CEOs and Corporations: In Bed With the IRS

A new report shows it's even worse than you think

By Will Ashworth, InvestorPlace Contributor

If you’re looking for a humorous read this weekend, glance through the Institute for Political Studies’ 19th annual report on excessive executive compensation in America. It’s been widely reported in recent days that 25 CEOs earned more in 2011 than their companies paid in taxes.

With an election looming, it’s a good idea for voters to understand some of the issues that plague the U.S. Excessive CEO compensation should be near the top of any list, and this report sure has interesting findings.

It’s important to remember when reading these types of reports that things aren’t always as they appear. I can guarantee you all 25 companies on the IPS list have ready explanations for why they’ve paid little or no federal tax. So, even though the findings themselves, when compiled in a vacuum, are quite damning, it’s important to keep an open mind.

Regardless of how you interpret the findings, here are three key points that aren’t up for debate:

1) The 100 highest-paid CEOs in America are overpaid

2) The tax code unfairly protects CEOs

3) America’s largest corporations have a vested interest in maintaining a tax code that favors tax avoidance.

CEOs Are Overpaid

The CEOs of the 25 firms that paid less in federal tax than they themselves received in total compensation in 2011, averaged a $20.6 million payday last year, 24% above their compensation in 2010.

One of the provisions yet implemented in the Dodd-Frank financial reform legislation would require public companies to report the pay gap between the CEO and the average employee. In 2011, the average S&P 500 CEO made 380 times the average U.S. worker. In 1980, that gap was just 42 times.

CEO compensation is so out of whack that executive pay proposals at 53 companies have failed to receive a majority of shareholder support in 2012, including Chesapeake Energy (NYSE:CHK), Citigroup (NYSE:C) and Cooper Industries (NYSE:CBE) — all three are part of the exclusive 25. It’s easy to see why the middle class is fading away: All the money’s going to a select few.

Tax Code Protects CEOs

Probably the most outrageous example is deferred compensation. CEOs can put an unlimited amount of their annual compensation into deferred accounts where the funds grow untaxed until drawn upon.

The most egregious example: Wal-Mart (NYSE:WMT) CEO Mike Duke put $17 million into his deferred compensation account in 2011, saving him $6 million in federal income tax. Duke’s total deferred compensation at the end of 2011 was $85 million. In case you didn’t notice, Duke was able to defer 774 times the amount the rest of us can put into our 401(k).

Other big winners in 2011 were David Zaslav of Discovery Communications (NASDAQ:DISCA) and James Gorman of Morgan Stanley (NYSE:MS).

IPS cites a total of four tax loopholes that boost executive pay. In addition to deferred compensation, it also lists unlimited tax liability of executive pay, preferential treatment of carried interest and stock option double standards. The biggest of these culprits is the unlimited tax liability of executive pay, which costs taxpayers at least $9.7 billion annually.

Corporate Tax Avoidance

The federal government passed a law in 1993 that capped the amount a company can deduct for executive salaries at $1 million. However, it left a loophole the size of a football field, allowing companies unlimited deductibility for “performance-based” pay.

Recently, I was watching a business program  where the host was discussing Yahoo (NASDAQ:YHOO) CEO Marissa Mayer’s pay package of $1 million in base pay and $60 million in stock and bonuses. The host commented that the base pay was relatively modest, not realizing it’s specifically that amount because of the tax code. Have a look at some proxies, and you’ll see that very few large corporations pay more than $1 million in salary to their executives.

The Economic Policy Institute estimates that the top five CEO beneficiaries of the tax deductibility loophole had a combined $232 million in performance-based pay in 2011. Because companies can deduct this expense, they were able to save $81 million in taxes.

At the top of the heap is Oracle (NASDAQ:ORCL) CEO Larry Ellison, who has managed to reduce his company’s tax bill by $240 million since 2008. Ellison owns 22% of Oracle’s stock, so he’s simply reducing his own tax bill by leaving the money in the corporation.

Democratic Representative Barbara Lee introduced the Income Equity Act (H.R. 382) in January 2011. The bill would deny companies any tax deductions for executive compensation that puts a CEO’s pay at more than 25 times the firm’s lowest paid employee, or $500,000, whichever is higher. Corporations would be able to pay their executives an unlimited amount but would be severely limited in the tax deductibility of that pay.

It’s a nice idea but, unfortunately, is unlikely to pass due to the Republican majority in the House.

Last, I’d like to point out that taxpayers are losing billions, thanks to the accounting double standard that allows corporations to deduct the difference between the price of stock options for employees versus the market price of the shares when exercised.

Facebook (NASDAQ:FB) estimates that it will eventually deduct $16 billion, saving it as much as $5.6 billion in taxes. In 2010, Apple (NASDAQ:AAPL) had $742 million in net excess tax benefits from employee stock plan awards, saving it approximately $260 million in taxes.

All told, the Citizens for Tax Justice estimate that 170 of the 280 major corporations it studied between 2008 and 2010 saved an estimated $2 billion in taxes in 2010 alone. Frankly, corporations should only be able to expense the exercise price of the options in the year the options are exercised with no carry forward or backward of the deduction.

Bottom Line

The most disturbing finding in the IPS report comes near the end when it lists all 25 companies, the  CEO compensation in 2011 and the federal tax paid in 2011. The total compensation of the 25 CEOs was $516 million, while their employers received $3.2 billion in future tax benefits. It’s enough to make you sick.

As of this writing, Will Ashworth did not own a position in any of the stocks named here. 

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