Deferred compensation is exactly what it sounds like: compensation that is deferred until a later date. Why would someone defer their compensation, especially given the time value of money? Well, it turns out that the government offered many tax benefits for those who did defer their compensation. Consequently, executives sought to defer large amounts of compensation as a way to avoid paying taxes. Recently laws have reversed this trend, however, by placing a $1 million cap on all deductions.

Under the new laws, a corporation may deduct compensation expenses as an ordinary and necessary business expense for its employees. However, the otherwise acceptable deduction for compensation paid or accumulated to a covered employee of a public corporation is limited to no more than $1 million a year. A person is considered a covered employee if they are the CEO of a corporation (or the individual acting in such capacity) at the close of the taxable year; as well, the four highest compensated employees are also taken into account for the limitation's rules.  

The deduction limitation is applied even in the case of an emergency resulting from transfer of property in connection with the performance of services. The deduction limitation applies to all compensation for services, including cash and the cash value of all remuneration (including benefits) paid in medium other than cash. There are a few factors that are not included in the deduction limitation. Such factors not included are remuneration based on commission; remuneration payable solely on account of the attainment of one or more performance goals if certain outside director and shareholder requirements are met (performance-based compensation); payments to a tax-qualified retirement plan (including salary deduction contributions); and amounts that are excludable from the executive's gross income (such as health benefits and miscellaneous fringe benefits). 

Executives are covered by a wide range of compensation arrangements, which will be discussed in our new series. These arrangements may include agreements between several employees or it may consist solely on individual agreements between the company and one executive. Typical arrangements include nonqualified deferred compensation and stock option programs due to their tax benefits. There is, however, a limit on a company's deduction for compensation of certain employees in excess of $1 million - a limitation that applies to the chief executive officer and the four other most highly compensated employees. However, performance-based compensation is not subject to the deduction limitation. Studies have indicated that the deduction limitation may have led to some substitution away from salary compensation toward performance-based compensation, but that growth in overall executive compensation has not been reduced.

Our series will primarily explore the various types of stock-based compensation, which includes stocks, stock options (right to purchase shares by a certain date), restricted stock (stock with restrictions tied to them, such that can't be sold for a certain amount of time, etc.), stock appreciation rights (the right to the gains of the stock as if you owned it), and phantom stock (artificial shares that the company values at the going market rate).

Regulatory filings yesterday showed that Toll Bros. CEO Robert Toll's salary slumped along with the rest of the housing market. The filings revealed that the housing sector CEO received only $29.3 million in salary, options, and benefits this year compared to $41.3 million in 2005 and $50.2 million in 2004. The executive, who ranked among the nation's highest-paid CEOs, agreed to the pay cut after the board felt it was "too big of a number" given the slowing of the economy for home building. Many investors continue to criticize the executive, however, as the company's shares were cut in half earlier this year before making a slight recovery during the past few months. Are these complaints justified? Well, let's take a look at Robert Toll's pay versus performance...

ExecutiveDisclosure.com reports reveal that the Robert Toll is still being paid far more than his peers. The actual numbers show that during 2003-2005 he was being paid 273% more than other in the housing industry. Here is a chart from ExecutiveDisclosure.com comparing Toll's salary to that of his industry peers:

If there is a problem, who is to blame? Ultimately, it is the board of directors that is responsible for executive compensation. The most important function in today's compensation environment is tying executive compensation to stock performance, giving management a "stake in the success" of the company. ExecutiveDisclosure.com can also make these comparisons via a compensation vs stock trend chart:



It appears as if the company's board of directors has done an excellent job of tying compensation to performance. So, the real question becomes whether this compensation "premium" over other industry executives is justified given Toll Bros.'s market positioning and Toll's influence on the company...

The chief executives of America's 500 biggest companies, measured by a composite ranking of sales, profits, assets and market value, received a combined 6% pay raise last year, which is minimal in comparison to their 54% pay raise in 2004. In total, America’s top CEO's earned a healthy $5.4 billion in 2006. 

The average paycheck for last year for each boss works out to $10.9 million. For the group of 500 as a whole, aggregate stock gains accounted for 51% of total compensation, versus 53% a year ago. The average boss took in $5.6 million from exercising options last year. When calculating a chief executive’s total pay, salary and bonuses, and other compensation, such as vested restricted stock grants, long-term incentive payouts and perks, are all taken into calculation. 

Who were the top earners? Richard D. Fairbank, chief executive of Capital One Financial, was the top earner in 2005, as he earned $249.3 million in total pay, which came almost entirely from exercised stock options. The same goes for the next four top-paid CEO's: Terry S. Semel of Yahoo! with $231 million, Henry R. Silverman of Cendant with $140 million, Bruce Karatz of KB Home with $136 million, and Richard S. Fuld Jr. of Lehman Brothers Holdings with $123 million.

Most people are now aware of the new laws aimed at curbing executive compensation by limiting the amount of money that can be put into their deferred compensation plan to $1 million (the rest incurring a 20% penalty). Democrats hail this as a final victory over a tax loophole that has allowed many executives to channel millions through a tax-free venue - which is true. The problem is that there are additional loopholes that these new regulations fail to address - loopholes that will be exploited by future executives. Consequently, these new regulations might end up hurting middle management and others while executives are free to get their money in other ways.

The main problem in corporate America is the power that most executives have over their own compensation. Ironically, in a market where shareholders are supposed to elect members of the Board to oversee management, CEO's serve as chairmans' of their own board in over 50% of all companies! This enables them to set their own pay in many cases, as management compensation is something that the board sets. Now, the problem lies in the fact that while these new regulations may limit the amount of money put into a deferred compensation account, they do not impose other limits on compensation. Therefore, executives can simply re-channel the money from these accounts to stock options, restricted stock grants, or a multitude of other venues. Meanwhile, middle management - who has very little control over their compensation - may end up paying more as a result.

Regulators made a similar mistake back in 1993, when they imposed a $1 million limit on tax-deductible CEO salary that wasn't tied to performance. This ended up being on of the major factors leading up to the explosion in the number of stock options granted to executives - a practice that was not as common before the regulations originally went into effect. In the end, the middle class ended up with a tax hike while executives ended up with more stock options. The laws we are seeing drafted today may turn out to be the same thing. Perhaps the old saying is true: history repeats itself.

President Bush addressed executive compensation in his "State of the Economy" speech today, delivered from New York City - the financial center of the world. President Bush reported that the economy has seen a faster-than-expected growth of 3.5% in the final quarter of last year. And while he did not go into any specific new laws that may go into effect, he did at least address the issue of executive compensation. He voiced his opinions on lavish salaries and bonuses for corporate executives, standing on Wall Street to issue a sharp warning for corporate boards to "step up to their responsibilities" and to tie compensation packages to performance. The president also recognized the continuing anxieties about the financial future, despite a string of reports that provide some reason for optimism. Finally, he noted that some workers are being left behind in the booming economy and that the disparity between the rich and the poor is growing, which is an issue that would need to be addressed.

A recent survey put out by PricewaterhouseCoopers and the Corporate Board Member magazine showed that directors still don't have as much control over corporate dealings that many believe is needed to curb super-sized compensation. The 1,300 directors polled indicated that one of the major problems is that in over half of the company's the CEO also served as chairman of the board. However, they also stated that they didn't want change; only 8 percent of the directors said that they would like more boardroom control while 59 percent said that they don't want the chairman position to be an independent director. Surprisingly, more directors were worried about the reprecussions associated with losing their CEO without a succession plan than they were awarding a CEO a $10 million bonus when their company's stock declined for the past two years. Another interesting statistic showed that less than half of those surveyed said their boards use tally sheets to add up total compensation, and about 20% directors said that they didn't know what the CEO would collect if they were terminated, retired or were subjected to a takeover. This lack of confidence and oversight in the boardroom is the reason for many of the problems surfacing with executive compensation. Perhaps this new wave of shareholder activism will help motivate change in a group of people that appears to be so resistant to it.

Executive compensation will be the focus of legislators again tomorrow as the Senate will vote on new tax legislation designed to impose higher taxes on executives, Wall Street banks, and other large companies. The move comes as the Democrat-controlled Congress continues to close loopholes and increase the costs of fraud in order to fund promised tax relief for the middle class and businesses. The new legislation, which will likely become law in a few months, could add up a collective $800 million tax bill for U.S. executives. The money will then be used to offset the costs of more than $8 billion in tax relief for small businesses hit by the upcoming rise in the minimum wage.

Specifically, the new legislation limits the amount of money that can be classified as "deferred compensation". While old laws allowed millions of dollars to be deferred (and therefore tax free), new legislation would limit this amount to just $1 million per year or the average of the previous five years salary (whichever is lower). Any amount above that would incur a hefty 20% penalty. The measures, however, were criticized by business organizations and executive pay consultants, who insist that they will encourage companies to pay higher salaries and bonuses to compensate for the higher taxes. Whether this is true or not remains to be seen; however, this is definitely a story to follow.