Congress says you can defer without paying taxes no more than $17,000 in a 401(k) plan, provided your employer offers one, in 2012. If you are age 50 or older, you get to set aside an additional $5,500 for a maximum savings of $22,500. If your employer does not have such a plan, the most you can defer is $5,000 or, for older workers, $6,000.Now imagine that you are an executive and you will be paid $105 million this year. You do not need that much money to live in the style to which you’ve become accustomed. Being a longtime executive, you have lots of investment income and enjoy an expense account that covers many of your living expenses, including golf outings with clients and celebrities.
Under a 1985 tax rule, you travel by company jet at up to a 97 per cent discount from actual costs, meaning a luxury cross-country trip will cost you less than a middle seat in coach. Shareholders pick up two-thirds of the cost and taxpayers the rest, minus the little bit of extra income tax you pay for your free personal flights.
So you tell your board of directors, whom you picked, and on some of whom you lavish consulting fees and company business, that you want to take $5 million in taxable cash and defer $100 million until you retire.
You may have the company invest your $100 million any way you want, but there is a very good chance you will ask to earn interest from the company at a higher rate than it pays for money borrowed in the bond market. Let’s say you want 7 per cent when the bond market is at 5 per cent.
The extra $2 million in interest paid to you the first year is money the company will not have available to invest in expanding its operations or paying its current workforce. Yet asking for 7 per cent when the market is 5 is not even greedy. Jack Welch, when he ran General Electric, demanded and got 14 per cent for five years on some of his deferred pay, three times what GE was paying at the time on its five-year bonds.
Artificially inflated interest rates are not the costliest part of the deal, but they are the only cost that the Securities and Exchange Commission requires be disclosed to investors in the fine print of proxy statements.
The biggest part of the cost remains undisclosed, but it can be calculated from the tax rules if you know how much is being deferred. Using our textbook example — $100 million deferred out of $105 million in annual pay — the deferred millions cannot be taken as a tax-deductible expense on the company’s tax return. This is one of the rare examples where tax accounting is worse for a company than book ac- counting. Since that $100 million is not deducted, the company for tax purposes will report profits to the IRS that are $100 million higher than profits reported to shareholders. And that, in turn, means the company owes $35 million of federal income taxes on the deferral. Let’s assume a state income tax adds another $5 million, making the total increase in company taxes $40 million. So in addition to costing the company $2 million in extra interest the first year that must be disclosed to shareholders, your pay package as CEO cost the company $40 million that is not disclosed. Ever wonder why so many seemingly reputable companies bought tax shelters in the nineties and two thousands? They were a way to compensate for the costs of executive deferrals.
Most of those tax shelters were shams, some of which I exposed in the New York Times. Some of the companies that bought them (but by no means all) had to pay back the taxes they tried to avoid. A few people went to jail for selling these tax shelters. But the fact that some people cheated, and some of them got away with it, does not change the fundamental economics of executive pay deferral.
Now, let’s assume you are 40-five years old and your deferral runs for 20 years. On your 60-fifth birthday, you retire and cash out. At 7 per cent interest, that one-year deferral of $100 million in salary is now valued at almost $387 million, of which $121 million is from those extra two percentage points of above-market interest, money that the company could have used to expand the business. The company now gets to take a deduction for the $387 million on its tax return and you pay your taxes.
(Actually, you may be able to get around the tax bill by having the company buy life insurance in a trust for your heirs. That way the company gets its deduction and, while you don’t get the money, your heirs can collect it free of tax when your time runs out.) Back to reality. Since you are not a hypothetical CEO making $105 million a year, what does all of this mean to you? A lot.
If this deal takes place where you work and your company employs 10,000 people, the tax cost alone for the chief executive’s deal is the equivalent of removing $4,000 for each worker from the budget for salaries and benefits. In contrast, your piddling 401(k) wage deferral imposes no extra cost on the company.
More than just CEOs get deals like this. They are common among senior executives, as well as brand-name athletes and movie stars.
Do you wonder why your company has been cutting back on your health insurance, demanding you pay part of the premium and slapping on ever-larger co-pays? Wonder why the company says it cannot afford your defined benefit pension plan anymore? Or why it has reduced or eliminated the match for your 401(k) plan? Part of the answer is in the cost of unlimited tax deferrals for your bosses.
Excerpted from THE FINE PRINT: How Big Companies Use “Plain English” to Rob You Blind. Published by Portfolio/Penguin. Copyright (c) David Cay Johnston, 2012.