High Incomes, Higher Taxes
“High personal taxes make high income an illusory treadmill,” says J. K. LASSER, the author of many books on taxation, including
by J. K. LASSER
THE National Broadcasting Company recently gave Milton Berle, its prize television attraction, a new contract. Newspaper stories indicate dial it pays $50,000 a year for thirty years; Berle works twenty years and stays thirty years on the payroll. For Berle, the contract must have meant a drop in current income. Before the deal he probably got $13,500 a performance. At that rate, he could make the $1,500,000 in three years, with Uncle Sam taking close to 85 per cent. Naturally Berle must love the deal: the spreading probably cuts the government’s share of his income in half.
Confiscatory personal taxes have brought into American business a whole new set of securitybuilding mechanisms. Yesterday the major dynamic ingredient sparking our industrial giants was a simple system of annual incentive compensation; today we reckon only take-home pay, plus what the job builds for tomorrow’s security. So repeatedly comes rejection of just high pay. High personal taxes make high income an illusory treadmill.
The best way to illustrate the tax consciousness of the average American is to tell the story of an ad for a top-grade man to manage plantations below the equator. The offer by an American company owning them proposed a residence plus $25,000 a year, all tax free. There were more than 2200 written applications, and the switchboard was swamped with telephone applications, more than a hundred of them long-distance calls. One applicant didn’t bother to write; he flew from the Midwest to New York for a personal interview. Several executives in the $50,000 salary bracket sought the job. The successful applicant did not have to give up his United States citizenship. With this deal, he could build up a substantial estate in a few years — and bring it into the United States without tax.
This is an isolated case, but at least it establishes the fact that the problem of take-home pay and security is uppermost in many executive minds.
The Berle type of contract is not limited to actors. We got to digging into the public records to find out how general is its application. Included in our list are contracts for the top executives in Safeway Stores, Bloomingdale’s, Allied Stores, American Viscose, American Locomotive, General Electric, Stewart-Warner, Warren Petroleum, and dozens more. All of them run in the same vein; all seek to postpone high income that might be taken today to some later year when tax rates may not be so high or one’s income, is naturally diminished as a result of retirement.
The arrangement Peoples Gas Light and Coke Company has with its president is typical. He gets $60,000 a year to the end of 1965. Then he collects $20,000 a year for advisory services until his death. The pattern is pretty much the same in other taxminded and security-worried companies. The idea is to get money out of a high-income-tax year over to some lower-income-lax year — simply spread the fruit of today s earning power to later years.
To get this income tax distribution men willingly turn down current pay beyond their wildest dreams; they gamble with promises to pay to them — or sometimes to their heirs — ten or twenty years later. And they often agree to be paid in the long deferred period based on earnings, sales, or dividends then available to stockholders. Sometimes they contract, in order to get the deferred pay, never to go over to competitors. If they do, they forfeit the built-up security.
Other deferred salary plans
The sort of contract we’ve been describing is only part of the present-day system of paying executives. Three other forms of deferred pay are important. These are pension, profit-sharing, and stock-bonus plans — devices which have government approval to defer compensation by contract. They follow prescribed rules in our law.
The surest way to defer income is in actuarially sound pension plans and profit-sharing plans, or a combination of the two. The profit-sharing deferral is particularly sought today. In it the employers’ annual contributions are based on a formula keyed to profits. This naturally produces a sizable fund to be laid away in high earning periods.
Pension and profit-sharing plans are encouraged bv the current high tax rates — because the employer gets a full deduction in the year of payment to the plan. And they are fine for the employee. He is taxed only at the deferred date when he receives the payments — even though his rights are vested when the employer makes his contribution. And there is another big stimulus for the employee: he or his family might get a capital gain under a qualified plan if he is paid his entire distribution when he leaves his job.
There are a great many stock plans in operation today designed to defer compensation. Some are set up so that an executive can avoid a tax when he acquires the stock. Under this type ot plan he pays a tax only if he sells the stock.
Example: A company may issue a high-leverage equity stock that has no present value, but a large potential value, to an officer. He has no tax to pay when the potential is realized. He only owes a maximum of 26 per cent tax on the sale of the stock when it reaches its higher value —and only if he sells it.
These stocks — affording a capital gain — are frequently used with the organization of a new company. A and B start an enterprise. A puts up all the money and takes for it a stock limited in dividends but giving A full compensation for his investment. The two then divide the equity stock, which may increase in value with earnings. B, who has contributed services to the company but has put up no money, may later dispose of this stock at the capital gain rate. The sale of the stock is really a method of giving B compensation at bargain tax rates.
Sometimes big business sets up sponsored corporations to buy its own stock. The employercorporation may invest company funds in some type of securities of the new company; then it sells the common stock to employees at a nominal value. The new company uses its funds to buy the employer’s common stock — particularly when it is selling cheaply or below the net asset value. The employees get what remains when the company management is eventually liquidated and the debts are paid up.
Stock options are favored just now
Occasionally corporations sell stock to employees at the current market price but ask only for payment over a long period and charge low interest or none at all. In these plans, employees are often credited with dividends to reduce the amount due. In some cases the purchaser may have the right to discontinue payment if the market price of the stock fluctuates.
The basic idea behind stock options is simple. A company gives an executive or an employee an option to buy a certain amount of its stock at present prices. At some future date he can exercise the option; he can cash in when the market is right. When he finally buys the stock, he pays no tax on any gain until he sells the stock. He is then charged the 26 per cent capital gain rate. The spread between the option price and the eventual sales price is really a method of paying deferred compensation. You get the same result as with a deferred compensation agreement.
Example: DoreShary, at Loew’s, can buy 100,000 shares for $16 7/16 a share. When he disposes of the stock, he can make a capital gain. The straight income tax on his gain might be three times the capital gain.
Most companies today set the option price at 95 per cent of the market. Many give no bargain rates at all — merely setting the price at the market. That is true of U.S. Steel’s new plan. The “bargain comes from the tax benefit if the stock climbs. Here’s just a bit of the record to show how large companies are currently granting stock options.
|Number of Shares||Number of Eligible Employees||Option Price As Per Cent of Market Price|
|Sea rs, Roebuck||500,000||40,000||85|
|Pittsburgh Plate Glass||450,000||4,000||85|
|Standard Oil (N .J.)||300,000||125||95 -100|
|Union Oil of California||300,000||30||100|
|Jones & Laughlin||300,000||100||100|
|S t. Regis Paper||250,000||100||95|
|United Pa ramount||250,000||50||95|
Here’s how an option works
A company sets aside 1000 shares for its president at $95 when the stock is selling for $100 a share. Five years later, the stock is selling for $120, and the president decides to buy. He gets his 1000 shares for $95,000, but they are now worth $120,000. (Before Congress changed the law last year, he’d pay his straight income tax on that paper gain.) Six months later, he sells at $120, netting $25,000. Since it is taxed as capital gain, the most the government can take of that $25,000 is 20 per cent, or $6500, As straight income, he would be able to keep much less than half that $25,000.
The advantage becomes greater when you go into still higher income levels. For the executive, this is a sort of painless, riskless hedge against inflation: he can make use of the option at the most opportune time; he can convert 1952 dollars into, say, 1956 dollars with little chance of losing his shirt in the process.
Expense deals can increase net take-home pay
Some companies allow executives to use expense accounts to increase take-home pay. To pay ordinary personal expenses not required by the job is a meaningless tax gesture. If a company does that, it merely increases an official’s taxed income.
What is a personal and what is a business cost is often hard to define. All we know is that up lo now our government has not at templed to tax employees when a company does these things: —
1. Pays group life insurance and even covers insurance costs for sickness, accident, or hospitalization.
4. Gives employees facilities and privileges furnished entirely for their safety, good will, health building, morale building, or efficiency.
3. Gives courtesy discounts on purchases.
4. Uses its own cars or planes for executives on company business.
5. Moves an employee’s family when his job forces changes in residence.
In a recent case an employer required a manager to move closer to his place of employment and reimbursed him for the loss on the sale of his home. The Treasury lost out when it sought to tax the payment as compensation.
Sometimes big business pays the dues for an executive in clubs or associations to which the company thinks he ought to belong. Sometimes it provides him cheap rent in company-owned dwellings and also furnishes utilities, repairs, and service to keep the houses in good shape. It often pays his doctor’s bills for periodic checkups essential to find out what his job has done to his health, or it furnishes rest cures. It is quite usual to find company-operated, free medical examination and treatments, whether or not the ailment is connected with work.
The business of having the company assume the financial responsibility for these costs is not a foolproof solution for overextended personal budgets. The government is naturally suspicious of these practices. It repeatedly losses the fair value of what the executive gets into his personal taxed income. So it is always essential to prove the employer has paid only personal costs demanded by a company policy.
Direct payment by the employer of costs required by the business eliminates much bickering. Of course, this doesn’t mean issuing company checks for purely personal expenses, (The Tax Court has refused to allow a company’s payments for the wedding party of its treasurer’s daughter.) But the alert arrange for all entertaining and traveling expenses to be directly paid by the company through credit cards, with the bill and supporting chits going to the company. Where the executive must lay out cash, he is required to put in an explanation of the purpose and an accounting for the amount of an advance or reimbursement.
Sometimes a business won’t, or can’t, take over the burden of paying the costs directly. Then the company will help the executive make sure he gets his tax deduction by establishing his duty to bear his costs. Some companies issue statements of policy or firm contracts ordering the cost as a duty, in order to sustain the employee’s right to deduct what might otherwise be costly personal expenses. The contract, clearly providing that an employee is paid on his agreement to spend part of his pay in specific channels, furnishes proof of the business need for the disbursement when it is questioned by the Treasury.
The Tax Court upset the government in allowing a salesman for Time magazine lo deduct his own business expenses. That followed proof that the Time management assumed the pay to its people covered a salesman’s costs in getting his business.
Employers sometimes designate a specific part of the salary as an allotment for expenses. Then the employee may deduct his reimbursed expenses from his income to get a double advantage. He can make use of the 10 per cent standard expense allowance and also get a deduction of his actual costs.
Example: A corporation pays a salary of $15,000 a year. It is understood that $1500 of it is to reimburse business expenses, say entertaining. Actual expenses for these items are $1200. An employee can deduct this amount from his gross income, He also can take the standard deduction of $1000.
All of these plans to build up take-home pay are extra inducements towards security.
My experience is that commonplace raises in salarv are too often symbolic only of appreciation for a job well done; they do not furnish the wherewithal to aid in living within one’s income. For many people, salary boosts are treadmill gains in the face of higher living costs and bigger tax bites.
It is absurd to say, as some do, that our ever increasing tax rate has killed all the incentives for exeeutives to advance themselves. But it certainly lias done this much: it has emphatically cut the moving about from job to job, when Hie next offer has failed to hold as much security as the present one. Yet it has made it attractive for executives to move to other companies which have better expense systems, stock options, or deferred salary plans.
I am sure, too, that a desire to fit into one of these plans is often subordinated to nonfinancial incentives: greater financial security is discarded for the degree of happiness, independence, and freedom of movement attached to the present job. How long that will hold with current personal tax rates is a question beyond the scope of this article.