Jeff McCutcheon

Managing Director

June 8, 2009

The Honorable Timothy F. Geithner

United States Secretary of the Treasury
1500 Pennsylvania Avenue NW
Washington, D.C. 20220

Re: Executive Compensation and Tax Policy

Mr. Secretary,

As a consulting practice that addressed executive pay & performance issues

everyday, we find that a few rather simple changes can dramatically increase the
accountability of executives and their alignment of long-term interests with those
of investors and other stakeholders. As you initiate actions through your
executive pay czar to bring accountability and trust to boards in their
management of executive compensation, I want to point out that there is some
low hanging fruit right outside your window.

With the use of “hold-till-retirement” executive equity restrictions, executives are

precluded from effectively timing the markets to capitalize on excessive risk
taking or minimizing losses during downturns in company value. Furthermore,
by requiring executives to hold all company-issued equity until two years
following retirement, a vested interest is created in the orderly succession of
management within the company and the protection of ongoing shareholder
value. In a nutshell – we directly address core causes of current problems.

I have attached a memo recently circulated to clients of Board Advisory that you
might find interesting and timely. In the bulletin we suggest that minor
amendment of existing tax rules regarding employer equity (IRC §421-424) could
eliminate an obstacle to implementing “hold-till-retirement” equity provisions and
at the same time substantially increase tax revenue without a formal rate
increase1.

1
Assuming a conservative $30B in annual present value of equity awarded by the S&P 500
companies, the present value of an eventual 15% capital gains tax is $4B annually for participants at those
500 companies alone, not considering revenues from smaller companies and private companies.

956 Elder Lane jmccutcheon@board-advisory.com office: 904-306-0907

Jacksonville, FL 32207 www.board-advisory.com mobile: 904-728-7700
June 23, 2009
Page 2

Mr. Secretary, we believe that subtle, well-thought out actions can produce great
results. Given the government’s limited success in attempts to restrain executive
compensation over the past 25 years and the public desire to find a smoking gun
to blame for our economic malaise, we do not believe additional regulation or
disclosure will be successful at increasing board responsiveness or improving
executive behavior. However, we remain convinced that an executive
compensation practice such as “hold-till-retirement”, that is viewed as
responsible and fair by pay experts and critics alike, when supported by tax
policy, can quickly improve the executive pay landscape.

* * * * *

We look forward to discussing this concept with you or your staff, at your
convenience.

Sincerely,

Jeff McCutcheon
June 23, 2009
Page 3

Aligning Tax Policy with

Sound Executive Compensation Practices

Executive compensation experts and investor representatives alike agree that rather
than limiting pay, we should create plans where executive wealth is tied to that of long-
term investors – where they are unable to profit (or limit losses) from short-term
changes in company performance or company stock price. There is much agreement
that this linkage is best accomplished through executive equity arrangements with
provisions such as “hold-till-retirement” requirements. Such provisions dramatically
reduce or eliminate the ability of the executive officer to time the market in their
employer’s security. By limited any sales to a period after retirement (e.g., two years),
a shared interest in a successful executive succession process is also created – an
interest woefully lacking in most current situations and evidenced by the appallingly
poor success of most succession efforts.

However, in implementing hold-till-retirement provisions boards of directors are now

finding that federal tax policy is not aligned with what is arguably in the best interest of
the public, not to mention shareholders. Our existing tax policy treats nearly all
executive equity arrangements as “compensation” rather than “investment”, providing
no incentive for executives to retain their employer stock once acquired or vested.

The table below shows the current taxation2 of various popular executive equity
compensation vehicles:

Corporate Tax Executive Tax Executive Tax

Equity Vehicle
Treatment Treatment Timing

Restricted Stock or Full value is deductible Ordinary income At vesting

Performance Shares

Nonqualified Stock Gain on exercise is Ordinary income At exercise

deductible
Option (NQSO)

Incentive Stock Not deductible Capital gain Upon sale of

shares
Option (ISO)

Employee Stock Only the discount portion is Discount is ordinary Upon sale of
Purchase Plan (ESPP) deductible income, all subsequent shares
gain is capital gain

2
Any compensation value from an executive equity grant today is also subject to the limits and performance
rules of section 162(m)). Ordinary income is subject to FICA/Medicare taxes from both the executive and
the employer at the time of vesting/exercise.
June 23, 2009
Page 4

The net effect of this approach is that today’s executives have a powerful incentive to
exercise stock options during favorable market cycles, then liquidate their positions to
provide cash flow to execute the exercise, including withholding taxes. Since there is no
further tax liability and typically little obligation beyond perhaps modest stock holding
requirements, a rational executive/investor would clearly sell their ownership position to
diversify their overall portfolio. The existing tax treatment does not encourage long-
term executive ownership nor penalize sale of stock during the executive’s career.

Alternative Tax Approach Creates Value from Holding to Retirement

An alternative approach is to treat executive equity awards as a sale of company stock

on the date of grant, similar to any other investor purchasing shares for cash or to any
qualifying employee purchase under an Employee Stock Purchase Plan (“ESPP”, IRC
§423). Where there is a discount element (e.g., restricted stock, performance shares or
a discounted option), the discount at grant would be treated as compensation to the
executive and deductible to the company (subject to IRC §162(m)), due upon eventual
sale of the equity. Thus a company could create a very favorable tax situation for its
executives (and an incentive benefiting investors and the public alike) by requiring that
they hold the stock until after they leave the company. Like other investors, any post-
grant gain (or loss) would be taxed as a capital gain at the time of sale. Similarly, any
dividends paid would be taxed at the 15% rate (under current law).

Vehicle Form of Income Timing

Restricted Stock or Value at grant is ordinary income, any post- Sale of Shares
Performance Shares grant change is capital gain/loss
Stock Options Gain at exercise is capital gain Sale of shares

These proposed tax rules create a strong incentive for executives and Boards to design
equity plans utilizing hold–till-retirement provisions. For example, without a hold-till-
retirement provision a performance share grant would trigger immediate taxation for the
full value at vesting. The executive would typically then sell shares to satisfy the
withholding tax. With the benefit of a hold-till-retirement provision, the executive would
not be liable for any tax until the shares were sold - at some point after retirement.
This will result in more net shares remaining in the hands of executives, presumably
providing a more significant incentive for delivering long-term results for investors and
the public at large.

Curiously, although the executive would receive favorable tax treatment, the tax
revenue gains to the government would be significant. Currently, the executive’s
ordinary income tax and the corporate deduction largely offset each other. As a result,
the executive’s basis in the stock is stepped up to the price at the date of vesting (for
full value shares) or exercise (in the case of an option). Thus the net tax received by
the federal government is limited to the capital gains tax calculated on any stock
June 23, 2009
Page 5

appreciation subsequent to vesting/exercise – and there is little incentive for executives

to hold shares after vesting/exercise.

Under the proposed approach, the executive’s capital gains would be measured from the
grant date price – as is the case with an investor purchase – with no offsetting tax
deduction by the corporation. While this results in a lower tax rate for the executive,
the effective taxation is increased by eliminating the employer’s tax deduction.
Furthermore, the combination of hold-till-retirement covenants and supporting tax policy
better aligns the executive performance incentive with the interests of investors and the
public over time, rather than allowing an executive group to be rewarded for short term
results. With a broad definition of equity incentive plans (i.e., including non-public
company equity and equity-like vehicles), this approach can successfully apply
regardless of company size or ownership structure (e.g., small businesses, joint
ventures, subsidiaries, private equity and start-ups).

This is an easily achievable3 first step toward aligning federal tax policy with public policy
interests regarding executive compensation and corporation accountability. Even with
supportive tax policy there is no assurance companies will adopt these programs, but by
signaling a willingness to provide tax policy consistent with long-term ownership and
responsible executive incentives the government can take the first step toward
improving executive accountability and in turn, our capital markets.

 Paul McConnell

Paul McConnell works with a number of Board Advisory clients within the banking and related
financial services arena on executive pay alignment, performance measurement, and executive
performance issues. Mr. McConnell’s bio is available at http://www.board-advisory.com. If you
have any question or comments on this article, or want to speak with Paul about any executive
rewards, performance, or succession issue, he can be reached at pmcconnell@board-
advisory.com, or at (407)876-7249.

3
Internal Revenue Code Sections 421 through 424 already contemplate treatment of employer-granted
equity consistent with the investor, as described above. However, existing limitations on Incentive Stock
Options (§421) and ESPP’s (§423) render the existing programs generally unusable for contemporary
executive compensation. The proposed approach would require amending the existing provisions to extend
the treatment already provided to ordinary investors and ESPP participants to practical application in
executive compensation programs.