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The Real Story About $1 CEO Salaries

I was looking at the new Money Blog Network and noticed a post, by JPL of All Things Finanacial, about the top Google Exec's pulling down only $1 for their salaries. This is something that Steve Jobs has been doing for years, as well as other execs. Now, many of you are aware that they are not getting compensated with just a $1 salary. Many of them receive annual bonuses that could make your ten year income look pitiful. However, a great amount of their salary comes from Incentive Stock Options (ISO). Understanding ISOs and their tax implications sheds considerable light on this perk of taking a miniscule salary in exchange for hefty stock options.

So what is all the fuss about this? Well, for starters, it is only a PR stunt. These guys get huge compensation; They have $6.3 billion in Google (GOOG) already. But, they will likely get more stock in the form of Incentive Stock Options. Essentially, Incentive Stock Options are given to executives of companies. Non-executives that receive stock options usually receive Non-Qualified Stock Options (NQSO). There are two differences here. One, NQSOs are taxed when they are excercised, whereas ISOs are not. What is excercising? Well, with stock options, you are given the opportunity to purchase stocks at the lowest price in a period. This means, a stock may have been worth $10 at some point in the period, but it may now be worth $20. So, if the stock reaches $20, and you can purchase it at $10, you have already doubled your investment. For ISOs, you pay no taxes on that amount. However, for NQSOs, you pay short-term capital gains tax on the difference. Further, short-term capital gains tax is the same as your marginal tax rate. Once you purchase these shares, you have excercised your options.

Now, if you hold your shares for at least one year after you have exercised them, you qualify for long-term capital gains tax on the difference. So, let's assume that the stock is worth $30 after holding it for a year. If you purchased the shares with NQSOs, you pay long-term capital gains tax on the difference of the shares when purchased to the time they are sold (so, you paid your marginal tax rate on the difference between the purchase price and the value at the time of purchase, and you pay long-term capital gains tax on the difference between the value at the time of purchase and the time of sale). If you purchased these stocks with an ISO, you pay long-term capital gains tax on the difference between your original purchase price ($10) and the sale price ($30). Now, assuming your marginal tax rate is 28% and you purchased 1000 shares, you paid $2800 ($10 * 1000 * .28) in marginal taxes for the year you exercised your stock options, if you did so with NQSOs. When you sell them you pay $2000 ($10 * 1000 * .20) in long-term capital gains tax, for a total of $4800 in taxes. Now, if you purchased these with ISOs, you pay $4000 ($20 * 1000 * .20) in capital gains tax when you sell the shares. So, as an executive you get a tax break already, as compared to non-executives that receive NQSOs.

So, why would a company elect to give employees NQSOs rather than ISOs? Because they get a tax break for doing so. Executives get it because they are priviledged, or something. But this is not where it ends. If you earned more than $326,450, in 2005, your marginal tax rate would be 35%. The long-term capital gains tax is 20%. So, you take a $1 salary which places you in the 10% marginal tax rate for your earned income (of only $1), and you get a bunch of ISOs that are taxed at 20% when you sell them. So, you are saving over 42% in taxes. These guys don't seem like such great statesmen after all, do they? I do not necessarily think there is anything wrong with this, but having the proper perspective really helps when you may be deceived by someone's character, which is what this has typically turned out to be. For instance, both Apple and Google try to display a corporate image of liberalism. They show the executives as earning $1 salaries by choice, they give employees help with purchasing hybrid automobiles, and the like. However, they are avoiding taxes, which most American's try to do, but their image is displayed to the contrary. I am not really trying to persuade anyone, but just dismiss the illusion of what is being conveyed. And maybe, this is a great way to handle CEO compensation, because their compensation gets tied to corporate performance.


Anonymous real people, real finances Says:

January 26, 2006 4:03 AM 

Great post. Never really took the time to think about it that way, but it makes sense.

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