When Shareholders Pay The CEO's Tax Bill

A backlash is building against payouts to cover taxes on huge severance packages

It's one of the easiest CEO perks to pick on: the so-called tax gross-up when a company is taken over. When SBC (T ) snatched up rival AT&T (T ) in late 2005, outgoing AT&T CEO David Dorman walked away with $29 million in cash and other severance. To help cover Dorman's IRS bill, the board forked over $11 million more.

Such payments are sure to be a hot-button issue this proxy season, with new rules that require companies to disclose the size of potential severance packages in the case of a merger or acquisition, including tax gross-ups.

They'll generate even more attention because, thanks to the complicated tax code, gross-up payments can easily double the severance. Some argue that they also let companies underplay what they've promised to executives. "To say we'll pay you $10 million plus a gross-up--it really means we'll pay you $20 million," says David S. Pottruck, ex-CEO of Charles Schwab & Co. (SCH ) and a member of the board compensation committee at Intel Corp. (INTC ), which does not offer the benefit. "It's a way of hiding the facts about what you're truly paying."

The little-known perk came to life in the merger-frenzied 1980s after Congress imposed a painful additional tax on executives who make windfalls by selling their companies and cashing out. To keep top executives happy--and help lure new talent--companies began agreeing to pick up the tax bill. According to a study of roughly 1,000 large U.S. companies by consulting firm Towers Perrin, only 10% had gross-ups in 1987; today it's 77%. The exceptions tend to be fast-growing tech companies and industry giants, such as Intel and Johnson & Johnson (JNJ ), that haven't had to worry about a takeover.

Problem is, gross-ups are costly. Because of the tax code's many quirks, companies can end up paying millions to the IRS so executives can take home just a few hundred thousand more in severance. "It's an incredibly inefficient use of shareholders' money," says Paula Todd, a managing principal at Towers Perrin. "It's often the most costly part of the golden parachute."

What's more, few insiders understood the true numbers involved. "In the past, most directors didn't know what gross-ups cost," says Lionel M. Allan, a former director of Catalyst Semiconductor (CATS ) and NetLogic Microsystems (NETL ) who now heads the Silicon Valley chapter of the National Association of Corporate Directors. "Very few drilled down into the numbers to figure out how it all added up."

Gross-ups aren't inherently bad. Pay consultants note, for example, that tax hits are arbitrary. The 20% "excise tax," which is in addition to income tax, kicks in when severance totals more than three times an executive's average income--including salary, bonus, and the gains on any exercised stock options--over the previous five years. Since the tax came into law, it has become standard for a CEO to get three times salary and bonus in severance. Because any outstanding options and restricted stock also immediately vest, the extra tax is almost always triggered, says Jannice L. Koors, a managing director at Pearl Meyer & Partners. But consultants note that CEOs who on paper are set to get the same severance could end up with dramatically different tax bills.

Why's that? Say two CEOs pocketed the same salary and bonus in the past five years, but one cashed out twice as many options. That executive would have reported a much higher income to the IRS, so less of the windfall would get hit by the excise tax. "A lot of directors felt the tax law gave screwy results," says Todd. "They wanted to give executives the severance they intended, and if it took a gross-up to do it, that's what they'd do." It was especially easy to be generous with tax breaks since the acquirer's shareholders would eventually foot the bill, says Allan. "It was someone else's money."

Such attitudes are starting to disappear. Gross-ups create a "challenge to reasonableness" that will be harder to justify, says Donald Perkins, retired chairman of retailer Jewel Cos., who has sat on the boards of AT&T, Corning (GLW ), and Time Warner (TWX ). "You'll see a lot fewer gross-ups in the future." Some boards are already limiting their obligations. The new contract for NASDAQ CEO Robert Greifeld includes a gross-up with limits if the cost of the payment far outstrips his benefit. That's bad news for Greifeld and Uncle Sam but good news for shareholders.

By Jane Sasseen

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