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Key Topics
Requirement
As a CPA with PWC, you advise the Compensation Committee of the Board of Directors of Mega Corporation, an NYSE listed company. Mega’s fiscal year-end is nearing and the company is in a celebratory mood – based upon financial results to date, revenues and earnings should increase more than 40% for the fiscal year. The Compensation Committee has just voted to award a $3 million bonus to Mega’s Chief Executive Officer. The award was not planned earlier in the year as no one anticipated such great results, but the committee has determined the award is justified based upon the results achieved. Additionally, based upon the results, the Committee determined Mega could lose the CEO to a competitor if the bonus was not awarded. Consequently, paying the bonus was in the best interest of the shareholders. As Mega’s CPA, please advise the Compensation Committee on whether any “tax issues” arise with respect to this level of executive compensation. Please advise the Committee on their belief that paying the
bonus is in the best interest of shareholders. What are your recommendations to the Compensation Committee members? While communicating your advice, please cite the specific internal revenue service tax codes and any applicable tax cases, if any, which support your views.
Solution
The fact of the case
Mega’s, NYSE listed company is at the end of the fiscal period and it is expected that the year will end with a 40% increase in revenue and earnings. The compensation committee has voted to pay $ 3 million compensation to its CEO; also they afraid if the compensation will be paid less, the company will lose the CEO.
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Discussion Applicable law with respect to Case
Section 162(m) of the Internal Revenue code of 1986 restrict deduction for compensation paid to a covered employee up to $1 *million. The Covered employee contains the CEO and other three highest compensation paid officer excluding the CEO and CFO. However, there is a certain exception to this provision. It is to be noted that qualified preference-based compensation are not covered under the limitation of compensation as stipulated under section 162(m). A bonus paid based on the profitability of the company is definitely performance-based compensation as the profitability of the company is always uncertain. However specific pre-established goals should be there and it must be approved by a shareholder by vote. Also, the certificate from the Compensation committee needs to be obtained before paying performance-based compensation stating that the required goals are fulfilled.
Recommendation to Committee
The compensation committee has two options
Option 1 -Paying $ 3 Million as normal compensation
Mega’s compensation committee has agreed for payment of $3 million compensation to the CEO as normal compensation, however, it the company can claim only $1 Million as a deduction for taxation, and for another $2 million the company will not get the deduction. So it will be a huge tax loss for the company and lead to loss of shareholder wealth.
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Place Your OrderOption 2- Paying compensation above $1 Million as a performance bonus
It is cleared said that companies' profitability will be 40% high at the end of the fiscal year and hence the company can pay the performance-based compensation to the CEO. The compensation over and above $1 million can be covered under this relation. To take a deduction for qualified compensation based on profitability, the compensation committee needs to take care following four points
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The company need to set the performance goal for the CEO in terms of profitability before year-end
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The Goals for the Profitability must be set by the compensation committee
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The approval of the shareholder must be taken in terms of the vote before payment, for performance criteria and amount of compensation.
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Before payment, the compensation committee needs to give a certificate that the performance goals has been achieved by the CEO.
The option 2 seems viable as it will result in tax deduction for compensation above $1 Million which was not deductible and also it will help to retain of the CEO
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