by a cash-basis taxpayer when it is "set apart for him, or otherwise made available so that he may draw upon it at any time," without "substantial limitations or restrictions." (1) Under the "doctrine of constructive receipt," if an individual can elect to receive compensation currently, the individual will be required to pay tax on that compensation currently. However, if the individual's control over the current receipt of compensation is subject to substantial limitations, then the compensation should not be subject to tax under the constructive receipt doctrine.
This means that an executive can defer an amount only so long as there is a "substantial limitation or restriction" on the right of the executive to receive the amount. The principle of constructive receipt ensures that an executive may not manipulate the timing of when taxes are due by turning his or her back on income that would be paid currently if the executive requested payment. (2) Accordingly, deferred compensation arrangements typically provide for the deferral elections to be made before the beginning of the taxable year for which the compensation is earned. The plans generally state the time when amounts will be paid out and the form of the distribution. However, many plans permit an executive to make a subsequent election to defer payouts that are otherwise due, or to change the form of the payout, or both. The plans typically require that the subsequent election be made a fixed number of months, generally 12, before the payout is due. Some plans also permit accelerated payouts, for example, an early distribution with a "haircut"--such as the forfeiture of 10 percent of the amount of the payout.
Second, the tax law treats an unfunded promise to pay differently from a funded promise. Therefore, the "economic benefit" doctrine and the rules governing transfers of property require that assets related to nonqualified deferred compensation remain subject to the claims of the general creditors of the company along with the other general assets of the company. Under the economic benefit doctrine, an individual is subject to tax currently (even though not necessarily in constructive receipt) if assets are unconditionally and irrevocably paid into a fund or trust to be used for the individual's sole benefit. Accordingly, if any economic or financial benefit is conferred on an individual as compensation in a taxable year, it is taxable to the individual in that year. (3) The general principle of taxing individuals upon the receipt of an economic benefit has been codified in Section 83 of the Code with respect to the transfer of property between an employer and an employee.
These rules are intended to put the executive at risk of non-payment if the company becomes bankrupt or insolvent. If a company insulates deferred compensation assets from the claims of its creditors--for example, by placing the deferred compensation in a trust or an escrow account for the executive to the exclusion of all others--the executive has a taxable economic benefit and must include the deferred compensation in gross income.
Limited funding vehicles have been permitted by the Internal Revenue Service (IRS), such as a "rabbi trust," without triggering current taxation to the executives. Assets held in a rabbi trust are treated as belonging to the company, and the company continues to pay tax on any income the trust produces, and the assets held in the trust are reachable by the creditors of the company in the event of the insolvency or bankruptcy of the company. However, some arrangements--which include offshore rabbi trusts--are established with the intention of protecting the assets held in the arrangements from creditors without triggering current taxation to the executives.
Additionally, the cash-equivalence and assignment of income doctrines require that the interest of the executive in the deferred compensation to be non-assignable. This ensures that the executive cannot sell, transfer, pledge, or borrow against the deferred compensation and thereby realize economic value from it before it is paid.
The practices of Enron suggest that the limits of the tax law may be stretched with undesirable consequence without good corporate governance and accountability in the administration and operation of deferred compensation arrangements. As Enron rapidly approached bankruptcy, Enron executives were able to accelerate the distribution of the compensation deferred pursuant to the deferred compensation arrangements. Although the accelerated distributions required a "haircut" the choice between receiving most of the deferred compensation and, perhaps, receiving none of the deferred compensation was relatively easy. And, if the compensation was distributed sufficiently ahead of the insolvency or bankruptcy of Enron, it becomes difficult to recapture the distributed amounts once the bankruptcy occurs. However, good corporate governance and accountability would, presumably, preserve the integrity of nonqualified deferred compensation arrangements and the purposes of those arrangements and undesirable consequences could be avoided.
Under the business judgment rule, the structure and administration of nonqualified deferred compensation plans should be governed by the conduct of the board of directors of the employer and the fiduciary duties of care and loyalty owed by the directors to the employer and its shareholders. This conduct may be governed under federal law and state law. In Buckhorn, Inc. v. Ropak Corporation, (4) Ropak Corporation and Ropak Holdings Corporation sought a preliminary injunction of certain actions taken by Buckhorn, Inc. and its board of directors in response to Ropak's tender offer for any and all shares of Buckhorn stock. Specifically, Ropak sought to enjoin various measures adopted by the board of directors including severance and stock option agreements with six key managers of Buckhorn, Inc. In considering the merits of Ropak's motion, the court noted that Buckhorn, Inc. was a Delaware corporation and, accordingly, the conduct of its directors was governed by Delaware law.
Under Delaware law, the directors of a corporation owe unyielding fiduciary duties of care and loyalty to the corporation and its shareholders. The fiduciary duty of care requires a director to exercise an informed business judgment and to consider all material information reasonably available before making a business judgment.
The court stated that, generally, when reviewing the action of directors, Delaware courts have applied the business judgment rule which presumes that "the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company." Therefore, whether the actions of a corporation's board of directors with respect to issues related to nonqualified deferred compensation plans are taken in the best interests of the corporation may depend upon the standard of conduct required under the business judgment rule and the fiduciary duties of care and loyalty to the corporation and the shareholders of the corporation owed by the directors.
Furthermore, if a court concludes that the terms of a deferred compensation arrangement are so unfavorable to a corporation that no director of ordinary sound business judgment would have voted in favor of it, the arrangement can be invalidated. The term used to describe such a result is "waste" or "gift" of corporate assets. If, in contrast, reasonable persons could disagree whether a compensation arrangement is favorable to the corporation, it could be upheld under the business judgment rule. (5)
Therefore, the company should determine for the executives the compensation reasonable …