Punishing the Victim: IRC §162(m) and the Limitation on Deducting Executive Compensation

Abstract

Section 162(m) of the Internal Revenue Code provides that a publicly held corporation may not deduct compensation in excess of $1,000,000 paid to certain of its principal officers. Until 2017, IRC §162(m) was fairly easy to avoid as it did not apply to performance-based compensation: bonuses, stock options, and so forth. However, the 2017 Tax Cuts and Jobs Act eliminated this escape route. Today, regardless of how the compensation package is structured, the corporation can deduct a maximum of $1,000,000 for each of its covered employees.

Underlying IRC §162(m) is the concern that the entrenched power of corporate management and the lack of effective oversight foster excessive executive compensation. The idea is that structural problems inherent in corporate governance result in publicly held corporations paying their top executives more than the fair market value of the services that those executives provide.

This article argues that the IRC §162(m) is misguided. The victims of the alleged malfeasance are the corporation’s shareholders. Salaries paid to executives reduce earnings available for distribution to shareholders. The overpayment of executives is effectively a misappropriation of money beneficially owned by shareholders by those who have the power to manage that money.

In response to this phenomenon, Congress chose to deny a deduction for that portion of the compensation presumed to be excessive. However, denying the deduction reduces the corporation’s after-tax earnings, and those who are beneficially entitled to the corporation’s after-tax earnings are none other than the shareholders. Thus, by denying a deduction for excessive executive compensation, U.S. tax policy is effectively punishing the victim.

Keywords: income tax, deductions, corporate governance, executive compensation, punishing the victim

JEL Classification: K34, H20, H21, H25, G30, G38, G35