The rhyme and reason of executive pay

By Anthony Otaigbe, CPA

Business owners and executive managers alike are responsible for protecting and growing profitability, but they are often ill-equipped with all necessary strategies to best to ensure profitability while maintaining shareholder value. Developing an objective basis for officer compensation not only protects the taxpayer from regulatory headaches brought on by the IRS, but also motivates employees to perform above and beyond. 

What is “reasonable” compensation?

The theory behind a well-organized company's remuneration plan consists of two major components. According to the theory, all levels of management should be motivated by performance-based pay and the targets set for each manager should be easily understood. The company’s emphasis on winning should explain the reliance on performance pay within the compensation system. The plan itself should be structured similarly to the compensation plans of most other companies that offer a combination of salary, short-term incentives and long-term incentives. Base salaries should be set near the median of competitors within the same industry. Short-term incentive performance targets are set at the average performance level of the relative performance groups. Executives that meet performance targets should typically receive a bonus of 40% of base salary, while executives doubling performance targets could receive as much as 140% of base salary. The short-term bonus performance targets are based on revenue growth, net income growth, and reduction in net working capital.

How does the IRS determine if executive compensation is reasonable? 

Independent Investor Test

The Independent Investor Test, also referred to as ROE (Return on Equity), tests the different rates of ROE at different salary levels and chooses the salary level at which the hypothetical independent investor would be satisfied with his or her rate of return. Because the average ROE varies by sector, the application of this method should be done using the appropriate benchmarks from relevant industries. This test is easy and relatively affordable to implement.

CEO effectiveness

Another strategy the IRS uses to determine reasonableness is an evaluation of the competencies of the shareholder-employee or sole-shareholder. As an extension of the underlying philosophy used in the Independent Investor Test, the IRS will test whether an independent investor would be willing to compensate the shareholder-employee as he or she is compensated.

“The nature and quality of the services should be considered, as well as the effect of those services on the return the investor is seeing on his investment,” wrote the Ninth Circuit Court in Elliotts Inc. v. Commissioner (716 F.2d 1241 (1983)). As such, this particular test’s rationale rests upon the idea that the investor would object to compensation that is not commensurate with the shareholder-employee’s requisite abilities, experience, qualifications or apparent skill level. 

Conflicts of interest

The third category focuses on those factors that suggest a conflict of interest exists. The main problem with this category is determining whether a relationship exists between the company and its employee that might permit the company to disguise nondeductible corporate distributions of income as employee compensation deductible under section 162(a)(1).

Internal consistency

Lastly, the IRS will almost certainly search for signs of inconsistency in a company's treatment of payments to employees. For example, bonuses that have not been awarded under a qualified incentive-based compensation plan will attract scrutiny. 

Activity-based management (ABM) approach

Human resource development, supply chain management, and internal business functions must be developed to facilitate the achievement of the organization’s strategic objectives. Consequently, the strategic allocation of human resources is pivotal in governing economic performance.

Unfortunately, oversight over this area requires highly specialized personnel to combine industry experience with technical knowledge. However, ABM offers a solution by managing resources and activities to improve the value of products and services.

Effective ABM is governed by the seamless communication of goals and project deliverables between the accounting, engineering, manufacturing and operations departments. Downstream, management and quality control will dictate the level of customer satisfaction and overall reductions due to defects and information asymmetry. As a result, an organization focused on ABM and reporting aims to set clear, obtainable performance quality targets and enable sustainability reporting by clarifying costs concerning corporate social responsibility and environmental concerns.

Achieving the level of information symmetry provided by ABM does have its challenges. The traditional activity-based costing (ABC) model is difficult for many organizations to implement because of exorbitant costs incurred to interview and survey relevant staff and the use of subjective and costly-to-validate time allocations. It can also be difficult to maintain and update the model as processes and resource spending change, new activities are added, and increases occur in the diversity and complexity of individual orders, channels and customers.

Under a carefully planned ABC schema, each activity will be allocated to a cost object at either the unit, product, batch or facility level. This granularity of information helps give management extra insight as to which process may be causing bottlenecks in the value chain. Moreover, the detailed cost information enables management to partition data to deliver sustainability reports to stakeholders. While the performance of any and every activity is a crucial element in all managerial thinking, adopting an ABC model requires a painstaking amount of planning and resources. Further, due to the high cost of continually updating the ABC model, many ABC systems are not updated on a routine basis, leading to out-of-date activity cost driver rates and inaccurate estimates of process, product and customer costs. 

ABM is guided by two main drivers: the activities performed in an organization and the cost and performance in terms of both time and quality. While ABM prescribes that “performance measures should be defined for each significant activity,” documented incentives should also be put into place to stimulate employee performance. For example, instead of simply requiring the human resources department to self-report the time spent on each activity throughout the day, management should go a step beyond and create incentives. A high-performance organization must be adaptable and flexible to foster an innovative and creative cultural environment. Thus, this model would be driven by total points achieved toward a tiered profit share scheme represented in Figure 1.

FIGURE 1. Tiered profit share based on incentive points

Activity                                     Measurement                                          Incentive
Résumé screening                  Decrease in interviews                            +5 points
Perform background checks   Decrease in employee turnover              +3 points       
Update company policies        Decrease in employee violations            +2 points
Update payroll information      Decrease in employee complaints          +5 points
                                                                                                                 15 points

Profit share                      Total points scored
2% profit share                   5 points
3% profit share                   10 points
4% profit share                   15 points
 
This model supports the value chain by defining a set of approaches designed to optimize each aspect of operations to make sure that services are delivered to the right locations to minimize system-wide costs while satisfying customer requirements.

Tax considerations for C corporations

Before the Tax Cuts and Jobs Act (TCJA) and the CARES Act

According to IRC § 162(m), for performance-based compensation paid to a covered employee (three highest-paid officers) greater than $1 million to be deductible, it must not also be receivable by death, disability or change of control or ownership. Any compensation paid in the applicable taxable year above $1 million must be based on objective performance criteria to be deductible on corporate tax returns as “qualified” performance-based compensation.

After the TCJA and CARES Act

C corporations can no longer deduct compensation greater than $1 million paid to any “covered employee.” Further changes by the TCJA have expanded the definition of a covered employee, now defined as the three highest compensated employees who act in an executive role. This means that officer titles such as “CEO” and “CFO” are no longer used as part of the criteria to determine a covered employee.

The CARES Act provides direct payments to U.S.-based businesses, nonprofits, states and municipalities eligible for funding by either the U.S. Department of Treasury or the Federal Reserve pursuant to a $500 billion Exchange Stabilization Fund. To meet the eligibility requirements for this funding, the recipient must agree to restrictions on compensation and severance for its senior executives. These restrictions apply during the period beginning on the date a loan agreement or loan guarantee is executed and ending on the date one year after the date on which the loan or loan guarantee is no longer outstanding. These restrictions include:

• No officer or employee of the business whose compensation exceeded $425,000 in calendar year 2019 may:
  • Receive compensation which exceeds, during any consecutive 12-month period, the total compensation received by the officer or employee during calendar year 2019.
  • Receive severance pay or other benefits upon termination of employment with the eligible business that exceeds twice the maximum total compensation received by the officer or employee from the eligible business during calendar year 2019.
• No officer or employee of the business whose compensation exceeded $3 million in calendar year 2019 may:
  • Receive compensation which exceeds, during any consecutive 12-month period, total compensation in excess of the sum of $3 million and 50% of the excess over $3 million of the total compensation received by the officer or employee during calendar year 2019.
• For this purpose, the term “total compensation” includes salary, bonuses, awards of stock and other financial benefits provided by an eligible business to an officer or employee of that business.

The CARES Act also provides for in excess of $30 billion in financial support payments to airlines, cargo air carriers and contractors. Similar to the approach taken for support payments to other businesses, as a condition to receiving this funding, the recipient must agree to restrictions on compensation and severance for its senior executives. The restrictions apply during the two-year period beginning on March 24, 2020, and ending March 24, 2022. These restrictions include:

• No officer or employee of the business, or contractor, whose compensation exceeded $425,000 in calendar year 2019 may:
  • Receive compensation which exceeds, during any consecutive 12-month period during that two-year period, the total compensation received by the officer or employee during calendar year 2019.
  • Receive severance pay or other benefits upon termination of employment with the eligible business which exceeds twice the maximum total compensation received by the officer or employee from the eligible business during calendar year 2019.
• No officer or employee of the business whose compensation exceeded $3 million in calendar year 2019 may:
  • Receive compensation which exceeds, during any consecutive 12-month period, total compensation in excess of the sum of $3 million and 50% of the excess over $3 million of the total compensation received by the officer or employee during calendar year 2019.
• For this purpose, the term “total compensation” includes salary, bonuses, awards of stock and other financial benefits provided by an eligible business to an officer or employee of that business.

Avoid challenges to reasonable compensation

Prudent accountants should advise their clients to carefully document each executive’s qualifications, duties and key accomplishments. This is important because it creates an audit trail. If the IRS selects the company for audit, the auditor will be able to trace a basis for the rationale behind executive compensation. The more accurate this information is, the less ammunition the auditor will have to challenge executive compensation.

Secondly, it falls on accounting professionals to advise clients to include more than just the most apparent factors found on a résumé or CV when describing an individual’s qualifications such as professional goodwill, which includes reputation and relationships. For example, we recently merged with an accounting firm. Part of the agreement of the merger is that upon exit of one of the partners, a fixed distribution payment will be paid on a bi-weekly basis that is commensurate with the fair value of the outgoing partner’s goodwill with his or her client accounts. 

In conclusion, although the executive remuneration plan at a company should be reasonable and effective, there are a few important issues the company might face in the future. First, with the growing trend in shareholder involvement in decision-making, companies will need to ensure shareholders approve of all changes to the compensation plan. S corporations should model their compensation plans after the performance-based compensation provisions used by C corporations. Secondly, corporations should apply the Independent Investor Test before setting officer salaries. Maintaining a competitive executive compensation policy is imperative. In the years to come, the company should continue to evaluate its executive remuneration plan, increasing levels of pay as necessary to attract top executive talent while continuously improving ways to increase intrinsic motivation. The corporation should document resulting determinations in meeting minutes. If the company decides to raise compensation or change the plan in any way, shareholder approval should be sought to avoid challenges to corporate governance and avoid negative reputational risks. 

Anthony Otaigbe, CPA, is managing partner of Otaigbe & Olumese, CPAs, in Manassas. Otaigbe & Olumese, CPAs, specializes in SOC, nonprofit, internal and forensic audit. Anthony also teaches accounting and business courses as an adjunct professor. Find the firm on Facebook, on Instagram @oandocpas and on Twitter at @oando_cpas.