The End of the $1 Million Salary ‘Cap’
November 06, 2018
A million dollars may not seem like a lot of money these days, especially considering a corporation that sells over $5 billion a year is considered only “mid-sized.”
But $1 million may become a hotly debated figure by board compensation committees over the coming months, thanks to a barely noticed change deep within the massive tax law passed nearly a year ago. Indeed, experts say the law change may encourage directors to rethink how they pay their C-suite executives, including giving them more cash.
The new law eliminates the tax deductions on executive performance-based pay above $1 million. Many organizations had been using performance-based pay programs to not only reward executives who did a good job but also to keep their tax bills down. With the tax incentive gone, organizations may be more willing to boost base pay as a way to retain its top talent. “Committees will be more comfortable moving salaries higher now,” says Irv Becker, vice chairman of Korn Ferry’s Executive Pay and Governance practice.
The provision overhauls Section 162(m) of the US Tax Code. Since 1994, it allowed companies to deduct the first $1 million of salary, bonus, and company stock grants for each of their top four employees (with some exceptions) from their corporate taxes. At the same time, there was no limit on deductions for performance-based pay, including stock options. So, companies had a big incentive to cap the salaries they paid CEOs and other top executives at $1 million, while giving them millions more in performance-based compensation, including stock options.
Now, as the year ends, boards must decide whether they want to redo their executive pay plans. Netflix made a splash soon after the tax law was enacted when it eliminated performance-based cash bonuses for its executives and, instead, increased their base salaries. But so far, that has been the exception to the rule. Becker says companies may start increasing CEO salaries above $1 million now that the tax incentive for them to keep it below that amount has disappeared. Becker says that salary, which makes up only about 10% of average CEO pay, is likely too low. “It has to be looked at as part of the overall pay mix,” he says.
Directors should always consider tax law changes if the changes adversely impact performance pay metrics for executives, as the revised Section 162(m) does, says Dennis Carey, a Korn Ferry vice chairman who recruits executives and board directors. “Although tricky, boards must evaluate this change and make adjustments if they believe that ‘catch-up’ compensation is necessary to properly align historical pay levels with performance-based incentives and strategic objectives,” he says.
Some argue that Section 162(m) is one of the reasons why total CEO compensation has soared over the last 20 years. As the broader stock market soared, CEOs saw the value of their stock options, and thus their total pay, inflate dramatically. But Becker says the provision likely caused other executives to be underpaid. “You had some executives who should have had salaries of more than $1 million, but you couldn’t go over because of tax reasons,” Becker says. Now, the corporate incentive to keep base salaries lower is gone, and it may help organizations better hang on to top leaders.