The Impact of Regulation on Executive Compensation: IRC Section 162(m) and the Unexpected Exclusion of CFOs

Abstract

IRC §162(m) originally denied corporations tax deductions for nonperformance compensation in excess of $1 million per executive when paid to the CEO and the next four highest paid named executive officers. Following the 2006 SEC proxy statement revision, which the IRS deemed incompatible with §162(m), the IRS excluded CFOs from §162(m). This exclusion exogenously altered the CFO compensation environment, creating a natural experiment we exploit to examine how §162(m) influences executive compensation. Using a difference-in-differences design, our analysis allows us to draw causal influences generally lacking in prior §162(m) studies. We find that after the IRS exclusion of CFOs, firms increased the nonperformance compensation of CFOs who otherwise would have been affected by §162(m). Consistent with the shift to less risky compensation reducing the risk premium demanded by CFOs, we find some evidence of a reduction in their compensation growth. Our analysis provides evidence that tax policy influences compensation design.

A Literature Review on the Dual Effect of Corporate Tax Planning and Managerial Power on Executive Compensation Structure*

“…Taking advantage of the 2007 passage of the "CFO million-dollar-rule-exemption," Balsam et al (2019) examine the effect of tax planning regarding executive compensation by comparing non-CFO executive compensation with CFO compensation. Since CFOs are exempt from the tax deduction limit imposed by Section 162(m), the authors predict that CFOs' non-performance-based compensation (e.g., salary) that would otherwise decrease in response to a tax deduction limit would, in fact, increase in the absence of a cap.…”

“…5 5 Covered executives are the top five most highly compensated executives—that is, the CEO and the next four highest compensated officers (Balsam et al 2019). …”

Examining the Effects of the Tax Cuts and Jobs Act on Executive Compensation*

“…There is some evidence that firms respond to tax incentives if they allow for a tax‐efficient increase in executive pay. For instance, Balsam et al (2019) find firms increased the fixed pay to CFOs after they were exempted from the definition of covered employees under 162(m). Harris and Livingstone (2002) find firms that previously paid their CEOs less than $1 million increased CEO fixed pay after 162(m).…”