WRITTEN TESTIMONY OF THE STAFF OF THE 

JOINT COMMITTEE ON TAXATION

ON EXECUTIVE COMPENSATION AND 

COMPANY-OWNED LIFE INSURANCE ARRANGEMENTS OF 

ENRON CORPORATION AND RELATED ENTITIES

Presented by

Mary M. Schmitt

Acting Chief of Staff of the

JOINT COMMITTEE ON TAXATION

At a Hearing of the

SENATE COMMITTEE ON FINANCE

On April 8, 2003

April 7, 2003

JCX-36-03
i

CONTENTS

Page

I. INTRODUCTION .......................................................................................................................1

II. ENRON’S EXECUTIVE COMPENSATION ARRANGEMENTS.........................................2

A. Summary Overview of Enron’s Executive Compensation Arrangements.............................. 2

B. General Observations with Respect to Enron’s Compensation .............................................. 4

C. Enron’s Executive Compensation Structure ........................................................................... 6

1. Compensation trends and philosophy ................................................................................ 6

2. Overview of Enron’s executive compensation arrangements............................................ 9

3. Bonuses.............................................................................................................................. 9

4. Special compensation arrangements................................................................................ 10

D. Discussion of Specific Issues................................................................................................ 12

1. Nonqualified deferred compensation............................................................................... 12

2. Stock-based compensation............................................................................................... 21

3. Employee loans................................................................................................................ 24

4. Split dollar life insurance arrangements .......................................................................... 25

5. Limitation on deduction of certain executive compensation in excess of $1 million...... 27

III. COMPANY-OWNED AND TRUST-OWNED LIFE INSURANCE ...................................32

IV. CONCLUSIONS ....................................................................................................................39
1

I. INTRODUCTION

My name is Mary Schmitt. I am Acting Chief of Staff of the Joint Committee on 

Taxation. It is my pleasure to present today the testimony of the staff of the Joint Committee on 

Taxation (the “Joint Committee staff”) concerning the executive compensation and companyowned life insurance arrangements of Enron Corp. and its related entities.1

In February 2002, Senators Max Baucus and Charles E. Grassley, then Chairman and 

Ranking Member of the Senate Committee on Finance (“Senate Finance Committee”), directed 

the Joint Committee staff to undertake a review of Enron’s2 Federal tax returns, tax information, 

and any other information deemed relevant by the Joint Committee staff to assist the Senate 

Finance Committee in evaluating whether the Federal tax laws facilitated any of the events or 

transactions that preceded Enron’s bankruptcy. The Joint Committee staff was also directed to 

review the compensation arrangements of Enron employees, including tax-qualified retirement 

plans, nonqualified deferred compensation arrangements, and other arrangements, and to analyze 

the factors that may have contributed to any loss of benefits and the extent to which losses were 

experienced by different categories of employees. 

In connection with a hearing on the investigation, the Joint Committee staff presented its 

official Report on the investigation3 to the Senate Finance Committee on February 13, 2003. 

This testimony highlights certain aspects of the Report relating to executive compensation and 

company-owned life insurance. The Report contains more detailed descriptions of Enron’s 

executive compensation and company-owned life insurance arrangements. 

 

1

 This document may be cited as follows: Joint Committee on Taxation, Written 

Testimony of the Staff of the Joint Committee on Taxation on Executive Compensation and 

Company-Owned Life Insurance Arrangements of Enron Corporation and Related Entities

 (JCX-36-03), April 7, 2003.

2

 Except as otherwise indicated, references to “Enron” refer to Enron Corporation and its 

affiliates, and references to “Enron Corp.” refer specifically to the parent company.

3

 Joint Committee on Taxation, Report of Investigation of Enron Corporation and 

Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations

(JCS-3-03), February 2003 (the “Report”).
2

II. ENRON’S EXECUTIVE COMPENSATION ARRANGEMENTS

A. Summary Overview of Enron’s Executive Compensation Arrangements

Enron’s compensation arrangements have received considerable media attention in the 

aftermath of the Enron bankruptcy. With respect to executive compensation, attention has 

focused both on the amount of compensation paid to certain executives and on the various forms 

of compensation used by Enron.4

During the period reviewed by the Joint Committee staff, executive compensation at 

Enron was generally comprised of base salary, annual incentives, and long-term incentives. 

Certain executives also participated in nonqualified deferred compensation and special 

compensation arrangements.

Enron’s compensation costs for all employees, and especially for executives, increased 

significantly over the years immediately preceding its bankruptcy. Enron’s executives, in 

particular, were paid substantial amounts. In 2000, total compensation for the 200 highestcompensated employees of Enron was $1.4 billion, an average of $7 million per employee. This 

consisted of $56.6 million of bonuses, $1.06 billion attributable to stock options, $131.7 million 

attributable to restricted stock, and $172.6 million of base salary and other income. Incentive 

compensation was a significant element of Enron’s executive compensation arrangements. In 

2000, base salary was less than 13 percent of total compensation for the 200 highestcompensated employees. 

Notable features of Enron’s executive compensation include the following:

• Nonqualified deferred compensation was a major component of executive 

compensation for Enron. Participants were eligible to defer all or a portion of 

salary, bonus, and long-term compensation into Enron-sponsored deferral plans. 

Over $150 million in compensation was deferred by the 200 highest-compensated 

employees for the years 1998-2001. In late 2001, in the weeks prior to Enron’s 

bankruptcy filing, early distributions totaling more than $53 million were made to 

certain participants from two of Enron’s nonqualified deferred compensation 

plans. 

• Enron used stock-based compensation as a principal form of compensation for 

executives. Enron’s stock-based compensation programs included nonqualified 

stock options, restricted stock, and phantom stock. Enron’s deduction for 

compensation attributable to the exercise of nonqualified stock options increased 

by more than 1,000 percent from 1998 to 2000. 

 

4

 Certain aspects of Enron’s tax-qualified retirement plans have also received

considerable media attention, particularly the extent to which plan assets were invested in Enron 

stock. These plans are discussed in detail in the Report.
3

• In the weeks immediately preceding the bankruptcy, Enron implemented two 

special bonus programs; one for approximately 60 key traders and one for 

approximately 500 employees that Enron claimed were critical for maintaining 

and operating Enron going forward. The combined cost of the programs was 

approximately $105 million.

• Enron had certain special compensation arrangements for limited groups of 

people or for specific individuals. One executive received the use of a 1/8 

fractional interest in a jet aircraft Hawker 800 as part of his compensation. A very 

limited number of employees received loans (or lines of credit) from Enron or 

split-dollar life insurance arrangements. Enron purchased two annuities from Mr. 

Kenneth L. Lay and his wife as part of a compensation package for 2001. Enron 

also had a Project Participation Plan for employees in its international business 

unit under which employees received interests in certain international projects.
4

B. General Observations with Respect to Enron’s Compensation

Enron’s stated compensation philosophy was a pay for performance approach; those who 

were determined to perform well were paid well. Enron implemented this approach with a broad 

array of compensation arrangements for its executives that included base pay, bonuses, and longterm incentive payments. In 2000, total compensation for the 200 highest-compensated 

employees of Enron was $1.4 billion dollars ($1.2 billion of which was attributable to stock 

options and restricted stock). For the same year, Enron reported $979 million of financial 

statement net earnings.5

Enron’s approval of compensation packages for its executives rested almost entirely with 

internal management. Although the Compensation Committee of the Enron Corp. Board of 

Directors (the “Compensation Committee”) formally approved both the total amount of 

compensation paid to executives and the form of such compensation, the Compensation 

Committee’s approval generally was a rubber stamp of recommendations made by Enron’s 

management. Missing was an objective assessment of the value added by top executives; 

compensation was typically deemed to be justified if it appeared to be consistent with what other 

companies paid executives. Targets for compensation were sometimes set, but in practice the 

total amount paid frequently exceeded the targets. The Compensation Committee went through 

the motions of satisfying its role as objective evaluator of reasonable pay by commissioning 

“independent” studies with respect to Enron’s compensation arrangements; in some cases, the 

studies appeared to be designed to justify whatever compensation arrangement management 

wanted to adopt.

The lack of scrutiny of compensation was particularly prevalent with respect to Enron’s 

top executives, who essentially wrote their own compensation packages. In some cases, 

although going through the formalities of reviewing arrangements, the Compensation Committee 

merely accepted what was presented. In other cases, the Compensation Committee either never 

reviewed certain arrangements for executives, or performed such a cursory review that they were 

not fully aware of what they were approving. For example, a former chairman of the 

Compensation Committee could not remember an arrangement under which an Enron executive 

was awarded a fractional interest in an airplane as a form of compensation.

There was no indication that Enron’s Compensation Committee ever rejected a special 

executive compensation arrangement brought to them. Indeed, the Compensation Committee 

used studies, sometimes commissioned after the fact, to justify the compensation arrangements 

for top executives. As a result, Enron’s top executives earned enormous amounts of money and 

even used the company as an unsecured lender. For example, from 1997 through 2001, Mr. Lay 

borrowed over $106 million from Enron through a special unsecured line of credit with the 

company.

 

5

 This was prior to Enron’s November 19, 2001, accounting restatement made public in 

filings with the Securities and Exchange Commission, which resulted in restated net income of 

$842 million. A true measure of Enron’s net income for the year cannot be determined without a 

restatement of Enron’s financial statements to conform with generally accepted accounting 

principles. 
5

Enron did not appear to maintain consistent or centralized recordkeeping with respect to 

compensation arrangements in general and executive compensation in particular. Enron could 

not provide documentation relating to many of Enron’s special compensation arrangements for 

its top executives. When asked about compensation arrangements in interviews, current and 

former Enron employees with responsibility for such matters had no knowledge of certain 

aspects of executives’ compensation, particularly in the case of special arrangements. Although 

Enron represented that it properly reported income with respect to employee compensation 

arrangements, the lack of recordkeeping made it impossible to verify whether this was true.

Enron’s heavy reliance on stock-based compensation, both with respect to executives and 

with respect to rank and file employees, caused significant financial losses when Enron’s stock 

price collapsed. As part of a philosophy that a large portion of executive compensation should 

depend on shareholder return, Enron rewarded executives with huge amounts of stock options, 

restricted stock, and bonuses tied to financial earnings. In addition, a strong company culture 

encouraging stock ownership by all employees led to high investments in Enron stock made by 

employees through the Enron Corp. Savings Plan. In the end, when Enron’s stock price 

plummeted, Enron’s employees and executives lost millions of dollars in retirement benefits 

under Enron’s qualified plans and nonqualified deferred compensation arrangements and through 

the loss of value of stock that had been received as compensation for services. Enron’s rank and 

file employees in many cases lost virtually all of their retirement savings because they believed 

statements made by Enron’s top executives up to the very end that Enron was viable and that 

Enron’s stock price would turn around. Although some executives suffered losses that appear 

stunning in amount, many executives also reaped substantial gains from their compensation 

arrangements. 
6

C. Enron’s Executive Compensation Structure

1. Compensation trends and philosophy

In general

Enron had a pay for performance compensation philosophy; employees who performed 

well were compensated well. Enron used a variety of forms of compensation in recent years, 

including cash, stock, stock options, restricted stock, phantom stock, performance units,6 and 

participation interests.7 Enron also offered employees benefits such as participation in qualified 

retirement plans and in health and life insurance. The amount of compensation that Enron paid 

to employees, especially executives, increased significantly over the years immediately 

preceding the bankruptcy. 

Tax return data for Enron Corp. and its subsidiaries show how compensation of officers, 

salaries and wages, and employee benefit program expenses increased over the years 

immediately preceding the bankruptcy. Table 1, below, shows the deduction taken by Enron 

Corp. and its subsidiaries for such expenses on its Federal income tax returns for 1998, 1999, and 

2000. Enron’s total compensation deduction dramatically increased from 1998 to 2000. The 

increase in compensation expense was, in part, due to the substantial increase in Enron’s 

deduction attributable to the exercise of stock options. 

The deduction for compensation of officers increased exponentially. The compensation 

of officers doubled from 1998 to 1999 and tripled from 1999 to 2000. As shown in Table 1, 

below, in 2000, the deduction for compensation of officers was almost twice the deduction for 

salaries and wages.

Table 1.–Enron Compensation Deductions for 1998, 1999, and 20008

Item 1998 1999, as amended 2000

Compensation of officers $149,901,000 $313,312,000 $952,492,000 

Salaries and wages $499,746,000 $702,725,000 $557,550,000

Pension, profit-sharing, etc., plans $628,000 $834,000 $20,000

Employee benefit program $344,676,000 $569,278,000 $1,456,796,000

Total $994,951,000 $1,586,149,000 $2,966,858,000

 

6

 Performance units were granted in the 1990’s under Enron’s Performance Unit Plan. 

The value of performance units was determined by reference to the ranking of Enron’s 

shareholder return relative to its peer group. 

7

 Participation interests were granted in international projects under the Enron 

International Project Participation Plan. 

8

 The Joint Committee staff was not provided information detailing what was 

specifically included in each category. 
7

Compensation paid to Enron’s 200 highest-compensated employees also increased 

significantly in the years preceding Enron’s bankruptcy. Table 2, below, shows information 

compiled by the IRS, which is based on information provided by Enron, on compensation of the 

200 highest-compensated employees for 1998 through 2000. Compensation for this group 

increased over recent years, particularly, the amount of compensation attributable to stock 

options. Base salary and other compensation also increased substantially. 

Table 2.–Compensation Paid to the 200 HighestCompensated Employees for 1998-2000 

Year Bonus Stock Options Restricted 

Stock

Base Salary 

and Other 

Income

Total

1998 $41,193,000 $61,978,000 $23,966,000 $66,143,000 $193,281,000

1999 $51,195,000 $244,579,000 $21,943,000 $84,145,000 $401,863,000

2000 $56,606,000 $1,063,537,000 $131,701,000 $172,597,000 $1,424,442,000

The range of total compensation paid to the 200 highest-compensated employees of 

Enron in the years immediately preceding Enron’s bankruptcy is shown in Table 3, below. 

Table 3.–Range of Per Employee Total Compensation Paid to the 200

Highest-Compensated Employees for 1998-2001

Year Range of Per Employee Total 

Compensation Paid to the 200 

Highest-Compensated Employees 

1998 $152,000 to $20,621,000

1999 $325,000 to $56,541,000

2000 $1,270,000 to $168,741,000

2001 $1,104,000 to $56,274,000

In 2000 and 2001, each one of the 200 highest-compensated employees was paid over $1 

million. In 2000, three executives were paid over $100 million, with the top-paid executive 

receiving $169 million. In 2000, at least 26 executives were paid over $10 million. In 2001, the 

year of Enron’s bankruptcy, at least 15 executives were paid over $10 million. One executive 

was paid over $56 million.

Enron’s Compensation Committee

Enron’s Compensation Committee (a Committee comprised of Members of the Board of 

Directors) was responsible for developing the Enron executive compensation philosophy. The 

Compensation Committee’s stated focus was to ensure a strong link between the success of the 

shareholder and the rewards of the executive. The Compensation Committee made decisions on 

a wide variety of compensation issues. While the Compensation Committee was principally 

involved with executive compensation, the duties of the Compensation Committee were not 

limited to executive compensation. The Compensation Committee approved all qualified 

retirement plan documents and amendments. The Compensation Committee also approved 

medical and dental plans, severance pay plans, and flexible compensation plans. The 
8

Compensation Committee approved all stock plans, bonus plans, and deferral plans and approved 

grants of stock options and other equity compensation. The Compensation Committee was 

responsible for authorizing bonus pools and often approved accelerated vesting of options and 

other equity-based compensation. Selected employment agreements were approved by the 

Compensation Committee. 

While the Compensation Committee had responsibility for a wide range of issues, the 

members of the Compensation Committee were not deeply involved in most issues. Members of 

the Compensation Committee interviewed by Joint Committee staff were not fully aware of all of 

the issues for which they were responsible and often made decisions. For example, even though 

changes to the nonqualified deferred compensation plans were approved by the Compensation 

Committee, one former member of the Compensation Committee interviewed by Joint 

Committee staff did not know whether Enron offered nonqualified deferred compensation. Even 

though reflected in the minutes, one former member of the Compensation Committee 

interviewed by Joint Committee staff could not recall whether the Committee approved qualified 

retirement plans issues, while another Compensation Committee member did not know what a 

qualified retirement plan was. The members of the Compensation Committee did not scrutinize 

proposed arrangements, but basically approved whatever compensation arrangements were 

presented to them by management.

Role of outside consultants

Enron stated intent was to use a market pricing approach to compensation. Enron 

frequently used outside consultants, principally Towers Perrin, to determine compensation 

practices in the market place. The Compensation Committee relied on outside consultants in 

making a variety of decisions. Enron frequently obtained analysis from consultants, particularly 

Towers Perrin, to ensure that the executive compensation program was within its stated 

philosophy and goals. Towers Perrin periodically issued opinion letters to Enron regarding its 

compensation programs in general and on specific compensation issues. General compensation 

studies were also performed. Studies and opinions provided by Towers Perrin are discussed in 

further detail in the Report.9

From Joint Committee staff interviews with many former members of the Compensation 

Committee, it appears that many members made decisions relying on the opinions of consultants 

without fully understanding the underlying issue. For example, former Compensation 

Committee members interviewed by Joint Committee staff could not explain why Enron 

purchased two annuities from Mr. Lay and his wife in 2001, but knew that Towers Perrin issued 

an opinion providing justification for the transaction.

 

9

 Appendix D of the Report includes studies and opinions provided to Enron by Towers 

Perrin. 
9

2. Overview of Enron’s executive compensation arrangements

Executive compensation at Enron was generally comprised of base salary, annual 

incentives, and long-term incentives. Base salary levels were targeted at the 50th percentile of 

the external marketplace, meaning that Enron tried to have its base salary at a level equal to 50 

percent of other companies. For total compensation, executives had the opportunity to earn at 

the 75th percentile or higher level, subject to obtaining performance at the 75th percentile or 

higher. In addition to the three principal components of executive compensation (base salary, 

annual incentives and long-term incentives), certain executives also participated in special 

compensation arrangements, such as nonqualified deferred compensation programs, split-dollar 

insurance arrangements, and employee loans. 

Annual bonuses were a major component of Enron’s executive compensation structure. 

Annual bonuses were targeted at the 75th percentile level compared to the market and could often 

be larger than base salary for some employees.

In recent years, the long-term incentive program provided for awards of nonqualified 

stock options and restricted stock. Participation in the long-term incentive plan was available to 

employees in the vice president job group and above, which generally ranged from 

approximately 300 to 400 executives. Stock-based compensation was a major component of 

executive compensation, especially in the years immediately preceding the bankruptcy.

Executives were given the opportunity to participate in nonqualified deferred 

compensation arrangements. Participants were eligible to defer receipt of all or a portion of 

salary, bonus and long-term compensation into Enron-sponsored deferral plans. The plans 

provided an opportunity for executives to choose to delay payment of Federal and State income 

taxes, and earn tax-deferred return, on deferrals of virtually any form of compensation.

3. Bonuses

In general

There has been much media attention focusing on the magnitude of bonuses paid to 

Enron executives. In many cases, bonuses were the principal compensation component. 

Individual executive bonuses paid in 2001, the year of Enron’s bankruptcy, were as high as $8 

million dollars. In 2001, at least 48 executives received bonuses of $1 million or greater. Table 

4, below, shows total bonuses for the 200 highest-compensated employees according to 

information obtained from the IRS. Enron’s bankruptcy filing Exhibit 3b.2 shows that bonuses 

to 144 insiders (managing directors and above) paid during the year preceding the bankruptcy 

totaled approximately $97 million.

Enron had two bonus deferral programs, the Bonus Stock Option Program and the Bonus 

Phantom Stock Deferral Program. The bonus deferral programs gave participants an opportunity 

to receive stock options and/or phantom stock in lieu of cash bonus payments.
10

Table 4.–Total Bonuses for the 200 Highest-Compensated Employees

Year Total Bonuses

1998 $41,193,000

1999 $51,195,000

2000 $56,606,000

Pre-bankruptcy bonuses

In the weeks immediately preceding the bankruptcy, Enron implemented two bonus 

programs for (1) approximately 60 key traders and (2) approximately 500 employees who Enron 

claimed were critical for maintaining and operating Enron going forward.10 As a condition to 

receiving pre-bankruptcy bonus payments, employees were required to execute an agreement 

requiring repayment of any amounts received, plus a 25 percent penalty, if the employee 

voluntarily terminated employment prior to the expiration of 90 days following the receipt of any 

payment. 

According to Enron, approximately 584 employees received payments totaling 

approximately $105 million. Additional information provided by Enron states that 490 

employees received key employee (non-trader) bonuses totaling approximately $50 million, 

which were paid from general company assets. Trader bonuses were paid to 67 employees 

totaling approximately $46 million, which were made from a grantor trust established to fund 

2001 performance bonuses. In addition, 27 Canadian employees received bonuses totaling $8 

million, which were paid by Enron Canada Corp.11 Pre-bankruptcy payments ranged from 

$2,500 to $8 million per employee. 

4. Special compensation arrangements

Enron had certain special compensation arrangements for limited groups of people or for 

specific individuals. For example, one executive received the use of a 1/8 fractional interest in a 

jet aircraft Hawker 800 as part of his compensation. A few employees received loans from 

Enron and had split dollar life insurance policies. Certain executives were allowed to exchange 

interests in plans for large cash payments or stock options and restricted stock grants. 

One of the most notable special compensation arrangements was the purchase by Enron 

of two annuities from Mr. Lay and his wife as a part of his compensation package for 2001. 

Under the transaction, Enron purchased the annuity contracts from Mr. and Mrs. Lay for $5 

million each (a total of $10 million) and also agreed to reconvey the annuity contracts to Mr. Lay 

if he remained employed with Enron through December 31, 2005. If Mr. Lay were to leave 

Enron prior to that date, reconveyance still would take place on the occurrence of one of four 

events: (1) retirement with the consent of the Board; (2) disability; (3) involuntary termination 

 

10 Appendix D of the Report includes a list of employees who received pre-bankruptcy 

bonus payments. 

11 These payments appear to have been made in connection with the trader bonus 

payments.
11

(other than a termination for cause); or (4) termination for “good reason.” Towers Perrin issued 

a letter regarding the benefits of the transaction. It is unclear whether the contracts have been or 

will be reconveyed to Mr. Lay.12 For more detail, see Part Four, III,C.4, of the Report.

Enron Development Corporation, which was later renamed Enron International, used a 

Project Participation Plan to grant awards to international developers and other employees 

working on international projects. Under the Project Participation Plan, employees were granted 

participation interests in particular international projects. Payments with respect to a project 

were triggered upon the occurrence of certain plan payment dates. Awards for top developers 

could be as high as $7 million for single projects. 

 

12 The Joint Committee staff was informed by counsel for former Compensation 

Committee members that the issue of whether Mr. Lay was entitled to receive the annuity 

contracts given the terms of his departure was under review by Enron and various legal counsel. 

Enron stated it was unable to give the Joint Committee staff any further information regarding 

the status of the annuity contracts and whether they had been or would be reconveyed to Mr. 

Lay. In response to Joint Committee staff written questions regarding the annuity contracts, Mr. 

Lay’s counsel, Piper Rudnic, responded that “We are not in a position to give a legal opinion 

about the current status of the annuity contracts.” They also stated their understanding that the 

characterization of Mr. Lay’s termination for purposes of severance benefits was still under 

review.
12

D. Discussion of Specific Issues

1. Nonqualified deferred compensation

Introduction and background

“Nonqualified deferred compensation” refers to compensation that is deferred other than 

through a tax-qualified retirement plan or similar arrangement. Nonqualified deferred 

compensation is a common form of compensation for executives. Nonqualified deferred 

compensation may be provided through a number of mechanisms. For example, an employer 

may have a qualified deferred compensation arrangement covering a specified group of 

executives or may provide for deferral for executives only as provided in individual employment 

contracts. In contrast to tax-qualified retirement plans, nonqualified deferred compensation 

arrangements are subject to few restrictions. Nonqualified deferred compensation arrangements 

are attractive to employees because they offer the ability to defer in effect unlimited amounts of 

compensation. Employers often make such arrangements available to executives in order to 

meet the desire of executives for tax deferral. In some cases deferred compensation may also be 

used by an employer to achieve certain objectives, such as providing a retention incentive.

In contrast to nonqualified deferred compensation arrangements, tax qualified retirement 

plans are subject to a variety of rules under the Federal tax laws and the Employee Retirement 

Income Security Act (“ERISA”), including limits on the amount that can be deferred, a variety of 

employee protections, and nondiscrimination rules that are designed to ensure that the plan 

covers a broad range of employees, not just highly compensated employees. In exchange for 

complying with these restrictions, tax-qualified retirement plans receive favorable tax benefits. 

Employees do not include qualified retirement plan benefits in income until received, even 

though the plan is funded and the participant is vested in his or her benefit. Employers receive a 

current deduction, within limits, for contributions to tax-qualified retirement plans, even though 

the income inclusion on the part of the employee is deferred. Qualified retirement plan assets are 

required to be held in trust for the exclusive benefit of plan participants and beneficiaries.

Nonqualified deferred compensation arrangements are not subject to the requirements 

applicable to tax-qualified retirement benefits, and the rules for the timing of the employer’s 

deduction and the employee’s income inclusion differ. For example, there is no statutory limit 

on the amount of compensation that can be deferred under a nonqualified deferred compensation 

arrangement. However, under a nonqualified deferred compensation arrangement, the employer 

is not entitled to a deduction until the employee includes the compensation in income. Thus, in 

theory, there is a tension between the interests of the employer in a current deduction and the 

employee in obtaining deferral of taxes. In practice, in many cases this tension is illusory and 

does little to impact the amount of compensation that is deferred. As described below, in 

Enron’s case, the possibility of a forgone deduction appeared to have little, if any, effect on the 

amount of deferred compensation.

Nonqualified deferred compensation arrangements are also not subject to the 

nondiscrimination rules applicable to tax-qualified retirement plans. Rather, in order to avoid 

being subject to ERISA’s requirements, nonqualified deferred compensation arrangements must 
13

be limited to a “select group of management or highly compensated employees”.13 This means 

that nonqualified deferred compensation arrangements do not cover a broad range of employees.

Unlike tax-qualified retirement plans, there is no single set of rules governing the tax 

treatment of nonqualified deferred compensation. The determination of when amounts deferred 

under a nonqualified deferred compensation arrangement are includible in the gross income of 

the individual earning the compensation depends on the facts and circumstances of the 

arrangement. A variety of tax principles and Code provisions may be relevant in making this 

determination.14

In general, the time for income inclusion of nonqualified deferred compensation depends 

on whether the arrangement is unfunded or funded. An arrangement is considered funded if 

there is a transfer of property under section 83. If the arrangement is not considered funded for 

tax purposes, amounts deferred are includible in income when actively or constructively 

received. In general, in order for an amount not to be constructively received, there must be a 

substantial limitation on the individual’s right to receive the amount. If compensation has been 

deferred under a funded arrangement, then income is includible for the year in which the 

individual’s rights are transferable or not subject to a substantial risk of forfeiture under the rules 

for section 83. 

Over time, arrangements have developed in an effort to provide employees with greater 

security for nonqualified deferred compensation and greater control over amounts deferred, 

while still providing the desired deferral of income. One such arrangement, designed to provide 

greater security for the employer, is a “rabbi trust.”

A “rabbi trust” is a trust or other fund established by an employer to hold assets from 

which nonqualified deferred compensation payments may be made. The trust or fund is 

generally irrevocable and does not permit the employer to use the assets for purposes other than 

to provide nonqualified deferred compensation, except that the terms of the trust or fund provide 

that the assets are subject to the claims of the employer’s general creditors in the case of 

insolvency or bankruptcy. Terms providing that the assets are subject to the claims of creditors 

of the employer in the case of insolvency or bankruptcy have been the basis for the conclusion 

that the creation of a rabbi trust does not cause the related nonqualified deferred compensation 

 

13

 See, e.g., ERISA section 201(2). Nonqualified deferred compensation arrangements 

exempt from ERISA are commonly referred to as “top-hat plans”. There is no precise definition

of the term “select group of management or highly compensated employees,” however, the term 

“highly compensated employees” as used in ERISA is not synonymous with such term as used in 

the Code.

14 These include the doctrine of constructive receipt, the economic benefit doctrine, the 

provisions of section 83 relating generally to transfers of property in connection with the 

performance of services, and provisions relating specifically to nonexempt employee trusts 

(sec. 402(b)) and nonqualified annuities (sec. 403(c)).
14

arrangement to be funded for income tax purposes.15 As a result, no amount is included in 

income by reason of the rabbi trust; generally income inclusion occurs as payments are made 

from the trust.

The IRS has issued guidance setting forth model rabbi trust provisions.16 Revenue 

Procedure 92-64 provides a safe harbor for taxpayers who adopt and maintain grantor trusts in 

connection with unfunded deferred compensation arrangements. The model trust language 

requires that the trust provide that all assets of the trust are subject to the claims of the general 

creditors of the company in the event of the company’s insolvency or bankruptcy.

In addition to arrangements to increase security, a variety of practices have developed to 

provide employees with greater control over deferred amounts. These include providing greater 

flexibility in distributions, greater flexibility in timing of elections with respect to initial deferrals 

and payments, and the ability to specify how earnings will be credited to deferred amounts. For 

example, one practice is to provide that distributions from a nonqualified deferred compensation 

arrangement may be made at any time, subject to the discretion of the committee or other body 

with authority over the plan and also subject to a forfeiture of some portion of the amount to be 

distributed, such as 10 percent. Such forfeiture provisions are often referred to as a “haircut.”

While many common practices, when viewed in isolation, may appear to be within the 

limits of present law, when examined in connection with other plan provisions and features, 

appear to provide executives with an excessive level of security and control. As discussed 

below, Enron used a number of these practices in its nonqualified deferred compensation 

arrangements. 

The development of questionable and aggressive practices regarding nonqualified 

deferred compensation is, at least in part, due to the moratorium on Treasury guidance 

addressing certain nonqualified deferred compensation arrangements. Section 132 of the 

Revenue Act of 197817 provides that the taxable year of inclusion in gross income of any amount 

covered by a private deferred compensation plan is determined in accordance with the principles 

set forth in regulations, rulings, and judicial decisions relating to deferred compensation that 

 

15 This conclusion was first provided in a 1980 private ruling issued by the IRS with 

respect to an arrangement covering a rabbi; hence the popular name “rabbi trust.” Priv. Ltr. Rul. 

8113107 (Dec. 31, 1980).

16 Rev. Proc. 92-64, 1992-2 C.B. 422, modified in part by Notice 2000-56, 2000-2 C.B. 

393.

17 Section 132 of the Revenue Act of 1978 was enacted in response to proposed Treasury 

regulation 1.61-16, which provided that if a payment of an amount of a taxpayer’s compensation 

is, at the taxpayer’s option, deferred to a taxable year later than that in which such amount would 

have been payable but for the taxpayer’s exercise of such option, the amount is treated as 

received by the taxpayer in such earlier taxable year. Prop. Treas. Reg. 1.61-16, 43 Fed. Reg. 

4638 (1978).
15

were in effect on February 1, 1978. Thus, the Treasury Department has been restricted in issuing 

new deferred compensation guidance for over 25 years. 

Enron’s deferred compensation programs in general

Nonqualified deferred compensation was a major component of executive compensation 

for Enron. Through Enron’s nonqualified deferred compensation programs, executives were 

able to defer more than $150 million in compensation from 1998 through 2001. Approximate 

amounts deferred under all deferred compensation plans for the 200 highest-compensated Enron 

employees for the years 1998-2001 are shown in the following table.

Table 5.–Amounts Deferred by the 200 Highest-Compensated Employees 1998-2001

Year

Amounts Deferred Under All Deferred 

Compensation Plans for the 200 Highest-Compensated 

(millions of dollars)

1998 $13.3

1999 19.7

2000 67.018

2001 54.4

Many executives participated in Enron’s deferral programs. In recent years, Enron had 

two nonqualified deferred compensation plans: the Enron Corp. 1994 Deferral Plan (the “1994 

Deferral Plan)” and the 1998 Enron Expat Services, Inc. Deferral Plan (the “Expat Deferral 

Plan”). The plans had almost identical terms and features except that the Expat Deferral Plan 

was used for expatriates who were ineligible to participate in the 1994 Deferral Plan because 

they were employed by Enron Expat Services Inc. In addition, a rabbi trust was established in 

connection with the 1994 Deferral Plan, but no such trust was established in connection with the 

Expat Deferral Plan. Enron also had older deferral plans that were predecessors to the current 

plans. 

Information provided by Enron shows that for the years 1999-2001, there were 

approximately 340 participants in the 1994 Deferral Plan and approximately 55 total participants 

in the Expat Deferral Plan. Under the deferral plans, participants could defer up to 35 percent of 

base salary, up to 100 percent of annual bonus payments, and up to 100 percent of select longterm incentive payments.

Specific features of Enron’s deferred compensation plans

In general

In the process of reviewing Enron’s deferred compensation arrangements, the Joint 

Committee staff identified a variety of features that allowed the executives to maintain security 

and control over the amounts deferred. These features are similar to those reportedly used by 

other employers. While the 1994 Deferral Plan and the Expat Deferral Plan were designed to 

 

18 Of the $67 million, $32 million was deferred by Mr. Lay. 
16

impose restrictions or limitations on the participant’s control of amounts deferred, such 

restrictions or limitations could be seen as illusory. While these plan provisions may not result 

in constructive receipt under present law, there is an issue as to whether the mere existence of 

such features should result in the application of the constructive receipt doctrine. When viewed 

collectively, the existence of the opportunities for accelerated distributions, participant-directed 

investment, and changes in participant elections lend credence to the argument that the doctrine 

of constructive receipt should apply.

Accelerated distributions

Normally, distributions of nonqualified deferred compensation were paid to Enron 

executives upon retirement, death, disability, or termination of employment. Participants were 

also allowed to receive special purpose deferrals while remaining active employed.19 In 

addition, participants could request accelerated distributions from the 1994 Deferral Plan and the 

Expat Deferral Plan. Such distributions were subject to the consent of the “committee” provided 

for by the terms of the plan. Upon an accelerated distribution, participants were required to 

forfeit 10 percent of the elected distribution amount and also would not be eligible to participate 

in the plan for at least 36 months. The plans were presumably designed with these restrictions to 

avoid constructive receipt. This provision allowed employees to avoid current taxation while 

maintaining the ability to request distribution of deferrals at any time.

Under present law, a requirement of surrender or forfeiture of a valuable right is a 

sufficient restriction to preclude constructive receipt of income. The IRS has not explicitly 

authorized the use of forfeiture provisions (i.e., “haircuts”) in nonqualified deferred 

compensation plans. Many nonqualified deferred compensation plans utilize a 10-percent 

forfeiture limitation (like that used by Enron) designed to prevent constructive receipt, based on 

the 10-percent early withdrawal tax applicable to distributions from qualified retirement plans 

and IRAs.20 The Joint Committee staff understands that some employers utilize haircuts of less 

than 10 percent.

In the weeks preceding Enron’s bankruptcy, participants began to request accelerated 

distributions of amounts deferred under Enron’s deferral plan. As a practical matter, the 10-

percent forfeiture provision and restriction on future deferrals did not appear to impose much of 

a deterrent for participants in requesting distributions. In total, 211 participants requested 

accelerated distributions.21 Greg Whalley, the newly appointed sole member of the 1994 

Deferral Plan Committee, had discretion whether or not to approve accelerated distribution 

requests from participants in the 1994 Deferral Plan. The Report outlines the process that Mr. 

Whalley stated that he used in making the determination of whether requests for early 

 

19 Special purpose deferrals could be received as soon as three years following the 

deferral in a lump sum or up to five annual installments and were intended to assist with 

anticipated expenses.

20 Sec. 72(f).

21 Appendix D of the Report includes a chart of all accelerated distribution requests. 
17

distributions should be approved. Under the process, the extent to which requests were granted 

depended upon the financial position of Enron at the time. In total, accelerated distributions 

totaling over $53 million were made to approximately 127 individuals from October 30, 2001, 

through November 29, 2001.22

Participant-directed investment

Under the 1994 Deferral Plan and the Expat Deferral Plan, participants could choose to 

have their deferrals treated as if they had been invested in either of two types of investment 

accounts -- the Phantom Stock Account or the Flexible Deferral Account. Deferrals treated as 

invested in the Phantom Stock Account were treated as if the participant purchased shares of 

Enron Corp. common stock at the closing price on the date of deferral. Participants electing 

deferrals to be treated as invested in the Flexible Deferral Account were allowed to select 

investment funds, which in recent years mirrored those of the Enron Corp. Savings Plan, for the 

crediting of earnings to their account balances. For 2001, participants could allocate deferrals 

among 17 investment choices that mirrored funds available in the Enron Corp. Savings Plan. 

Daily changes in election choices within the Flexible Deferral Account were allowed. This 

allowed participants to direct how earnings on amounts deferred should be credited. 

Subsequent elections

Distributions from the Enron deferral plans could be made upon the participant’s 

retirement, disability, death or termination of employment.23 Participants could elect to receive 

payments in a lump sum or in up to 15 annual installments. Participants in the 1994 Deferral 

Plan were allowed to change payout elections at any time subsequent to the initial deferral. 

Elections were effective one year after being received by Enron.

Allowing participants to make subsequent changes to payout elections gives them control 

over the amounts deferred. Nevertheless, courts have generally been lenient in applying the 

constructive receipt doctrine with respect to subsequent elections. 

Rabbi trust

Enron established an irrevocable rabbi trust in connection with the 1994 Deferral Plan. 

Upon the establishment of the trust, 100 trust-owned life insurance (“TOLI”) policies were 

purchased on the lives of 100 participants in the 1994 Deferral Plan. According to Enron, the 

assets of the trust were not intended to be sufficient to pay entirely for the nonqualified deferred 

compensation obligations under the 1994 Deferral Plan.24 Distributions to participants were not 

 

22 In the weeks preceding the bankruptcy, participants also made requests for hardship 

distributions. There were no hardship requests granted in 2001.

23 As previously discussed, special purpose deferrals were also allowed.

24 According to Enron, only initially did Enron direct investments in the rabbi trust to 

generally correspond with participant elections. 
18

made from the trust, but were made from the general assets of Enron. According to Enron, as of 

October 28, 2002, the cash surrender value of the remaining insurance policies was $25 million.

It appears that Enron may have intended the rabbi trust used in connection with the 1994 

Deferral Plan to comply with the safe harbor requirements of Revenue Procedure 92-64.25 It was 

certainly intended that the trust not result in current income taxation. Even if the trust were a 

valid rabbi trust when evaluated solely on the basis of the trust document, there is an issue as to 

whether other provisions under the 1994 Deferral Plan would cause the trust to be considered 

funded for tax purposes. 

In the case of a rabbi trust, trust terms providing that the assets are subject to the claims 

of creditors of the employer in the case of bankruptcy or insolvency have been the basis for the 

conclusion that the creation of a rabbi trust does not cause the related nonqualified deferred 

compensation arrangement to be funded for income tax purposes. In the case of Enron, even 

though the trust document provided that the assets of the trust were subject to the claims of 

creditors, because participants had the ability to obtain accelerated distributions, there is an 

argument that the rights of such employees were effectively greater than the rights of creditors, 

making the trust funded for tax purposes. If, in fact, the arrangement was not subject to the 

claims of creditors, the arrangement should be considered funded, and income inclusion should 

have occurred to the participants when there was no substantial risk of forfeiture. 

Deferral of stock option gains and restricted stock

Enron’s deferral plans allowed for deferral of income attributable to stock options and 

restricted stock. Under the deferral of stock option gains program, participants could make an 

advance written election to defer the receipt of shares of Enron Corp. common stock from the 

exercise of a stock option granted under a stock plan sponsored by Enron, when such exercise 

was made by means of a stock swap using shares owned by the participant. Under the deferral of 

restricted stock program, participants could make an advance written election to defer the receipt 

of shares of Enron Corp. common stock to be released according to a grant of restricted shares 

under a stock plan sponsored by Enron Corp.

Although these types of programs may be commonly used, there are questions whether 

they should result in effective income deferral. There is no authority clearly addressing these 

deferral programs. The programs do not fit within the IRS ruling guidelines on the application of 

constructive receipt to nonqualified deferred compensation.26 The favorable tax treatment is 

achieved by allowing employees to exchange a future right to receive property for an unfunded 

promise to pay. The Joint Committee staff believes that allowing individuals to control the 

timing of income inclusion in this way should not be allowed. 

The deferral of stock option gains program can be viewed as a manipulation of the rules 

for deferred compensation and stock-for-stock exercise, which were not intended to be 

 

25 Rev. Proc. 92-64, 1992-2 C.B. 422, modified in part by Notice 2000-56, 2000-2 C.B. 

393.

26 Rev. Proc. 71-19, 1971-1 C.B. 698; Rev. Proc. 92-65, 1992-33 I.R.B. 16. 
19

combined, thus resulting in an unintended and inappropriate result for Federal income tax 

purposes. In the deferral of stock option gains, the election to defer could be made even after the 

options were vested. The fact that the favorable tax result on the deferral of stock option gains 

can only be achieved through a stock-for-stock exercise, rather than a cash exercise, suggests that 

there is a manipulation of rules in order to achieve the desired tax result. 

Discussion and recommendations 

In general

The experience with Enron demonstrates that the theoretical tension between an 

employer’s interest in a current tax deduction and an employee’s interest in deferring tax has 

little, if any, effect on the amount of compensation deferred by executives. In Enron’s case, 

because of net operating loss carryovers, denial of the deduction did not have a significant 

impact on its current tax liability. Despite any possible effect on its tax deduction, Enron’s 

deferred compensation arrangements allowed executives to defer millions of dollars in 

compensation that would otherwise be currently includible in income. The amount of 

compensation deferred by Enron’s 200 highest-compensated employees increased significantly 

in the years prior to bankruptcy. 

While there are a number of reasons why nonqualified deferred compensation 

arrangements are adopted, a primary factor is the desire of executives to defer payment of 

income tax. For example, a stated purpose of the 1994 Deferral Plan and Expat Deferral Plan 

was to allow executives to reduce current compensation and thereby reduce their current taxable 

income and earn returns on a tax-favored basis. Without the tax benefit of deferral, it is unlikely 

that nonqualified deferred compensation arrangements would exist, and certainly would not exist 

to the extent they do under present law.

Enron’s nonqualified deferred compensation arrangements contained a variety of features 

that serve to blur the distinction between nonqualified deferred compensation and qualified 

plans. Enron’s nonqualified deferred compensation plans included features that to some extent 

provided the advantages of a qualified plan, such as security for and access to benefits without 

current income inclusion, despite not meeting the qualified plan requirements. Because 

nonqualified arrangements have features like qualified plans, there may be less incentive for 

employers to adopt broad-based qualified retirement plans. If executives are able to fulfill their 

retirement needs through the use of nonqualified plans, for some employers there would be no 

incentive to offer qualified retirement plans to rank and file employees.

As previously discussed, there are no precise rules governing many aspects of 

nonqualified deferred compensation arrangements. As a result, taxpayers may design deferred 

compensation arrangements based on varying interpretations of authority that may not be strictly 

applicable to the situation in question. Under present law, a variety of practices have developed 

with respect to deferred compensation arrangements which are intended to achieve the desired 

tax deferral, while at the same time attempting to provide some sense of security to executives as 

well as some degree of flexibility regarding time of payment and other plan features. Many of 

the practices with respect to nonqualified deferred compensation have developed over time. 

However, since 1978, the IRS has been precluded from issuing guidance addressing many of 
20

these issues. Thus, the IRS is at a disadvantage in responding to the growth and development of 

these arrangements. The IRS is unable to adequately address common deferral arrangements that 

are viewed by many as pushing the limits under present law. 

While deferred compensation arrangements vary greatly, many of the plan features used 

by Enron are not uncommon. A recent article shows that the practice of providing security for 

amounts deferred is not uncommon.27 Even though certain aspects of Enron’s deferral plans may 

be within common practices, some issues may be raised with respect to whether they meet the 

requirements necessary to obtain the desired tax deferral. In addition, even if the present-law 

rules are satisfied, certain of the arrangements Enron maintained raise broader questions of 

whether they fall within the spirit of the present-law rules or whether they should, as a policy 

matter, result in tax deferral.

Specific recommendations

The Joint Committee staff believes that some changes to the present-law rules regarding 

the taxation of nonqualified deferred compensation are appropriate. The Joint Committee staff 

believes that such compensation should be includible in income no later than the time it is earned 

unless there is a substantial risk of forfeiture of the rights to the compensation. This rule would 

tax the income at a more appropriate time than under present-law rules in which, for example, an 

unfunded promise to pay, even if vested, is not currently taxable.

Because of the difficulty of identifying the precisely correct time to tax nonqualified 

deferred compensation and the potential hardship to the employee, one possible way to revise 

current law is to continue existing treatment of the employee but to make sure any income 

deferral is accompanied by a consequence to the employer that is commensurate with the benefit 

obtained by the employee. The consequence might arise, for example, regardless of the tax-loss 

status of the employer. Such an approach, however, would represent a significant change in the 

law.

In the alternative, specific rules should be provided to limit the circumstances under 

which compensation will continue to receive deferred treatment in the future. Rules should be 

developed to require current income inclusion in the case of plan features that give taxpayers 

inappropriate control over amounts deferred. The Joint Committee staff believes that the 

existence of plan provisions that allow accelerated distributions, participant-directed investment, 

or subsequent elections should result in current income inclusion. These provisions give 

participants control over amounts deferred. The Joint Committee staff also believes that 

consideration should be given to whether rabbi trusts are appropriate for deferred compensation, 

or whether additional requirements should be imposed with respect to such trusts. In addition, 

the Joint Committee staff believes that the use of programs such as Enron’s deferral of stock 

options gains and restricted stock programs should not be allowed. 

 

27

 See Theo Francis & Ellen E. Schultz, As Workers Face Pension Cuts, Executives Get 

Rescued, WALL ST. J., April 3, 2003, at C1. 
21

The ability of Treasury to issue guidance on deferred compensation should not be 

restricted. The Joint Committee staff recommends the repeal of section 132 of the Revenue Act 

of 1978.28 The restriction imposed by section 132 of the Revenue Act of 1978 has prevented 

Treasury from issuing more guidance on nonqualified deferred compensation and may have 

contributed to aggressive interpretations of present law. The existence of the moratorium on 

Treasury guidance puts Treasury in a disadvantaged position because it cannot respond 

adequately to forms of deferred compensation not contemplated prior to 1978. This has a 

chilling effect on the ability of Treasury to enforce the law in a consistent and effective way. 

Restricting Treasury guidance to the rules in effect more 25 years ago paralyzes Treasury to 

address current common practices that may be inconsistent with the law.

The Joint Committee staff believes that annual reporting of deferred amounts should be 

required to provide the IRS greater information regarding such arrangements.

2. Stock-based compensation

Enron used stock-based compensation as a principal form of compensation for 

executives. Management believed that executive compensation should be tied to company 

performance. There was a stock ownership requirement for certain executives, the stated 

purpose of which was to align the interests of executives and stockholders. A stated focus of the 

Compensation Committee was ensuring that there was a strong link between the success of the 

shareholder and the rewards of the executive. The Compensation Committee believed that a 

great deal of executive compensation should be dependent on company performance. 

The Enron culture also promoted Enron stock ownership by employees. For example, 

Joint Committee staff was told that there was a monitor in the lobby of the Enron headquarters in 

Houston so that the performance of Enron stock could be viewed by all who entered the building. 

Even up to the months immediately preceding the bankruptcy, employees were encouraged that 

the company was in strong financial shape. Stock-based compensation was used for all 

employees in a variety of forms, including as an investment in the Enron Savings Plan and Enron 

Employee Stock Ownership Plan, in addition to the all-employee stock option programs. Stock 

was used as a form of compensation for nonemployee directors. 

Enron utilized various types of programs to provide its employees with compensation tied 

to the equity or long-term performance of the company. During the 1990s, Enron had two 

principal stock plans: the 1991 Stock Plan and the 1994 Stock Plan. In addition, the 1999 Stock 

Plan was used as a funding mechanism for the issuance of common stock in connection with 

special circumstances. The stock plans generally allowed awards to be made in stock options, 

restricted stock, phantom stock units, and in some cases, stock appreciation rights.29 

 

28 The Joint Committee staff does not intend the repeal of section 132 to include the 

finalization of Proposed Treasury Regulation section 1.61-16, which section 132 was enacted to 

prevent.

29 In addition to stock option grants under Enron’s stock plans, Enron periodically made 

stock option grants to all employees to allow all employees to become shareholders of Enron. 
22

In recent years, Enron used stock options and restricted stock as the long-term component 

of executive compensation. Stock-based compensation, and stock options in particular, was the 

principal form of compensation for many executives. The amount of compensation generated 

from such arrangements increased dramatically in the years immediately preceding the 

bankruptcy, particularly in 2000.

Table 6, below, shows Enron’s deduction attributable to stock options for 1998 through 

2000 on Enron’s corporate tax returns.

Table 6.–Enron Deduction Attributable to Stock Options (1998-2000)

Year Amount of Deduction

1998 $125,343,000

1999 $585,000 as filed

$367,798,000 as amended

2000 $1,549,748,000

Table 7, below, shows the amount of compensation attributable to stock options for the 

200 highest-compensated employees for 1998, 1999, and 2000.

Table 7.–Compensation Attributable to Stock Options for the 

200 Highest-Compensated Enron Employees (1998-2000)

Year Amount of Compensation

1998 $61,978,000

1999 $244,579,000

2000 $1,063,567,000

Table 8, below, shows the compensation generated from the release, i.e., vesting, of 

restricted stock for the top-200 most highly paid Enron employees for 1998-2000. 

Table 8.–Compensation Attributable to the Vesting of Restricted Stock for 

Top-200 Most Highly Paid Enron Employees (1998-2000)

Year Amount of Compensation

1998 $23,966,000

1999 $21,943,000

2000 $131,701,000

From a Federal tax perspective, Enron structured its stock-based compensation 

arrangements with an eye toward tax planning, sometimes from the point of view of Enron, 

sometimes from the point of view of the executive. 

 

These grants included the All-Employee Stock Option Program, Project 50, and EnronOptionsYour Stock Option Program. There was an all-employee stock option grant as recently as 

August 2001.
23

For example, Enron used nonqualified stock options, but did not use qualified stock 

options (i.e., incentive stock options and options granted under an employee stock purchase 

plan). The tax treatment of these two types of options differs for both the employer and the 

employee. In the case of a nonqualified option, the difference between the option price and the 

fair market value of the stock (i.e., the “spread”) is generally includible in income as 

compensation at the time the employee exercises the option. A corresponding compensation 

expense deduction equal to the amount of ordinary income included in the gross income of the 

employee is allowable to the employer. In the case of a qualified option, no income is includible 

in the gross income of the employee on either the grant or exercise of the option.30 No 

compensation expense deduction is allowable to the employer with respect to the grant or 

exercise of a qualified stock option. 

The difference in the employer’s deduction for qualified and nonqualified options is one 

factor in determining what type of option to grant. In the case of qualified options, the employer 

forgoes a deduction entirely. In the case of nonqualified options, compared to the payment of 

current compensation, the employer’s deduction is deferred until the option is exercised. The use 

of nonqualified stock options resulted in tax deductions for Enron that would not have been 

available if Enron had used qualified stock options. There may be other reasons Enron did not 

use qualified options, including the restrictions placed on those options under applicable Code 

requirements.

Enron also made use of techniques that benefited the executives from a tax perspective.31 

For example, the use of stock-for-stock exercises provided a more favorable tax result for the 

executive than would have resulted if the executive sold Enron stock and used the cash proceeds 

to exercise options. In addition, the stock option transfer program, which allowed the gifting of 

stock options to family members and certain other persons, was clearly an estate planning device 

and was described to employees as such. However, both of these programs appeared to operate 

in accordance with published IRS rulings. In these cases, Enron appeared to do little more than 

take advantage of tax planning opportunities provided by clear IRS authority.

The use of stock options by Enron brings renewed attention to discussions regarding the 

proper treatment of stock options for accounting purposes, and the difference between the 

treatment of options for tax and accounting purposes. Under APB 25, which Enron followed, no 

compensation cost is generally required to be recorded in financial statements for stock options 

issued to employees if the exercise price is equivalent to or greater than the market price on the 

grant date. FAS 123, the “preferred,” but optional, approach, would require stock option costs to 

 

30 If a statutory holding period requirement is satisfied with respect to stock acquired 

through the exercise of a qualified stock option, the spread, and any additional appreciation, will 

be taxed as capital gain upon disposition of such stock.

31 The materials provided in response to the Joint Committee staff’s general request for 

information regarding Enron compensation arrangements included documents describing a tax 

shelter technique purporting to defer inclusion of income upon the exercise of an employee’s 

stock options. It is not clear whether or not any Enron executives entered into a transaction of 

this type. Appendix D of the Report includes these materials.
24

be taken into account when options are granted, based on a determination of the value of the 

option.

Even if the FAS 123 approach is made mandatory, as currently being considered, because 

of the differences between accounting rules and tax rules, the amount shown on financial 

statements as a cost attributable to stock options, can be substantially less than a company’s tax 

deduction for stock options. Accounting rules and tax rules have somewhat different purposes, 

and it may be appropriate for different rules to apply in order to achieve the differing purposes. 

Nevertheless, the sheer magnitude of the amount of corporate deductions and executive income 

generated by the exercise of stock options in some cases, such as Enron’s, may appropriately 

focus attention on whether proxy disclosure rules and accounting rules are sufficient to properly 

inform shareholders.

While some argue that linking shareholder and executive success is beneficial for 

shareholders, conflicts may arise. Linking compensation of executives to the performance of the 

company can result in executives taking measures to increase short-term earnings instead of 

focusing on longer-term interests. Enron’s heavy reliance on stock-based compensation, both 

with respect to executives and with respect to rank and file employees, caused significant 

financial loss when Enron’s stock price collapsed. Although some executives suffered losses 

that appear stunning in amount, many executives also reaped substantial gains from their 

compensation arrangements. 

3. Employee loans

Enron did not have a general policy or program relating to executive loans. However, 

from time to time Enron extended loans to various executives. These loans were individually 

designed arrangements, and varied considerably. Most prominent among the loans was a 

noncollateralized, interest-bearing line of credit extended to Mr. Lay. The line of credit was 

originally set at $4 million and was later increased to $7.5 million. The aggregate amount 

withdrawn pursuant to this line of credit from 1997 through 2001 was over $106 million. In 

2001 alone, Mr. Lay engaged in a series of 25 transactions involving withdrawals under the line 

of credit. The total amount of withdrawals for 2001 was $77.525 million (of which all but $7.5 

million was repaid). During 1997 through 2001, Mr. Lay repaid principal amounts of $99.3 

million. Over $94 million of this amount was repaid with 2.1 million shares of Enron stock. Mr. 

Lay’s counsel told the Joint Committee staff that in 2001 Mr. Lay drew down on the Enron line 

of credit and then repaid it with stock principally because he needed funds to avoid or, if 

unavoidable, to pay margin calls on secured lines of credit Mr. Lay had established with certain 

banks and brokerage firms. These lines of credit were secured primarily by Enron stock, the 

price of which was falling. 

The Joint Committee staff also reviewed loans to nine other persons, including loans to 

Mr. Skilling. These loans ranged in amount from $200,000 to $4 million, and generally accrued 

interest at the applicable Federal rate. In two cases, loan agreements provided that the loan 

would be forgiven if the executive stayed with Enron for a certain period of time. Other loans 

did not have a provision regarding forgiveness, but were forgiven by Enron. In such cases, the 

amount forgiven was treated as compensation to the executives.
25

Certain of the loan arrangements, particularly those that provided that the loan would be 

forgiven if the executive worked for Enron for a certain period of time, raise questions as to 

whether the arrangements were in fact the payment of compensation rather than a real loan. The 

loan transactions raise corporate governance issues of whether corporate funds were in essence 

being used for personal purposes. 

The Sarbanes-Oxley Act contains a prohibition on executive loans. If this prohibition 

had been in effect in prior years, it is likely that the loans reviewed by the Joint Committee staff 

in this case would not have been made. Thus, the Joint Committee staff is not recommending 

further legislative changes at this time.

4. Split-dollar life insurance arrangements

Introduction

The term “split-dollar life insurance” refers to splitting the cost and benefits of a life 

insurance contract. The cost of premiums for the contract often is split between two parties. 

One party typically pays the bulk of the premiums, and is repaid in the future from amounts 

received under the contract. The other party often pays a small portion of the premiums, but has 

the right to designate the recipient of the bulk of the benefits under the contract. This type of 

arrangement transfers value from one party to the other party.

Split-dollar life insurance arrangements have been used for several purposes. A principal 

use has been by employers to provide low-cost life insurance benefits or to provide funds for 

other compensatory benefits (such as nonqualified deferred compensation) for employees on a 

tax-favored basis.

Enron’s split dollar life insurance arrangements

Enron entered into split-dollar life insurance arrangements with three of its top 

management: Mr. Lay (two arrangements, for $30 million and $11.9 million); Mr. Skilling ($8 

million), and John Clifford Baxter ($5 million). The specific details of these split-dollar 

arrangements are discussed in the Report. 

Another split-dollar life insurance agreement with Mr. Lay for $12.75 million of life 

insurance coverage was later approved by the Compensation Committee of the Board of 

Directors on May 3, 1999, at Mr. Lay’s request. Although Enron purchased the life insurance 

contract in 2000, Enron and Mr. Lay did not enter into the split-dollar arrangement.

Discussion and recommendation

Enron’s split-dollar life insurance arrangements with Mr. Lay, Mr. Skilling, and Mr. 

Baxter were entered into between 1994 and 2000, before the issuance of the series of recent IRS 

guidance starting with Notice 2001-10 in January, 2001. Under the limited guidance issued by 

the IRS prior to Notice 2001-10,32 the cost of current term insurance protection would have been 

 

32 In the 1960s, the IRS published rulings providing that the amount includible in an 

employee’s income under a split-dollar insurance arrangement is the cost of current term 
26

includible in income of the owner of the life insurance contract (less the amount paid by the 

owner). The value of the current term insurance protection was determined by reference to a 

table (P.S. 58) based on the age of the insured. This guidance would not affect the tax treatment 

of an employer that enters into a split-dollar arrangement; thus, Enron would not be permitted to 

deduct the premiums.33

In January 2001, the IRS issued Notice 2001-10.34 It provided interim guidance for the 

tax treatment of split-dollar life insurance, including types of split-dollar life insurance 

arrangements between an employer and employee in which the employee has an interest in the 

cash value of the contract (equity split-dollar arrangements) that were not addressed by the 

limited earlier guidance. The Notice provided that split-dollar arrangements would be subject to 

tax under either a loan approach or an economic benefit approach. Notice 2001-10 provided a 

new table, Table 2001, to replace the P.S. 58 table for valuing the cost of current life insurance 

protection.

A year after Notice 2001-10 was issued, it was revoked by Notice 2002-8.35 Notice 

2002-8, however, provides interim guidance applying the general concepts of the earlier Notice, 

and provides that Table 2001 generally applies for valuation purposes for arrangements entered 

into after January 28, 2002 (the date Notice 2002-8 was issued).

The IRS issued proposed regulations on split-dollar life insurance arrangements on July 

5, 2002.36 The proposed regulations provide guidance on the income, employment, and gift tax 

treatment of split-dollar life insurance arrangements. Somewhat like the earlier notices, the 

proposed regulations generally provide two mutually exclusive regimes for taxing split-dollar 

arrangements, one taking an economic benefit approach,37 and the other applying loan 

treatment.38 

Under the economic benefit approach of the proposed regulations, the value of economic 

benefits under the life insurance contract is treated as being transferred from the contract owner 

 

insurance protection (less the amount, if any, paid by the employee). Any policyholder 

dividends paid to, or benefiting, the employee are also includible in income. Rev. Rul. 64-328, 

1964-2 C.B. 11, and Rev. Rul. 66-110, 1966-1 C.B. 12.

33 Sec. 264; see the Report at note 2146.

34 2001-5 I.R.B. 459.

35 2002-4 I.R.B. 398.

36 REG-164754-0, July 5, 2002. Regulations are proposed under Code sections 61, 83, 

301, 1402, 7872, 3121, 3231, 3306, and 3401.

37 Sec. 61.

38 Sec. 7872 (or secs. 1271-1275, if the loan is not below-market).
27

to the nonowner (reduced by any consideration paid by the nonowner to the owner). The tax 

consequence of the transfer depends on the relationship of the owner and nonowner;39 in the 

employment context, the transfer is regarded as compensation for services. 

Under the loan approach of the proposed regulations, the owner and nonowner are treated 

as borrower and lender, respectively, if the nonowner (e.g., employer) paying premiums is 

reasonably expected to be repaid from the contract’s cash value or death benefits. If the loan 

does not provide sufficient interest, then interest is imputed under the rules of section 7872. In 

general, such interest is not deductible by the borrower, but is includible in the income of the 

deemed lender (generally, the employee) in the arrangement.

Until the issuance of Notice 2001-10 in 2001, the IRS had issued very little guidance on 

split-dollar life insurance since the 1960s. During this period, the use of split-dollar life 

insurance became more widespread, and variations on the product proliferated. In the absence of 

guidance, some taxpayers may have taken a variety of positions as to the includibility in income 

of benefits under the arrangements, and as to the timing or amount of items that are includible. 

From a tax policy perspective, taxpayers’ failure to include in income the appropriate value of an 

economic benefit received by an employee from an employer indicates a need for guidance as to 

the proper tax treatment of split-dollar life insurance arrangements.

Under the recent interim guidance published by the IRS relating to split-dollar life 

insurance arrangements, the economic benefit received in a split-dollar life insurance 

arrangement is treated more like other economic benefits received by employees. This recent 

interim guidance specifies the tax treatment in greater detail than previously in an area in which 

practices that may not accurately measure income had become increasingly common. 

Requiring taxpayers to include in income the economic value of the benefit received in a 

split-dollar life insurance arrangement (or to treat the arrangement as a loan, if that treatment 

reflects the nature of the transaction) is consistent with the goal of the income tax system to 

accurately measure income. The Notices and proposed regulations generally serve the tax policy 

goal of improving accurate income measurement in the case of split-dollar life insurance 

arrangements. The Joint Committee staff recommends that the pending guidance relating to 

split-dollar life insurance should be finalized.

5. Limitation on deduction of certain executive compensation in excess of $1 million

Present law

Present law generally allows a deduction for ordinary and necessary business expenses, 

including a reasonable allowance for salaries and other compensation for personal services 

actually rendered. However, compensation in excess of $1 million paid by a publicly held 

company to the company’s “covered employees” generally is not deductible.40 Covered 

 

39 For example, depending on the relationship, the arrangement may be a payment of 

compensation, dividend distribution under section 301, gift under the gift tax rules, or other 

transfer. Prop. Treas. Reg. sec. 1.61-22(d)(1).

40 Sec. 162(m).
28

employees are the chief executive officer and the four other most highly compensated employees 

of the company as reported in the company’s proxy statement.

Subject to certain exceptions, the deduction limitation applies to all otherwise deductible 

compensation of a covered employee for a taxable year, regardless of the form in which the 

compensation is paid and regardless of when the compensation was earned. The deduction 

limitation applies when the deduction would otherwise be taken. For example, in the case of a 

nonqualified stock option, the deduction is normally taken in the year in which the option is 

exercised, even though the option was granted with respect to services performed in a prior year.

Certain types of compensation are not subject to the deduction limitation. With respect to 

compensation paid to Enron executives, the most relevant exception is for performance-based 

compensation. In general, performance-based compensation is compensation payable solely on 

account of the attainment of one or more performance goals with and respect to which certain 

requirements are satisfied, including a shareholder approval requirement.

Discussion and recommendation

Based on the review of Enron’s compensation arrangements, the Joint Committee staff 

found that the $1 million limitation on the deductibility of certain executive compensation did 

not appear to have had a substantial impact on either the amount of compensation paid by Enron 

or the structure of its compensation arrangements.

Table 9, below, shows total compensation, performance-based compensation, additional 

deductible compensation, and nondeductible compensation for 1998 through 2000. 

Table 9–Application of $1 Million Deduction Limitation for 1998-2000

(Millions of Dollars)

Year (1)

Total 

Compensation 

of Covered 

Employees

(2)

PerformanceBased 

Compensation

(3)

Additional 

Deductible 

Compensation**

(4)

Nondeductible 

Compensation

1998 48.5 20.9 4.0 23.6

1999 124.2 111.6 4.2 8.4

2000 260.9 241.0 3.5 16.5

Total 1998-2000* 433.6 373.5 11.7 48.5

* Details may not add to totals due to rounding.

**Additional deductible compensation is the amount of total compensation, minus performance-based 

compensation, not in excess of $1 million.

The existence of the $1 million deduction limitation does not appear to have had any 

effect on the total compensation provided to Enron executives. Based on information provided 
29

by Enron to the IRS, as shown in Table 9, above, total compensation for the top-five executives 

for 1998-2000 was $433.6 million.41 

Enron intended certain of its compensation arrangements to qualify as performance-based 

for purposes of the deduction limitation,42 and treated substantial amounts of compensation as 

meeting this requirement. Based on information provided by Enron to the IRS, as shown in 

Table 9 above, performance-based compensation for 1999 and 2000 was comparable, 90 percent 

and 92 percent, respectively of total compensation. In those years, seven percent and six percent, 

respectively, of total compensation of covered employees was not deductible. In the case of 

certain executives, the amount of performance-based compensation was so great compared to 

total compensation that less than $1 million of compensation was potentially subject to the 

deduction cap.

For 1998, however, performance-based compensation was only 43 percent of total 

compensation of covered employees, and 49 percent of the total compensation of covered 

employees was not deductible because of the $1 million deduction limit. This is due in large part 

to the compensation provided to two covered employees. The nondeductible compensation for 

those two employees was 82 percent of the total nondeductible compensation of all five covered 

employees. Seventy-six percent of the total compensation for those two employees was not 

deductible.

Although Enron treated substantial amounts of compensation as performance-based, the 

$1 million deduction limitation does not appear to have had a significant impact on the overall 

structure of Enron’s compensation arrangements. The arrangements that Enron considered to 

provide performance-based compensation were generally utilized prior to the enactment of the

deduction limitation. Enron made certain modifications to its compensation arrangements in 

order to meet the Code’s definition of performance-based compensation; however, these 

modifications were generally limited to relatively minor changes needed to meet the 

requirements rather than changes to the overall structure of its compensation arrangements. For 

example, in the case of bonuses, the Compensation Committee was advised by its outside 

consultants to establish a high enough “soft” target that could be approved by the shareholders so 

that whatever level of bonuses Enron ultimately paid would be within the target and thus would 

not fail to be performance based. It is possible that certain arrangements might not have been 

submitted for shareholder approval had this not been required in order to meet the requirements 

for performance-based compensation.

 

41 Enron also paid compensation in excess of $1 million to many employees not subject 

to the deduction limitation. The information regarding the top-200 most highly compensated 

employees provided by Enron to the Joint Committee staff indicates that 46 employees, 93 

employees, and all 200 top-paid employees received compensation in excess of $1 million in 

1998, 1999, 2000, and 2001, respectively.

42 Enron submitted three plans for shareholder approval in order to meet the requirements 

of the exception for performance-based compensation: the 1991 Stock Plan, the Performance 

Unite Plan, and the Annual Incentive Plan.
30

The Compensation Committee was required to take certain actions in order for 

compensation to qualify as performance-based. A review of the Compensation Committee 

minutes indicates that the deduction limitation was discussed from time to time, and the role of 

the Compensation Committee with respect to approval of performance targets was mentioned. 

In addition, the annual report of the Compensation Committee in proxy statements discussed the 

deduction limitation. While the deduction limitation was discussed in Compensation Committee 

meetings, it appears that more time was spent on broader compensation issues, such as overall 

compensation targets. One former member of the Compensation Committee interviewed by the 

Joint Committee staff indicated he had no knowledge of the deduction limitation and did not 

remember it ever being discussed. This may be an indication that the limitation was not a 

significant concern for Enron.

The existence of the $1 million deduction limitation did not prevent Enron from paying 

nondeductible compensation. From 1998 through 2001, $48.5 million of nondeductible 

compensation was paid to covered employees.

Another aspect of the deduction limitation that can be observed from the review of Enron 

is the discrepancy between the operation of the limitation, which is based on generally applicable 

tax rules, and compensation as reported in Federal proxy statements. Proxy statements include a 

summary compensation table for covered employees (referred to as “named officers” under the 

securities laws) as well as other information regarding executive compensation. Because of 

timing differences and other factors, compensation as reported for proxy purposes can vary 

significantly from compensation subject to the $1 million deduction limitation. The difference in 

the treatment may cause confusion for persons who are attempting to determine the amount of 

nondeductible compensation from publicly available sources; it is not possible to make this 

determination based on proxy information.

The determination of whether a corporation has properly applied the $1 million dollar 

deduction can involve a time consuming, labor intensive process. In Enron’s case, the IRS 

review of the application of the $1 million deduction involves extensive factual review and 

determinations, including a review of terms of numerous plans and individual employment 

contracts, examining materials submitted to shareholders, and the need to reconcile a number of 

inconsistencies in information.

The Joint Committee staff believes that, in Enron’s case, the $1 million deduction 

limitation was ineffective at accomplishing its purpose. The Enron experience raises serious 

doubts about the effectiveness of the $1 million deduction limitation. If this experience is 

widespread among public companies, the Congress should consider repealing the rule. The 

concerns reflected in the limitation can be better addressed though laws other than the Federal 

tax laws.

The $1 million deduction limitation reflects corporate governance issues regarding 

excessive compensation, rather than issues of tax policy.43 It is often difficult for tax laws to 

 

43 H.R. Rep. No. 103-111, at 646 (1993).
31

have the desired effect on corporate behavior.44 Taxpayers may simply choose to incur the 

adverse tax consequences rather than change their behavior. In Enron’s case, due to the 

existence of net operating losses, the denial of the deduction may not have been an issue.

In Enron’s case, the $1 million deduction limitation appeared to have little, if any, effect 

on the overall level of compensation paid to Enron executives or the structure of Enron’s 

compensation arrangements. To the extent that performance-based compensation is viewed as 

being a preferable form of compensation, some may argue that the $1 million limitation was 

effective in the Enron case, because such a large part of compensation was structured to be 

performance-based. However, as noted above, the deduction limitation did not appear to be a 

motivating factor in the structure of Enron’s compensation and the arrangements that it treated as 

performance-based (or similar arrangements) generally predated the enacted of the limitation. In 

addition, some may question whether the compensation was truly performance based, 

particularly given Enron’s financial decline; to the extent the limitation affected Enron’s 

compensation arrangements, it may have merely placed more emphasis on the desire to increase 

reported earnings.

 

44 Another example of tax laws that are aimed at corporate governance issues are the 

golden parachute rules that limit the compensation that may be paid to certain employees due to 

the change of control of a company. Sec. 280G. Failure to comply with these rules results in a 

denial of the deduction to the company and the imposition of a 20 percent excise tax, payable by 

the employee. Sec. 4999. Commentators generally observe that the golden parachute rules have 

done little to affect the amount of compensation payable upon a change of control. Rather, the 

rules are often thought of as providing a road map as to how to structure compensation 

arrangements. It is not uncommon for employment agreements to provide that, in the event the 

employee is subject to the excise tax, the tax will be paid by the company, with a gross up to 

reflect the income tax payable as a result of the employer’s payment of the tax.
32

III. COMPANY-OWNED AND TRUST-OWNED LIFE INSURANCE

Enron implemented company-owned life insurance (“COLI”) and trust-owned life 

insurance (“TOLI”) programs. COLI generally has been the subject of considerable publicity 

due to its Federal income tax and financial accounting benefits,45 and Congress has sought to 

limit its use as a tax arbitrage mechanism in Federal tax legislation since the 1940’s.

Enron’s COLI and TOLI transactions

During the 1980’s and early 1990’s, Enron bought approximately 1,000 life insurance 

contracts covering employees. Approximately $178 million had been borrowed under these life 

insurance contracts at the end of 1994, after which Enron stopped purchasing life insurance 

contracts covering employees. Approximately half of Enron’s life insurance contracts covering 

employees (including a group of 201 contracts purchased June 1, 1986) were purchased before 

June 20, 1986, the effective date of 1986 legislation limiting the tax deduction for interest on 

debt under a life insurance contract. A 1999 summary by Clark-Bardes showed that interest rates 

charged on loans under some of the contracts -- those issued by Massachussetts Mutual and 

Great West -- ranged from 6.75 percent to 11.75 percent during the period 1983 - 1999. As the 

cash surrender value of the contracts increased, Enron continued to borrow under the contracts. 

The summary states, “Enron’s policy blocks retain 100% loan interest deductibility under current 

legislation; this deductibility is a commodity that is no longer available in the insurance 

marketplace.” By late 2001, the amount borrowed under Enron’s life insurance contracts had 

grown to approximately $432 million. 

Portland General Electric, an Enron subsidiary acquired in 1997, also owned life 

insurance contracts covering its employees. As of 1999, Portland General Electric had 

approximately $79 million worth of such life insurance contracts, and its affiliates owned 

approximately $59 million worth. Policies covering a total of 2,315 Portland General Electric 

employees were purchased between 1996 and 1999. 

Following Enron’s bankruptcy filing, Enron surrendered its life insurance contracts 

during 2002. Portland General Electric’s life insurance contracts were in the process of being 

surrendered as of early 2003.

 

45

 See, e.g., Francis, Bill Seeks Disclosure on Insuring Employees, Wall St. J., Feb. 5, 

2003; Francis, Insurance Disclosure of S&Ls May Change, Wall St. J., Jan. 27, 2003; Gettlin, 

Tax-Free Earnings: A Life-And-Death Issue, National J., Oct 26, 2002, at 3140; Clark, Better off 

dead?, U.S. News & World Report, May 6, 2002, at 32; Schultz and Francis, The Economy: 

Senator to Target Tax Boon to Firms Insuring Workers, Wall St. J., May 3, 2002; Francis and 

Schultz, Big Banks Quietly Pile Up 'Janitors' Insurance,' Wall St. J., May 2, 2002; Francis and 

Schultz, Many Banks Boost Earnings with 'Janitors' Life Insurance,' Wall St. J., April 26, 2002; 

Francis and Schultz, Why Secret Insurance on Employees Pays Off, Wall St. J., April 25, 2002; 

Schultz and Francis, Why Are Workers in Dark? Most States Don't Force Firms To Disclose 

'Janitors' Insurance,' But Congress May Change That, Wall St. J., April 24, 2002; Schultz and 

Francis, Valued Employees: Worker Dies, Firm Profits, Wall St. J., April 19, 2002.
33

Discussion

Tax arbitrage

No Federal income tax generally is imposed on a policyholder with respect to the 

earnings under a life insurance contract46 (“inside buildup”).47 Further, an exclusion from 

Federal income tax is provided for amounts received under a life insurance contract paid by 

reason of the death of the insured.48 Because of the nontaxation of inside buildup, life insurance 

contracts provide an opportunity for tax arbitrage. 

Borrowing by a business with respect to a life insurance contract is attractive because the 

earnings under the policy (i.e., inside buildup) increase tax-free. The loans permit the borrower 

to have the current use of income that has not been taxed. If the business borrows directly under 

the policy it owns, interest paid by the borrower is credited to the policy; the effect is equivalent 

to paying interest to itself. The amount of the loan reduces the death benefit when the insured 

person dies, if the loan has not yet been repaid; however, this is not a disadvantage to the 

borrower if another person (such as an employee’s spouse) is the recipient of the death benefit. 

A further advantage of borrowing with respect to a life insurance policy arises to the extent the 

interest on the policy loan is deductible. Although 1996 legislation limited the interest deduction

on debt under a life insurance, annuity or endowment contract, and 1997 legislation imposed a 

pro rata interest deduction limitation on debt allocable to unborrowed policy cash values of a life 

insurance, annuity or endowment contract, tax arbitrage opportunities related to the nontaxation 

of inside buildup remain under exceptions to the 1997 legislation. 

 

46 By contrast to the treatment of life insurance contracts, if an annuity contract is held 

by a corporation or by any other person that is not a natural person, the income on the contract is 

treated as ordinary income accrued by the contract owner and is subject to current taxation. The 

contract is not treated as an annuity contract (sec. 72(u)).

47 This favorable tax treatment is available only if a life insurance contract meets certain 

requirements designed to limit the investment character of the contract (sec. 7702). Distributions 

from a life insurance contract (other than a modified endowment contract) that are made prior to 

the death of the insured generally are includible in income, to the extent that the amounts 

distributed exceed the taxpayer's basis in the contract; such distributions generally are treated 

first as a tax-free recovery of basis, and then as income (sec. 72(e)). In the case of a modified 

endowment contract, however, in general, distributions are treated as income first, loans are 

treated as distributions (i.e., income rather than basis recovery first), and an additional 10 percent 

tax is imposed on the income portion of distributions made before age 59-1/2 and in certain other 

circumstances (secs. 72(e) and (v)). A modified endowment contract is a life insurance contract 

that does not meet a statutory “7-pay” test, i.e., generally is funded more rapidly than seven 

annual level premiums (sec. 7702A).

48 Sec. 101(a).
34

COLI legislation

Provisions of tax legislation designed to limit the tax arbitrage of deducting interest on 

borrowings with respect to a life insurance contract date to the 1940’s. 49 The deductibility of 

interest on borrowings that relate to life insurance contracts has been limited most recently by 

Federal tax legislation in 1986, 1996, and 1997. 

In 1986, deductible interest on borrowings under life insurance contracts was capped at 

debt of $50,000 per contract, to combat the use of life insurance loans as an “unlimited tax 

shelter.”50 This provision was effective for contracts purchased on or after June 20, 1986. Life 

insurance contracts purchased before that date were grandfathered; the $50,000 cap did not apply 

to interest on debt borrowed under such contracts.

A pattern then developed of businesses insuring the lives of thousands of their employees 

to increase the amount of interest to deduct on borrowings under the contracts.51 In 1996, a 

broader limitation on deductibility of interest on debt under a life insurance contract was enacted, 

generally replacing the $50,000 cap. That rule provided that no deduction is allowed for interest 

paid or accrued on any indebtedness with respect to one or more life insurance, annuity or 

endowment contracts owned by the taxpayer, and covering the life of any individual who is or 

has been (1) an officer or employee of, or (2) financially interested in, any trade or business 

currently or formerly carried on by the taxpayer.52 A key person insurance exception was 

provided. The 1996 legislation applied generally to interest paid or accrued after October 13, 

1995, with a phase-in rule. However, the grandfather rule for pre-June 20, 1986, contracts was 

preserved, with a new interest rate cap based on a Moody's rate.53

 

49 Section 129 of the Revenue Act of 1942 (Pub. L. No. 753, 77th Cong., 56 Stat. 798) 

added Internal Revenue Code section 24(a)(6), which provided that no deduction was allowed 

for “any amount paid or accrued on indebtedness incurred or continued to purchase a single 

premium life insurance or endowment contract. For the purposes of this paragraph, if 

substantially all the premiums on a life insurance or endowment contract are paid within a period 

of four years from the date on which such contract is purchased, such contract shall be 

considered a single premium life insurance or endowment contract.”

50 Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986 

(JCS-10-87), May 4, 1987, at 579. See Tax Reform Act of 1986, Pub. L. No. 99-514, sec. 1003, 

100 Stat. 2388 (1986).

51 See Lee Sheppard, “’Janitors’ Insurance as a Tax Shelter,” Tax Notes, Sept. 25, 1995, 

p. 1526.

52 Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 

104th Congress (JCS-12-96), Dec. 18, 1996, p. 365. See Health Insurance Portability and 

Accountability Act of 1996, Pub. L. No. 104-191, sec. 510, 110 Stat. 2090 (1996).

53 Sec. 264(e)(2).
35

The interest deduction limitation was further expanded in 1997 when Congress became 

aware of the practice of businesses insuring the lives of customers or debtors (for example, 

financial institutions insuring the lives of mortgage borrowers while borrowing under the life 

insurance policies, or maintaining other debt, and deducting the interest thereon).54 The 1997 

legislation provided that no deduction is allowed for interest paid or accrued on any debt with 

respect to a life insurance, annuity or endowment contract covering the life of any individual. It 

also provided that, for taxpayers other than natural persons, no deduction is allowed for the 

portion of the taxpayer’s interest expense that is allocable to unborrowed policy cash values of a 

life insurance, annuity or endowment contract. An exception is provided under this proration 

rule for contracts that cover an individual who is a 20-percent owner, officer, director or 

employee of the taxpayer’s trade or business.55 The pro rata interest deduction limitation applied 

generally to contracts issued after June 8, 1997. Thus, the phase-in rule under the effective date 

of the 1996 legislation, and the grandfather rule under the 1986 and 1996 legislation for contracts 

purchased on or before June 20, 1986, were not affected.

Judicial decisions relating to COLI

Interest deductions under COLI arrangements have also been limited by recent case law 

applying general principles of tax law, including the sham transaction doctrine. These cases 

generally cover taxable years of taxpayers before the recent 1996 and 1997 legislation took 

effect. These principles of tax law continue to apply after enactment of the specific interest 

deduction limitation rules.

The case of Winn-Dixie Stores, Inc. v. Commissioner56 involved the application of the 

sham transaction doctrine. In 1993, Winn-Dixie entered into a COLI program on the lives of its 

36,000 employees. Under the program, Winn-Dixie purchased whole-life insurance policies and 

was the sole beneficiary. Winn-Dixie borrowed periodically against the policies’ account value 

at interest rates that averaged 11 percent. The 11-percent average interest rate, when coupled 

with the administrative fees, outweighed the net cash surrender value and benefits paid on the 

policy. Thus, although Winn-Dixie lost money on the program each year, the tax deductibility of 

the interest and fees yielded a benefit of several billion dollars over 60 years. In 1997, WinnDixie terminated its participation in the COLI program following the enactment of tax law 

changes in 1996 that limited the deductibility of interest on COLI policy loans. On audit, the IRS 

 

54

 See “Fannie Mae Designing a Program to Link Life Insurance, Loans,” Washington 

Post, Feb. 8, 1997, p. E3; “Fannie Mae Considers Whether to Bestow Mortgage Insurance,” Wall 

St. Journal, April 22, 1997, at C1.

55 This proration rule applies to policies issues after June 8, 1997. See Taxpayer Relief 

Act of 1997, Pub. L. No. 105-34, sec. 1084, 111 Stat. 951 (1997), and see Joint Committee on 

Taxation, General Explanation of Tax Legislation Enacted in 1997 (JCS-23-97), Dec. 17, 1997, 

p. 272.

56

 Winn-Dixie, 113 T.C. 254 (1999), aff’d 254 F.3d 1313 (11th Cir. 2001), cert. denied, 

April 15, 2002.
36

disallowed the deductions for interest and administrative fees that Winn-Dixie claimed on its 

1993 tax return with respect to its COLI program and COLI policy loans.

On petition to the Tax Court, Winn-Dixie argued that the deductions relating to its COLI 

program were proper because: (1) the COLI program satisfied the business purpose and 

economic substance prongs of the sham transaction doctrine and (2) in any case, the sham 

transaction doctrine was inapplicable because Congress explicitly authorized the deductions in 

connection with the COLI program. However, the Tax Court sustained the IRS disallowance of 

the COLI-related deductions claimed by Winn-Dixie, concluding that the COLI program 

(including the associated policy loans) was a sham.

Other recent cases have also upheld the disallowance by the IRS of deductions for 

interest relating to COLI programs. In Internal Revenue Service v. CM Holdings, Inc.,

57 Camelot 

Music had purchased COLI policies in 1990 covering the lives of 1,430 employees. Camelot 

borrowed under the policies to pay the first three annual premiums and sought to deduct the 

interest on the borrowings. Camelot subsequently filed a petition under chapter 11 of the 

Bankruptcy Code, and the IRS filed proofs of claim based on disallowance of the interest 

deductions. The District Court held that the interest deductions should be disallowed, and also 

concluded that the application of accuracy-related penalties was appropriate. The court stated 

that there were two rationales for the interest deduction disallowance. First, the interest 

deductions were part of a transaction that was in part a factual sham and therefore did not meet 

the "4-out-of-7" exception to the interest deduction disallowance rule of Code section 264(a)(3). 

In addition, the COLI plan lacked economic substance and business purpose, and was a sham in 

substance.58 On appeal, the Third Circuit affirmed, "based on the . . . reasoning, that the COLI 

policies lacked economic substance and therefore were economic shams."59 The Appellate Court 

also affirmed the assessment of penalties.

In American Electric Power, Inc. v. U.S.,

60 the District Court concluded that interest 

deductions on policy loans under a COLI program covering the lives of over 20,000 employees 

should be disallowed. The court concluded that the "plan as a whole was a sham in substance,"61

as well as concluding that first-year policy loans, and the first-year and fourth-through seventhyear loading dividends and corresponding portions of the premiums, were factual shams. The 

court stated that it had "independently reached many of the same conclusions as the [District] 

 

57

 Internal Revenue Service v. CM Holdings, Inc., 254 B.R. 578 (D. Del. 2000).

58

 Id. at 583, 654.

59

 IRS v. CM Holdings, Inc. (In Re: CM Holdings, Inc.), 301 F.3d 96 (3d Cir. 2002), at 

96.

60

 American Electric Power, Inc. v. U.S., 136 F.Supp. 2d 762 (S. D. Ohio 2001).

61

 Id. at 795.
37

court in C.M. Holdings," and that the policies in that case were in all relevant respects identical 

to those involved in this case.62

In another recent District Court case, however, Dow Chemical Company v. U.S.,

63

involving two groups of COLI policies (one group of policies covering 4,051 employees and the 

other covering 17,061 employees), the court held that the IRS improperly disallowed Dow's 

deductions for interest and expenses in connection with the COLI plans. Although the court held 

that partial withdrawals under the policies to pay premiums in the fourth through seventh years 

"were not real and constituted shams in fact,"64 the court determined that "the policy loans were 

real transactions consistent with commercial norms, and therefore were not factual shams."65 

The court concluded that Dow's COLI plans were "imbued with economic substance."66

Enron's grandfathered contracts

Enron’s COLI and TOLI arrangements were leveraged, showing approximately $432 

million of debt on $512 million of life insurance coverage by November, 2001. The purchase of 

these contracts predated the 1996 and 1997 legislation limiting interest deductions under life 

insurance contracts and imposing a pro rata reduction on interest deductions in the case of 

taxpayers that have life insurance contracts but do not borrow directly under the contracts.

The grandfather rule under the 1986 COLI legislation would apply to those contracts 

Enron purchased on or before June 20, 1986. Under this grandfather rule, neither the 1986 

$50,000 per-contract cap on debt, nor the broader 1996 rule disallowing interest on debt under a 

life insurance contract, applied to contracts Enron purchased on or before June 20, 1986 

(although for interest incurred after the 1996 legislation, those contracts were subject to an 

interest rate cap based on a Moody's rate relating to corporate bond yields). 

This grandfather rule continues in effect, allowing the continued deduction of interest on 

debt under contracts that were purchased on or before June 20, 1986. As years pass from the 

1986 date, the value of this tax treatment increases with the growth of the cash surrender value of 

the grandfathered contracts (assuming they are not treated as materially changed or otherwise 

ceasing to be pre-June 20, 1986, contracts). This result could be viewed as inconsistent with 

Congress' repeated legislation limiting interest deductions with respect to life insurance 

contracts. 

 

62

 Id. at 769.

63 Case No. 00-10331-BC, E. D. Mich., Mar. 31, 2003. The court stated that many of the 

issues in the case were "thoroughly litigated" in the Winn-Dixie, CM Holdings, and American 

Electric Power cases, supra. Dow Chemical at 3. The court in Dow Chemical reached different 

conclusions on many of the issues, however.

64 Id. at 139.

65 Id. at 138.

66 Id.
38

Recommendations

The Joint Committee staff recommends termination of the grandfather rule for pre-June 

20, 1986, COLI contracts. Even though Enron did not purchase any additional life insurance 

contracts after 1994, Enron's debt and deductible interest under life insurance contracts continued 

to increase throughout the 1980s and 1990s (along with the cash surrender value of the 

contracts). This result is inconsistent with the legislative limitations imposed by Congress in 

1986, 1996, and 1997 on interest associated with the tax-free inside buildup of life insurance 

contracts. If the 1986 grandfather rule was intended to provide transition relief to businesses that 

had purchased life insurance contracts before the 1986 date, sufficient time has passed that a 

redeployment of such businesses' assets could have been possible. The grandfather rule can no 

longer serve any reasonable need for transition relief.

Although the COLI transactions in which Enron engaged suggest repeal of the 

grandfather rule for such contracts, there may be other issues relating to COLI that arise from 

other corporations' practices with respect to ownership of life insurance. Tax arbitrage 

opportunities that arise in such contexts may suggest other legislative responses.
39

IV. CONCLUSIONS

Some of the issues examined by the Joint Committee staff with respect to Enron’s 

compensation arrangements raise nontax issues, such as issues of corporate governance, which 

would be better addressed outside of the tax laws. With respect to tax-related issues, as 

discussed above, the Joint Committee staff finds it appropriate to make the following 

recommendations:

• Changes should be made to the rules relating to nonqualified deferred compensation 

arrangements to curb current practices that allow for the deferral of tax on 

compensation income while providing executives with inappropriate levels of 

security, control, and flexibility with respect to deferred compensation. These 

changes include providing that certain plan features result in current taxation, 

including the ability to obtain accelerated distributions, direct investments, and make 

subsequent elections. In addition, the Joint Committee staff believes that the use of 

programs such as Enron’s deferral of stock options gains and restricted stock 

programs should not be allowed. The ability of the Treasury to issue guidance with 

respect to deferred compensation should not be restricted. Reporting of deferred 

compensation amounts should also be required; 

• Guidance relating to split-dollar life insurance should be finalized; 

• Congress should consider whether the limitation on the deduction for compensation 

in excess of $1 million should be repealed; and 

• With respect to company-owned life insurance, the Joint Committee staff 

recommends termination of the grandfather rule with respect to interest deductions 

that is applicable to pre-June 20, 1986, contracts.

The Joint Committee staff notes that there were executive compensation provisions 

included in the National Employee Savings and Trust Equity Guarantee Act (“NESTEG”), 

approved by the Finance Committee on July 11, 2002. The provisions included:

• Section 501 of the bill, which repealed the limitation on Treasury guidance regarding 

nonqualified deferred compensation;

• Section 502 of the bill, which taxed deferred compensation provided through offshore 

trusts;

• Section 503 of the bill, which treated certain loans as compensation; and 

• Section 504 of the bill, which required wage withholding at the top marginal rate for 

supplemental wages in excess of $1 million. 

The Joint Committee staff recommendation to repeal section 132 of the Revenue Act of 

1978 was included in section 501 of the bill. In addition, section 502 of the bill provides current 

taxation of deferred compensation provided through offshore trusts. The Joint Committee staff 
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supports this provision, but notes that it would have no direct effect on Enron, as the Joint 

Committee staff found no evidence that Enron provided assets through an offshore trust. As 

announced by Senator Grassley, section 503 of the bill, which would treat certain loans as 

compensation has been mooted by the Sarbanes-Oxley Act. In addition to the executive 

compensation provisions included in NESTEG, additional steps beyond those contained in 

NESTEG should be taken to curb the use of certain executive compensation arrangements.