The IRS tackles excessive executive compensation

"... Where there is smoke, there is fire, and many companies are not in complete compliance while others are underreporting. "

OVER THE PAST few years, there has not been a headline, outside of the war in Iraq, that has received as much attention and press space as "executive corruption and abuse" and its supposed evil twin sister, "excessive executive compensation." As a result, corporate governance and compensation reforms have abounded. Included in the mix are the Sarbanes-Oxley Act, expensing of stock options, new stock exchange guidelines, and the Internal Revenue Service's initiative to determine the extent of noncompliance with respect to specific executive compensation issues. Indeed, the IRS has assigned a higher priority to the examination of issues surrounding executive pay as it relates to corporate tax laws.

Bottom line, the IRS has been able to prove that, in many cases, where there is smoke, there is fire, and many companies are not in complete compliance while others are underreporting.

Actually, executive compensation has become more formulaic and easier to understand in recent years. With tools such as proxy reports disclosing the amount of compensation received by the top five officers of a company, online services and published reports, the curtain has been pulled back a bit. Moreover, companies must be in compliance with the IRS, Securities and Exchange Commission, and other legal entities--thus pushing them more towards the middle.

However, there remains the increasingly diversified needs of executives, as a result of age, family, health care, motivation, company outlook, new legislation, etc. Companies, out of necessity more and more are designing innovative ways to maximize their return on their most expensive and important asset--their people.

One solution may be an individually tailored compensation package. This approach allows executives to weigh the compensation alternatives of at-risk compensation vs. guaranteed compensation, benefits, and retirement as they relate to their individual situations.

Since the amount of reasonable total direct compensation efficiently is determined in today's environment, the challenge is how to balance equally the varying forms of compensation. For instance, how many dollars of base salary is equal to one dollar in annual incentive target opportunity? This question may never be answered by a true scientific or mathematical formula because different individuals have different prerequisites and perceptions.

In light of this, a better approach is to develop a formula based on risk vs. reward vs. time, in trading off guaranteed compensation for at-risk compensation for deferred compensation, the basics still apply--more risk equals more reward. This shift will be reminiscent of past changes that have occurred in the area of pensions (defined benefit plans to defined contribution plans) and health insurance (sole indemnity plans to flexible managed care alternatives). The option of employee choice adds significantly to the perceived value and utility of the awards involved, which, in turn, bolsters the morale and productivity of the company.

Further, in light of the IRS's intense examination program, employees proactively can audit their key executive pay programs to ensure compliance. They also can measure the potential exposure the company has around the eight key issues (see sidebar: "Under the Microscope") that the IRS is targeting. Based on the findings, actions can be taken to correct any indiscretions, allowing everyone involved to rest easier.

It is not advisable, however, for companies to allow executives to tailor 100% of their pay packages. By sacrificing control, firms run the risk of contradicting pay policies and objectives of the company. Instead, there should be some trade-off. For example, an ideally tailored executive compensation program may permit the executive to select the appropriate vehicle for 25-30% of his or her own compensation while the firm chooses the remaining 70-75%. This would allow executives to have buy-in to their own compensation while the company would retain control of the budget.

Despite all of the tools that are being developed for companies to better manage their compensation programs and provide more cost-effEctive ways to attract, motivate, and retain key employees, determining the right compensation for any one individual will continue to be more art than science, in which firms desperately are attempting to control their budgets, be in compliance with the law, and reinforce annual and long-term objectives while maximizing the utility of every compensation dollar spent. Remember, in every situation, there is a silver lining--just be sure if it is taxable or not.

Brent M. Longnecker is president and Christopher S. Crawford is managing director off Longnecker & Associates, a Houston, Tex.-based executive benefits consulting company.

UNDER THE MICROSCOPE