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Proposed limitation on deductibility of corporate salaries.

On June 19, 1992, Tax Executives Institute filed the following comments with the members of the Senate Finance Committee and the House Ways and Means Committee on the proposed limitation on the deductibility of corporate salaries in excess of $1 million. The comments, which took the form of a memorandum from TEI President Reginald W. Kowalchuk to members of the congressional tax-writing committees, were prepared under the aegis of its Federal Tax Committee, whose chair is David F Nitschke of Amerada Hess Corp.

As International President of Tax Executives Institute, I am writing to voice the Institute's opposition to the legislative proposal to limit the deductibility of compensation paid to corporate officers in excess of $1 million a year. The proposal, which is included in the House bill to extend unemployment compensation benefits, is devoid of any legitimate tax policy rationale. TEI strongly recommends that it be rejected.


Tax Executives Institute is the principal association of business tax executives in North America. The Institute's nearly 4,800 members represent more than 2,000 of the largest companies in the United States and Canada. TEI is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the legislative proposal to limit the deductibility of corporate salaries.

Description of House Proposal

On June 9, the House of Representatives approved H.R. 5260, the principal purpose of which is to extend unemployment compensation benefits. To fund the extension of benefits, the House bill includes a provision to limit the deductibility of compensation paid to "covered employees" to $1 million annually. The term "covered employee" generally includes any employee of the taxpayer who is an officer of the taxpayer, other than an employee-owner of a personal service corporation. An "officer" is an administrative executive in regular and continued service, regardless of the employee's job title; the term does not encompass partners or independent contractors.

In determining whether the $1 million threshold has been met, the taxpayer is to take into account all remuneration for services, including cash and the cash value of remuneration (including benefits) paid in a medium other than cash. Fringe benefits excluded from income under sections 132 and 119 of the Code are not included, nor generally are payments under qualified pension, profit-sharing, or annuity plans. The value of employee stock options, however, would be taken into account at the time those options are exercised or otherwise give rise to a deduction by the employer.


(*) The House proposal should

be rejected because it violates

the basic tenet of America's

net income tax system

that taxpayers be allowed to

deduct their ordinary and

necessary business expenses.(1)

The proposal would give

rise to the double taxation of

officer salaries -- once at the

individual level (as is currently

the case), and once at

the corporate level (as a result

of the denial of a deduction).

This alone should be

sufficient reason to defeat

the proposal.(2)

(*) Without any public policy

basis, the proposal would

discriminate against similarly

situated individuals -- for

example, corporate officers

and non-corporate officers

whose duties are virtually

identical. Hence, the

limitation would not apply

to employees of a partnership

who perform services

substantially identical to

those performed by corporate

officers at a competing

firm, nor would it apply to

non-officer employees or to

employee-owners of personal

service corporations. For

example, an enterprise or

group of individuals choosing

to conduct business as a

corporation would find itself

subject to the limitation,

whereas the same business

would escape the provision's

reach by organizing itself as

a partnership; investment

banking is but one example

where firms performing substantially

identical services

are organized as either partnerships

or corporations.

Contrary to the avowed purpose

of the Tax Reform Act

of 1986 (and other recent

bills), therefore, the proposal

would violate the principle

of neutrality and interfere

with basic business decisions.

(*) The proposal raises significant

issues of retroactivity

in respect of stock options

and forms of deferred compensation

"granted" before,

but not taxable to the employee

(or deductible to the

employer), until after its effective

date. Thus, the putative

rationale of policing

"excessive" corporate compensation

is totally undercut

because the proposal

could obviously not discourage

already-granted compensation.

Equally important,

the proposal would penalize

taxpayers who granted

options as a form of compensation

over the same period

of time they may have

paid their employees lower

cash wages.

(*) Through its application to

compensation in the form of

stock options, the proposal

runs counter to national policies

of encouraging entrepreneurship.

As SEC Chairman

Breeden recently testified,

converting employees

into owners (through the

grant of stock options) is

highly desirable and should

be facilitated, not impeded.

The proposal would discourage

businesses from developing

compensation arrangements

pursuant to

which employees would accept

lower current wages in

exchange for the opportunity

to share in the future

profits of the corporation as

a shareholder.

(*) Finally, the proposal represents

a crude attempt to

deal with an issue of corporate

governance through the

tax code. The proposal

would subject all corporations -- no

matter how large

or small, no matter how successful -- to

the same arbitrary

rule. It would thus ignore

the specific facts and

circumstances that could

make compensation in excess

of $1 million clearly

proper -- in the words of the

Internal Revenue Code, "ordinary

and necessary." To

the extent that so-called excessive

executive compensation

is a matter of national

concern, TEI believes the issue

should be dealt with as

a matter of corporate governance -- for


through the revision of certain

SEC rules relating to

shareholder oversight of executive

salaries -- not the

tax law.


For the foregoing reasons, Tax Executives Institute urges Congress to reject the proposal to limit the deductibility of corporate salaries in excess of $1 million annually. If you should have any questions about TEI's position, please do not hesitate to call Timothy J. McCormally, General Counsel and Director of Tax Affairs, at (202) 638-5601. (1) The Internal Revenue Service currently has ample authority to challenge the reasonableness and, hence, the deductibility of excessive salaries. Indeed, the case law is replete with examples of situations where the IRS has argued that no deduction should be allowed for an unreasonably large salary on the grounds that the payment constitutes a disguised dividend. Hence, the proposal is not necessary to protect against tax law abuses. (2) TEI recognizes that section 274(n) of the Code currently limits the deduction for meals and entertainment expenditures. Although the Institute questions the tax policy rationale for the section 274(n) limitation -- that the employer's disallowance is a surrogate for an income inclusion by the employee for the personal portion of the expenditure -- we note that no such rationale can be set forth here; indeed, the remuneration that would be subject to the limitation on deductibility is already included in the employee's gross income.
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Publication:Tax Executive
Date:Jul 1, 1992
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