Executive Compensation, Interlocked Compensation Committees, and the 162(M) Cap on Tax Deductibility

Abstract

Tax code IRS Section 162(m) effective prohibits corporate tax deductibility of non-performance based compensation expenses over $1 million for any one of its top 5 employees. This $1 million cap also applies to all forms of compensation if a firm has an insider on its compensation committee, thus imposing differing cost of compensation on firms with differing compensation committee structures. Using the introduction as a natural experiment, we provide evidence of agency problems and private benefit seeking behaviors that increases with managerial entrenchment and interlocked compensation committee. We find a significant salary reduction for executives dropping their interlock statuses as a result of 162(m). More broadly, we examine 162(m)'s effect on compensation and describe where it is ineffective or has unintended consequences.

Keywords: Corporate Governance, Executive Compensation, Insiders, Interlock, Corporate Taxes

JEL Classification: G18, G30, G38, G34, G39, J33, K33