Executives these days don't just receive a base salary. They get large bonuses, life insurance policies, security services, travel services and a host of other perks that you and I would give an arm and a leg for. Furthermore, many of these same executives are also receiving a benefit (ie: cash) that helps them pay the taxes that they incur on these perks. This benefit is known as a "gross up". Read on to learn more about this type of compensation and how it can affect investors.

Why gross up?
Back in the 1980s Congress imposed an excise tax on "golden parachutes," the lucrative severance benefits that were given to top executives if the company was taken over by another firm. The goal was to prevent "greedy" executives from reaping huge windfalls upon a change in control of a business. (To learn more about CEO compensation, see Putting Management Under The Microscope, Evaluating A Company's Management and Lifting The Lid On CEO Compensation.)

However, the plan put forth by Congress didn't work as planned.

Crafty boards soon figured out a way around the new law. That is, boards would simply compensate their executives so that any taxes they incurred upon a change in control would be covered. Over the years, this compensation practice expanded to cover taxes that senior executives incurred on many other sources of income (including perks).

However, the practice of offering gross ups didn't really become popular until the late '90s and early '00s. That's because employee stock options (ESOs) were the preferred method of lining executives' pockets. And why not? Stock options were a form of potentially vast compensation that could be realized over a short period of time - typically a couple of years. Plus, the exercise price could be tinkered (through backdating) with to maximize an insider's profit. (To keep reading on this subject, see The Controversy Over Option Compensations, The "True" Cost of Stock Options and our Accounting And Valuing ESOs tutorial.)

In the late 1990s, investors started complaining and the press chimed in and ran a number of high profile articles on corporate excess. As a result, boards were forced to resort to more subtle ways of compensating their senior executives.

It was out of this bag of tricks that the gross up emerged.

Upping the Gross Pay
Given that an executive's salary, bonuses and options pay has historically received so much scrutiny, gross up compensation seemed like a terrific answer. After all, it effectively moved money from the company's coffers into the executive's piggy bank beyond the notice of most people in the investment community. That's because details regarding gross up compensation is typically buried in the footnotes of the company's proxy statement. (Find out more in Footnotes: Start Reading The Fine Print.)

Also because gross up pay is related to taxes (and doesn't appear to be a brazen perk like a country club membership) it seems that the investment community largely overlooked it.

However, the community's attitude is starting to change and companies that offer gross up pay are starting to take some heat. That is primarily due to the fact that more and more companies have resorted to using gross ups in recent years. This may be because options-based compensation packages have lost some of their luster (much of that credit going to the backdating scandal). (Keep reading about this subject in The Dangers Of Options Backdating and Reining In CEO Rewards.)

Why are gross ups bad?
The practice of "grossing up" an executive's pay isn't bad in and of itself, but the practice is usually done on the sly and the average investor has no idea it has even taken place. In addition to its secretiveness, it also costs the company - and its shareholders - a lot of money.

Companies in the News
So how prevalent has the practice of offering gross up pay become?

In a Wall Street Journal article, "A Growing Executive Perk: Taxes" (European Edition, December 2005), a study by compensation consulting group Towers Perrin stated that of the 1,000 public companies they tracked, 77% offered gross ups as part of their change in control plans in 2005. They found those numbers were up sharply from the 55% in 1999 and 10% in 1987.

Many companies have been accused of abusing gross ups. Let's take a look at a few high profile companies that have had their gross up practices make the news:

  • Gillette: The razor maker's former chief executive, James Kilts, is said to have received as much as $13 million in gross up payments (in part to cover taxes) related to the sale of the company to Proctor & Gamble in 2005.
  • Coca Cola Bottling: Chief executive J. Frank Harrison III is said to have received more than $4 million over a period of about five years (from 2000 to 2005) to cover taxes on a restricted stock grant.
  • Home Depot: Ex-chief executive Bob Nardelli was said to have received upwards of $3 million in the 2004-2005 time frame to cover taxes on a host of perks. A quick glance at the company's proxy statement reveals that Nardelli has garnered a host of benefits during his tenure, with some ranging from travel, the forgiveness of a roughly $10 million loan and a high-end automobile.

The Bottom Line
When perusing a company's proxy statement and/or analyzing an executive's pay - be sure to read the footnotes. By combing through the fine print you'll find that many companies have taken kindly to the practice of shielding their executives from taxes that most others would have to pay.

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