How to adjust to the $1 million compensation cap.

The newest compensation proposal seeks to amass more tax revenues while restricting a company's authority to adopt appropriate compensation programs for senior management. But all is not lost. Here are some tips to beat the cap.

The Clinton Administration's proposal to eliminate a federal income tax deduction for certain compensation in excess of $1 million per year (the "Compensation Cap") is rooted in social rather than tax policy. If enacted as approved by the House Ways and Means Committee in the "House Bill," the Compensation Cap generally will limit a corporation's ability to adopt appropriate compensation programs for senior management, but will raise little in additional tax revenues.

This article will describe the principal features of the House Bill and show how possibly to avoid the loss of an income tax deduction without reducing the total compensation payable to affected executives over their careers.

THE PROPOSAL

The Compensation Cap, which would apply to taxable years beginning on or after January 1, 1994, is more limited in scope than the provision vetoed last year by President Bush. It only applies to the "Named Executives" of a Publicly Traded Corporation--one that has a class of common equity which is required to be registered under section 12 of the Securities Exchange Act of 1934. Named Executives are each of the corporation's executive officers whose compensation must be reported in the summary compensation table of the company's proxy statement. The House Bill does not apply to compensation paid under many existing contracts, and it offers an opportunity to avoid disallowance through deferring compensation or obtaining shareholder approval of performance-based programs.

Who is affected? The Compensation Cap applies to those individuals who are a Publicly Traded Corporation's Named Executives with respect to the taxable year in which the compensation is paid. For any given fiscal year, this group usually includes the corporation's CEO and the four other most highly compensated executive officers who are serving in such capacities on the last day of that year. Thus, an executive who retires prior to the last day of a fiscal year will not be a Named Executive for that year, and the compensation paid to him or her for that year and any subsequent year will not be subject to the cap.

A Publicly Traded Corporation's Named Executives are determined based on the annual salaries and bonuses, whether paid or deferred, of its executive officers--not their total compensation. The ability to make year-to-year changes in the affected group by adjusting the amounts paid as salary or bonus may present opportunities for executives other than the CEO. For example, a company may issue restricted stock instead of an annual bonus so that an officer is not a Named Executive for that year.

What is grandfathered? The Compensation Cap will not apply to a binding plan or agreement between the corporation and the covered employee in effect on February 17, 1993, unless there is a material modification to the terms of the contract. Thus, if an existing plan or arrangement can be amended unilaterally by the corporation to reduce the compensation payable in the future, it seems likely that only benefits accrued on or before February 17 would be protected by this "Grandfather Rule." Moreover, it is not yet clear how this Grandfather Rule will apply to plans or agreements that contain "binding" terms that are affected by actions within the discretion of the corporation, such as an employment agreement that guarantees the CEO an annual increase in salary determined by the average rate of increase for all of the corporation's executive officers.

Exception for certain performance-based compensation. Compensation not protected by the Grandfather Rule generally will be subject to the Compensation Cap, unless it is paid solely under a shareholder-approved arrangement on account of the attainment of one or more performance goals applied to an individual executive, a business unit, or the corporation as a whole. Stock options and stock appreciation rights will be treated as qualified performance-based compensation, because the compensation payable is based on an increase in the corporation's stock price. However, any stock option granted with an exercise price below the stock's fair market value at the grant date or which otherwise protects a Named Executive from decreases in the stock's value will not be treated as performance-based.

A compensatory arrangement (including the performance objectives) must be established by a committee of two or more independent directors under a program disclosed to and approved by a majority vote of the corporation's shareholders prior to payment to qualify for this "Qualified Performance Exception." (An award made prior to shareholder approval must be contingent on such approval to qualify for this exception). A director will be considered independent only if he or she is not a current employee of the corporation or an affiliate; was not at any time an officer of the corporation or an affiliate; and is not receiving compensation from the corporation for services other than a director's, such as consulting fees or retirement benefits.

According to the explanation accompanying the House Bill, shareholders need only approve "the general terms of the plan and the class of executives to which it applies." Disclosure related to the arrangement must provide sufficient information for shareholders to "determine the maximum amount of compensation" payable, whether by formula or otherwise (e.g., the chief executive will receive a bonus of $1 million if one in a series of enumerated performance goals is attained). With respect to stock option grants, the disclosure would be similar to that required under the SEC's current proxy rules, except that it must affirmatively state a maximum potential award for each Named Executive.

HOW TO AVOID THE COMPENSATION CAP

* Accelerate payments. Under the House Bill, the Compensation Cap will not apply to any compensation paid prior to the Publicly Traded Corporation's taxable year beginning on or after January 1, 1994. Thus, accelerating the payment of compensation that is not "grandfathered" will avoid the Compensation Cap and also should benefit the Named Executives, who are expected to face higher federal income tax rates in 1994. At a minimum, annual bonuses that would be paid early in fiscal 1994 should be paid before the end of fiscal 1993.

* Mandatory deferral. To avoid the Compensation Cap, a corporation could defer payment of any otherwise non-deductible compensation until the first year in which the executive is no longer a Named Executive. Under this approach, however, executives who have been receiving salaries and bonuses in excess of $1 million will receive less current cash. Additionally, important issues regarding the operation and administration of such deferrals--for example, what earnings to credit on the amounts deferred--will have to be resolved, and the Named Executives will have to assume the risks of non-payment, such as bankruptcy, associated with being a general creditor of the corporation. A corporation that uses such mandatory deferral should consider adopting a loan program for its affected Named Executives, despite the related proxy disclosure. Such a loan program will have to be administered properly to assure that the Named Executives are not treated as having received the loan proceeds for tax purposes.

* Qualifying for the performance exception. This will result in greater shareholder involvement in the corporation's compensation practices. Moreover, given the disclosure required under the House Bill and the SEC's annual compensation committee report, it is likely that this approach will either require public disclosure of sensitive information involving the corporation's plans and objectives or result in less flexibility in designing incentives.

For example, with respect to a non-equity-based performance compensation plan, a corporation may have to use performance objectives that are tied to objectives identified in publicly available financial statements (such as net income before taxes, earnings per share, or return on equity) that do not bear any relationship to the corporation's strategic plans, and that do not change from year to year, despite fluctuations in the general economic climate or the corporation's business. If such a program does not suit a Publicly Traded Corporation's needs, it may have to find alternatives to cash bonuses. For instance, additional stock options granted under a qualifying plan could be used in lieu of a cash bonus.

* Elimination or modification of other programs. Programs for Named Executives that have not been tied to performance objectives may have to be amended to add a performance feature--or perhaps eliminated--if the Compensation Cap is to be avoided. For example, restricted stock awards will need to have a performance-based vesting schedule (despite the associated accounting problems), and secular trusts and similar vehicles, including annuity contracts, may become extinct or be used on a limited basis only if and when there is sufficient room under the cap.

THE BOTTOM LINE

The Compensation Cap will make it more difficult to craft compensation programs for Named Executives that provide effective incentives to increase shareholder value. Careful planning may help to avoid some but not all of the Compensation Cap's consequences. The cap probably will not raise much in additional tax revenues but, like the golden parachute excise tax and the new SEC disclosure rules, it will serve to further curtail the authority of a corporation's board to fix the compensation paid to the company's executives.

Lawrence K. Cagney is a partner in the New York office of the international law firm, Debevoise & Plimpton. He is the co-chairman of the firm's Executive Compensation Practice Group.