Maybe it's just a little naive to be surprised that a high-paid executive might expect his company to pay his personal income taxes.
But with merger activity moving at a record pace this year, investors are likely to hear more tales of the golden parachutes top executives get when they sell their companies — including a rather stealthy form of compensation that's perverse for more than the usual reasons investors gripe about.
The proposed takeover of North Fork Bancorp. Inc. for $14.6 billion announced this week by Capital One Financial Corp. could trigger a payout worth nearly $200 million for John Kanas, the chief executive of the relatively small New York area bank being acquired.
While such numbers sound staggering on their own, the merger windfall for Kanas features an extraordinary example of the tax assistance that's become common in most parachute deals.
To be fair, more than $100 million of this parachute will go straight to the government as the company covers the income taxes that Kanas will owe on the rest of his good fortune.
The magnitude of this particular tax reimbursement is somewhat rare because North Fork agreed to pay all of Kanas' tax obligations from his severance deal.
Still, a growing number of companies have agreed to cover a special federal excise tax of 20 percent that their executives would owe on any merger compensation above a certain threshold. That level is determined by the executive's average taxable earnings during the preceding five years.
In a survey of securities filings by roughly 1,000 companies, more than three-quarters had provisions to cover the excise tax on merger payouts to senior executives as of 2004, according to Towers Perrin, a human resources consulting firm. The tally compares with a 55 percent reading in 1999 and just 10 percent in 1987.
That the practice has grown more common at a time of widespread outcry about executive pay testifies to how poorly these tax reimbursement provisions are disclosed — a problem that may be alleviated with new rules proposed by the Securities and Exchange Commission that would require companies to provide a clear table detailing potential post-retirement payments.
Golden parachutes are largely intended to provide executives with an incentive not to pass up a good deal for shareholders just so they can keep their jobs. As such, these arrangements and related tax perks are slightly less common at bigger corporations, possibly a reflection that these firms are more likely to acquire than be acquired. Among 100 of the nation's biggest companies, almost half have parachute arrangements, and 60 percent of those come with tax reimbursement, according to compensation consultant Frederic W. Cook & Co. Inc.
These tax provisions, also known as gross-ups, took root with the creation of the federal excise tax in the 1980s. The tax was intended as a deterrent against making parachutes too golden, but quickly backfired as companies responded with gross-up pledges to "make the executive whole."
Beyond the philosophical question of why a well-paid executive shouldn't be responsible for his own taxes, or why companies should undermine the will of Congress, this practice is financially illogical and wasteful. That's because the tax bill is more expensive for the company to pay than the individual.
In the North Fork case, if Kanas was held responsible for his own excise and personal income taxes, he'd likely need to hand over roughly $45 million of his actual merger-related pay, estimates of which range as high as nearly $80 million.
But because the company is taking on his obligations, the tax payments soar to more than $110 million. How?
It starts with the initial tax payment of about $45 million. If the company covers that for Kanas, then the tax authorities view his savings as more taxable earnings. In the twisted logic of these arrangements, the company takes care of the personal and excise taxes on that income too, which in turn creates another tax bill for Kanas that the company also pays.
Depending on the size of the initial gross-up, this process can continue for dozens of cycles. In general, while the size of the North Fork example is extreme, the resulting tax bill usually totals between 2 and 2.5 times more than what would have been owed if it had just been paid by the executive.
In a realm where executives and auditors devise all manner of strategies to minimize taxes, it's more than a little odd that a company would voluntarily enter into an arrangement that artificially inflates this expense by tens of millions of dollars. This is not sound business logic.
One solution might be to get rid of the federal excise tax. But a more cynical observer would say that this sense of entitlement is now so entrenched that it would spread into other areas of executive pay. Indeed, The Corporate Library reports that nearly a third of the Standard & Poors 500 companies now provide tax reimbursement on some portion of the CEO's pay, usually perks such as personal use of a corporate aircraft.
No, this doesn't seem to be about making executives whole so much as making them a whole lot richer.