Executive Compensation Case Study

This case study examines a scenario where a company, Mega's, is considering a $3 million compensation package for its CEO. The analysis focuses on Section 162(m) of the Internal Revenue Code, which limits the tax deductibility of executive compensation to $1 million. The study explores two options: paying the compensation as normal income, which would result in a significant tax loss, or structuring it as a performance-based bonus, which could be fully deductible if specific criteria are met. The recommendation is to pursue the performance-based bonus option, provided the company sets clear performance goals, obtains shareholder approval, and certifies that the goals have been achieved. This approach would maximize tax benefits and help retain the CEO.

Fact of the case
Mega’s, NYSE listed company is on the end of fiscal period and it is expected that the year will
end with 40% increase in revenue and Earning. The compensation committee has voted to pay $
3 million compensation to its CEO; also they afraid if the compensation will be paid less,
company will lose the CEO.
Discussion Applicable law with respect to Case
Section 162(m) of the Internal Revenue code of 1986 restrict deduction for compensation paid to
covered employee up to $1 *million. The Covered employee contains CEO and other three
highest compensation paid officer excluding CEO and CFO. However there is certain exception
to this provision. It is to be noted that qualified preference based compensation are not covered
under the limitation of compensation as stipulated under section 162(m). Bonus paid based on
the profitability of the company is definitely performance based compensation as the profitability
of the company is always uncertain. However specific pre-established goals should be there and
it must be approved by shareholder by vote. Also the certificate from the Compensation
committee need to be obtain before paying performance based compensation stating that the
required goals are fulfilled.
Recommendation to Committee
The compensation committee has two options
Option 1 -Paying $ 3 Million as normal compensation
Mega’s compensation committee has agreed for payment of $3 Million compensation to the
CEO as normal compensation , however it the company can claim only $1 Million as deduction
for taxation , and for another $2 million the company will not get the deduction. So it will be
huge tax loss for the company and lead to loss of shareholder wealth .
Option 2- Paying compensation above $1 Million as performance bonus
It is cleared said that companies profitability will be 40% high an end of the fiscal year and
hence company can pay the performance based compensation to CEO. The compensation over
and above $1 million can be covered under this relation. To take deduction for qualified
compensation based on profitability, the compensation committee needs to take care following
four points
1. The company need to set the performance goal for CEO in terms of profitability before
year end
2. The Goals for the Profitability must be set by compensation committee
3. The approval of the shareholder must be taken in terms of vote before payment , for
performance criteria and amount of compensation.

4. Before payment the compensation committee need to give certificate that the
performance goals has been achieved by the CEO.
The option 2 seems viable as it will result in tax deduction for compensation above $1 Million which
was not deductible and also it will help to retain of the CEO