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Avoiding the Tax on Excess CEO Pay

Write-Off: The Tax Blog

Many people are frustrated with how much CEOs get paid. There have been many proposed solutions to this perceived problem. One that has gained traction recently is to impose some kind of tax on the difference between CEO pay, and, the average worker in the corporation’s pay. One proposal that has been around for a while, but, currently being floated by democrats, would have an incremental tax on the difference between average CEO pay and the median worker, up to a maximum of a 5% tax for companies that pay their CEO more than 500 times the average worker. There are so many interesting ways around this tax, some of which are intended by the proponent of this tax (pay employees more, or CEOs less), and some of which would be unintended (outsourcing more work, using more independent contractors, shifting income abroad if the extra tax applies only to domestic income, etc.). But, one way I have not heard discussed goes back to the time honored method of bunching, useful when taxes are imposed with maximum (or minimum) thresholds. Here is how it would work:

Imagine the average wage of employees is $10,000, and, the CEO gets paid $5,000,001 million a year. This pay ratio would qualify the firm for a 5% charge, because the ratio of CEO to employee pay is more than 500 to 1. The tax is maxed out. Let’s say the CEO is planning to be around for 5 years. Instead, we pay the CEO $25,000,000 in her first year, and, pay that 5% surcharge because the ratio is more than 500 to 1. But, the other 4 years, we pay the CEO a dollar in salary, and, pay nothing in tax on excess executive compensation. The firm is better off because they pay the 5% surtax only one year. The CEO is better off because she gets her money up front. What if the CEO is fired before 5 years? If the firm is large enough, it might even be worth it to the firm to do this, even at risk the CEO leaving after 2 years, if the 0% tax in year two outweighs the $20,000,000 in compensation paid but not earned (this is assuming the tax law won’t allow us to explicitly contract and force the CEO to pay back any amount paid for future work).

Will anyone do this? Who knows? But, I do enjoy thinking about all the ways companies might get around taxes, as they are structured when first proposed. Often, the final proposal will take into account some of these planning opportunities, but, they are unlikely to be able to account for all of them.

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