The AIG Bonuses, Part 2:
The House tax bill

23 Mar 2009 in Regulatory Economics, Regulatory Policy

Friday we posted an analysis of the economics of bonus payments as part of an employee's compensation. Today we look at H.R. 1586 (Rangel [D-NY]), which was introduced in the House on Wednesday and passed 328-93 on Thursday.

H.R. 1586 is intended to ensure that recipients of these bonuses do not collect them.

WHO IS SUBJECT TO THE TAX?

Many more individuals are potentially covered than just the few dozen AIG employees who are contractually entitled to receive bonuses. It covers:

Current or former employees of Fannie Mae
Current or former employees of Freddie Mac
Current or former employees of any firm receiving more than $5 billion in total capital infusions from the Troubled Assets Relief Program (TARP), including
- certain subsidiary partnerships
- affiliated groups as defined in section 1504 of the Internal Revenue Code of 1986

News reports indicate that thousands of individuals would be subject to the tax.

WHAT IS THE AMOUNT OF THE TAX?

The tax is equal to the lesser of:

90% of the bonus (plus Medicare and applicable state and local taxes, bringing the total tax to 102% for taxpayers in New York City
100% of the taxpayer's adjusted gross income exceeding $250,000, or $125,000 for married individuals filing separately (it is not clear how single taxpayers are treated)

To see how this would work, consider a pair of simplified examples.

Example #1: The employee had a base salary of $1 million and received a $1 million bonus. This employee can either (a) repay the $1 million bonus to the employer or (b) pay the federal government $1,750,000.

Example #2: The employee had a base salary of $125,000 and received a $125,000 bonus. This employee can keep the bonus and owe no additional taxes.

An employee whose adjusted gross income exceeds $250,000 solely due to the bonus also is better off keeping it and invoking the second prong of the test.

In combination, these provisions are redistributional. The opprobrium Congress directs to bonus recipients depends solely on their adjusted gross income. As long as a recipient's AGI stays below $250,000, there is nothing "wrong" with receiving a bonus. If AGI exceeds $250,000, however, then receiving a bonus is so wrong that it must be returned or it will be confiscated.

ARE THERE UNRESOLVED TECHNICAL QUESTIONS?

Commentary on the bill appears to be unanimous that bonuses received prior to January 1, 2009, are covered. However, the tax is triggered by cumulative TARP capital infusions beginning on January 1, 2008. For the employees of firms that received more than $5 billion in TARP funds in 2008, bonus payments made in 2009 are covered.

Such payments are not covered if the firm received less than $5 billion in 2008, but they could be covered retroactively in future years. Suppose the employer's firm received $3 billion in TARP funds in 2008, paid the contractually obligated bonus in 2009, then received another $3 billion in TARP funds in 2010. In that case, the firm's receipt of TARP funds in 2010 creates new tax liabilities for employees in 2009. Bonus payments that were exempt from the tax when paid would be subject to it retroactively. To protect against this, firms can be expected to revise their labor contracts to characterize all compensation as salary, notwithstanding the 1993 cap on deductibility of executive salary compensation.

The same is true if a firm exceeds $5 billion in TARP capital infusions in any future tax year. As long as the aggregate exceeds $5 billion, then bonus payment received in previous tax years appear to trigger new retroactive tax liabilities.

CAN THE TAX BE AVOIDED?

The tax goes away if the taxpayer:

"irrevocably waives the employee's entitlement to such payment, or
"the employee returns such payment to the employer, before the close of the taxable year"

Note that there is no factual or legal dispute concerning the employee's right to receive the bonus. It is understood to be a legal entitlement pursuant to the employee's labor contract.

The tax is linked to adjusted gross income, not income after deductions. Thus, the employee cannot reduce his tax liability by, for example, making charitable contributions.

The employer might act to reduce the effect of the tax, such as by reimbursing the employee for his losses. However, section (b)(3) treats any such reimbursement as an additional "unqualified bonus" subject to the tax. The only option that appears to be available under H.R. 1586 is to modify labor contracts to explicitly label it salary and defer its payment to a future tax year. Of course, Congress could return to the issue and declare deferred non-bonus compensation to be "unqualified" and thus subject to the tax.

The only other way for the employee to avoid the tax is to reduce taxable income for 2009. Former Wall Street Journal personal finance columnist, and now director of financial guidance for Citigroup's new myFi unit, Jonathan Clements says that is what he will do:

Being somewhat knowledgeable about personal finance, I'm trying to figure out how to finagle this. By minimizing my investment income in 2009 and pushing other income into 2010, I reckon I can delay the day of tax reckoning. But even with that finagling, by mid-October, I will hit $250,000 in total income -- and have no incentive to earn any more income in 2009.

At that point, I plan to ask Citi for an unpaid sabbatical. Forget earning more income. There's no point. Instead, you will find me hunkered down at home, desperately trying not to spend money. This will make entire financial sense for the Clements household. What about the struggling economy? Not so much.

Employees who received larger bonuses might decide to stop working now. They can keep the first $250,000, and they cannot keep a single dollar earned for working any more during 2009. (Alternatively, they can insist that their employment contracts be renegotiated such that what they previously received in the form of a bonus is now called salary. Clements does not discuss this option in his commentary, but nonetheles it remains available.)

Finally, firms can protect their employees from the tax by declining to accept more than $5 billion in TARP funds. Some firms may decide not to exceed this threshold irrespective of the potential value to shareholders or to the US economy as a whole. Other firms will pay back TARP funds to stay below the threshold. Whatever TARP's net social benefits might be, H.R. 1586 reduces them. (Conversely, if TARP does not have net social benefits, then H.R. 1586 will reduce its net social coists.)

ARE THERE PREDICTABLE INCENTIVE EFFECTS?

Until now, high marginal value product employees were essentially indifferent with respect to whether their compensation was described as "salary" or "bonus." If it saved the employer on taxes by calling it a "bonus," fine. If H.R. 1586 is enacted -- and quite likely, even if it isn't -- these employees will now demand that their compensation be paid as "salary" even if the employer must pay a tax penalty for the portion exceeding $1 million. This may make executive compensation more transparent -- an admirable objective in its own right -- but it will no longer be possible to base compensation on an employee's performance or commitment to stay with the company for an extended period. The ability to structure contracts this way is an important managerial tool.

A larger incentive issue arises insofar as H.R. 1586 has the practical effect of abrogating legal employment contracts. Employers and employees may reasonably conclude that Congress will also intervene to impair the obligations of future contracts Typically, an employment contract specifies the duties of the employer and employee. It includes provisions for liquidated damages in the event that either party commits a breach, and other provisions for "acts of God" that neither party could influence, much less control. Now, employment contracts will need to include provisions managing political risk.

Finally, H.R. 1586 will have spillover effects on (among other things) the Federal Reserve's new Term Asset Loan Facility (TALF) and the Obama Administration's proposal to create public-private partnerships to dispose of so-called "toxic" assets. TALF recipients are not currently covered by H.R. 1586. The bill could be amended easily to bring them in, and the mere threat that this could happen might discourage participation in TALF.

Treasury Secretary Timothy Geithner is announcing today the Obama Administration's plan to sell "toxic" assets to private investors. Geithner says in a Wall Street Journal commentary:

The Public-Private Investment Program will purchase real-estate related loans from banks and securities from the broader markets. Banks will have the ability to sell pools of loans to dedicated funds, and investors will compete to have the ability to participate in those funds and take advantage of the financing provided by the government.

The funds established under this program will have three essential design features. First, they will use government resources in the form of capital from the Treasury, and financing from the FDIC and Federal Reserve, to mobilize capital from private investors. Second, the Public-Private Investment Program will ensure that private-sector participants share the risks alongside the taxpayer, and that the taxpayer shares in the profits from these investments. These funds will be open to investors of all types, such as pension funds, so that a broad range of Americans can participate.

Third, private-sector purchasers will establish the value of the loans and securities purchased under the program, which will protect the government from overpaying for these assets.

ACcording to Geithner, "The private sector will set prices," and "Taxpayers will share in any upside." What is not clear is whether the government will retroactively change the prices set by the private sector to increase the taxpayer's share in the upside. H.R. 1586 sets the precedent that it will do so if investors make "too much" money, with the definition of "too much" to be decided later.

Any investor considering participation in the Administration's proposed public-private partnership must prudently expect that if these investments are more profitable than the government now expects, the government will expropriate the "excess" profits. Potential investors can account for this risk only by offering lower bids. That will reduce the taxpayers' initial share of upside risk, and ironically, it also will increase the likelihood that Congress will act to expropriate investors' gains.

A reasonable inference is that investors will bear all of the risks of financial losses written into the program but be able to capture only a regulated rate of return. That makes the program a very risky investment. Unless contractual terms are written that Congress cannot later invalidate, prudent investors are likely to stay away from this new program. (One way this might be done is to prescribe the liquidated damages that investors automatically receive -- and an automatic way to deliver these benefits, such as a refundable tax credit -- if Congress takes any adverse action. Congress cannot be prohibited from acting, but the effects of future congressional action might be neutralized if they are properly anticipated.)

IS THIS BILL CONSTITUTIONAL?

Maybe. Maybe not.

H.R. 1586 has retroactive effect, making is unambiguously an "ex post facto" law. It does not directly abrogate existing labor contracts but it renders them practically null and void. Such acts are prohibited by the U.S. Constitution, but the prohibition is limited to the States:

Section 10. No state shall enter into any treaty, alliance, or confederation; grant letters of marque and reprisal; coin money; emit bills of credit; make anything but gold and silver coin a tender in payment of debts; pass any bill of attainder, ex post facto law, or law impairing the obligation of contracts, or grant any title of nobility.

The power to tax, however, is squarely within the scope of congressional power:

Section 8. The Congress shall have power to lay and collect taxes, duties, imposts and excises, to pay the debts and provide for the common defense and general welfare of the United States; but all duties, imposts and excises shall be uniform throughout the United States...

The other argument for unconstitutionality is equal protection. H.R. 1586 singles out a class of individuals and treats them differently based on whether their employers follow one set of legal procedures or another.

To secure a decision that H.R. 1586 is unconstitutional is an expensive proposition. First, plaintiffs must have standing to sue, and it is not clear that a firm receiving TARP funds (or an trade association comprised of such firms) would be successful. Nothing in the bill directly applies to these firms.

Second, it is expensive to prosecute such a case even if standing is assured. The Justice Department would defend the law to the best of its ability, even if its senior lawyers believe that the plaintiffs are right. Unlike private parties, the Justice Department has an effectively unlimited litigation budget.

CAN THE OBAMA ADMINISTRATION DO ANYTHING TO NEUTRALIZE THE BILL'S ADVERSE INCENTIVES?

The bill gives the Treasury secretary discretionary authority to issue implementing regulations. Treasury could exercise its authority passively (that is, accepting the bill as it was written and intended) or aggressively (that is, exercising its ability, if not legal authority, to rewrite the law administratively). Executive branch agencies have been known to rewrite legislation in ways Congress does not recognize. Indeed, Congress complains that this is a commonplace occurrence. The question in this case is: Does Congress truly intend for H.R. 1586 to be enforced, or would it be content to let the Treasury Department quietly emasculate it?

H. R. 1586

AN ACT

To impose an additional tax on bonuses received from certain TARP recipients.

Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled,

SECTION 1. BONUSES RECEIVED FROM CERTAIN TARP RECIPIENTS.

(a) In General- In the case of an employee or former employee of a covered TARP recipient, the tax imposed by chapter 1 of the Internal Revenue Code of 1986 for any taxable year shall not be less than the sum of--

(1) the tax that would be determined under such chapter if the taxable income of the taxpayer for such taxable year were reduced (but not below zero) by the TARP bonus received by the taxpayer during such taxable year, plus

(2) 90 percent of the TARP bonus received by the taxpayer during such taxable year.

(b) TARP Bonus- For purposes of this section--

(1) IN GENERAL- The term `TARP bonus' means, with respect to any individual for any taxable year, the lesser of--

(A) the aggregate disqualified bonus payments received from covered TARP recipients during such taxable year, or

(B) the excess of--

(i) the adjusted gross income of the taxpayer for such taxable year, over

(ii) $250,000 ($125,000 in the case of a married individual filing a separate return).

(2) DISQUALIFIED BONUS PAYMENT-

(A) IN GENERAL- The term `disqualified bonus payment' means any retention payment, incentive payment, or other bonus which is in addition to any amount payable to such individual for service performed by such individual at a regular hourly, daily, weekly, monthly, or similar periodic rate.

(B) EXCEPTIONS- Such term shall not include commissions, welfare or fringe benefits, or expense reimbursements.

(C) WAIVER OR RETURN OF PAYMENTS- Such term shall not include any amount if the employee irrevocably waives the employee's entitlement to such payment, or the employee returns such payment to the employer, before the close of the taxable year in which such payment is due. The preceding sentence shall not apply if the employee receives any benefit from the employer in connection with the waiver or return of such payment.

(3) REIMBURSEMENT OF TAX TREATED AS TARP BONUS- Any reimbursement by a covered TARP recipient of the tax imposed under subsection (a) shall be treated as a disqualified bonus payment to the taxpayer liable for such tax.

(1) IN GENERAL- The term `covered TARP recipient' means--

(A) any person who receives after December 31, 2007, capital infusions under the Emergency Economic Stabilization Act of 2008 which, in the aggregate, exceed $5,000,000,000,

(B) the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation,
(C) any person who is a member of the same affiliated group (as defined in section 1504 of the Internal Revenue Code of 1986, determined without regard to paragraphs (2) and (3) of subsection (b)) as a person described in subparagraph (A) or (B), and
(D) any partnership if more than 50 percent of the capital or profits interests of such partnership are owned directly or indirectly by one or more persons described in subparagraph (A), (B), or (C).
(2) EXCEPTION FOR TARP RECIPIENTS WHO REPAY ASSISTANCE- A person shall be treated as described in paragraph (1)(A) for any period only if--
(A) the excess of the aggregate amount of capital infusions described in paragraph (1)(A) with respect to such person over the amounts repaid by such person to the Federal Government with respect to such capital infusions, exceeds

(B) $5,000,000,000.

(d) Other Definitions- Terms used in this section which are also used in the Internal Revenue Code of 1986 shall have the same meaning when used in this section as when used in such Code.

(e) Coordination With Internal Revenue Code of 1986- Any increase in the tax imposed under chapter 1 of the Internal Revenue Code of 1986 by reason of subsection (a) shall not be treated as a tax imposed by such chapter for purposes of determining the amount of any credit under such chapter or for purposes of section 55 of such Code.

(f) Regulations- The Secretary of the Treasury, or the Secretary's delegate, shall prescribe such regulations or other guidance as may be necessary or appropriate to carry out the purposes of this section.

(g) Effective Date- This section shall apply to disqualified bonus payments received after December 31, 2008, in taxable years ending after such date.

Passed the House of Representatives March 19, 2009.

Attest:

Clerk.

"Affiliated groups"

Neutral Source director Charles M. Watkins provides the following explanation of section (c)(1)(C):

Section 1504(a) of the Internal Revenue Code defines an “affiliated group” for purposes of determining which corporations must file a consolidated return. Under Sec. 1504(a)(1), an affiliated group is one or more chains of includible corporations connected through stock ownership with a common parent corporation that is an includible corporation, but only if–

the common parent owns directly stock meeting the [80% voting and value test] in at least one of the other includible corporations; and
stock meeting the [80% voting and value test] in each of the includible corporations is owned by one or more of the other includible corporations.

The 80% voting and value test is satisfied if the “parent” owns stock possessing 80% of the total voting power of the stock of the “subsidiary,” and the stock owned also has at least 80% of the to value of the stock of the corporation.

Under the general rules in Sec. 1504(b), an “includible corporation”—a corporation that must be included in the affiliated group—includes any corporation EXCEPT (among others)—

(b)(2) Insurance companies subject to taxation under section 801; and
(b)(3) Foreign corporations

An exception to the exception applies when the only members of the affiliated group are domestic insurance companies. Another conditional exception permits an election to include a domestic insurance company in the affiliated group if it has otherwise been part of the group for at least 5 years and the group is willing to agree to certain accounting changes.

Thus, the effect of (c)(1)(C) is to include both insurance companies and foreign corporations in the “affiliated group” for purposes of defining the corporations whose bonus payments to employees will be covered.

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