Friday, July 24, 2009

Senate Legislation Would Align Option Accounting Standards with Tax Code and Make Options Part of 162(m) Salary Cap

Bipartisan Senate draft legislation would bring stock option accounting rules and the federal tax code into alignment by requiring that the stock option tax deduction be no greater than the stock option expenses shown on the corporate books each year. Currently, stock options are the only compensation expense where the tax code allows companies to deduct more than their book expenses. The Ending Excessive Corporate Deductions for Stock Options Act, S.1491, would end use of the current stock option deduction under Section 83 of the IRC, which allows companies to deduct stock option expenses when exercised in an amount equal to the income declared by the individual exercising the option, replacing it with a new Section 162(q), which would require companies to deduct the stock option expenses shown on their books each year.

The draft, introduced by Senators Levin and McCain, would also eliminate the favored treatment of executive stock options by making deductions for this type of compensation subject to the same $1 million cap that applies to other forms of compensation covered by IRC Section 162(m), which caps at $1 million the compensation that a company can deduct from its taxes. However, the cap currently does not apply to stock options, allowing companies to deduct any amount of stock option compensation, without limit.

By not applying the $1 million cap to stock option compensation, reasoned Sen. Levin, the tax code created a significant incentive for companies to pay their executives with stock options. It is effectively meaningless to cap deductions for executive salary compensation but not also for stock options.

The measure would apply only to corporate stock option deductions. It would make no changes to the rules that apply to individuals who have been given stock options as part of their compensation. Individuals would still report their compensation on the day they exercised their stock options. They would still report as income the difference between what they paid to exercise the options and the fair market value of the stock they received upon exercise. The gain would continue to be treated as ordinary income rather than a capital gain, since the option holder did not invest any capital in the stock prior to exercising the stock option and the only reason the person obtained the stock was because of the services they performed for the company.

The amount of income declared by the individual after exercising a stock option will likely often be greater than the stock option expense booked and deducted by the corporation who employed that individual. In part, that is because the individual’s gain often comes years later than the original stock option grant, and the underlying stock will usually have gained in value. In addition, the individual’s gain is typically provided, not by the company that supplied the stock options years earlier, but by third parties active in the stock market.

The legislation would put an end to the current approach of using the stock option income declared by an individual as the tax deduction claimed by the corporation that supplied the stock options. It would break that old artificial symmetry and replace it with a new symmetry, noted Sen. Levin, one in which the company’s stock option tax deduction would match its book expense.

The sponsors of the legislation describe the current approach to corporate stock option tax deductions as artificial because it uses a construct in the tax code that, when first implemented forty years ago, enabled corporations to calculate their stock option expense on the exercise date, when there was no consensus on how to calculate stock option expenses on the grant date. The artificiality of the approach is demonstrated by the fact that it allows companies to claim a deductible expense for money that comes not from company coffers, but from third parties in the stock market. Now that U.S. accounting rules require the calculation of stock option expenses on the grant date, however, there is no longer any need to rely on an artificial construct that calculates stock option expenses on the exercise date using third party funds.

It is important to note that the legislation would not affect current tax provisions providing favored tax treatment to incentive stock options under IRC Sections 421 and 422. Under those sections, in certain circumstances, corporations can surrender their stock option deductions in favor of allowing their employees with stock option gains to be taxed at a capital gains rate instead of ordinary income tax rates. Many start-up companies use these types of stock options, because they don’t yet have taxable profits and don’t need a stock option tax deduction. So they forfeit their stock option corporate deduction in favor of giving their employees more favorable treatment of their stock option income. Incentive stock options would not be affected by the legislation and would remain available to any corporation providing stock options to its employees.

The legislation would also allow the old Section 83 deduction rules to apply to any option which was vested prior to the effective date of FASB Standard 123R, and exercised after the date of enactment of the legislation. The effective date of FAS 123R is June 15, 2005 for most corporations. Prior to the effective date of FAS 123R, most companies would have shown a zero expense on their books for the stock options issued to their executives and, thus, would be unable to claim a tax deduction under new Section 162(q). For that reason, the measure would allow these corporations to continue to use Section 83 to claim stock option deductions on their tax returns.

For stock options that vested after the effective date of FAS 123R and were exercised after the date of enactment, the draft takes another tack. Under FAS 123R, these companies would have had to show the appropriate stock option expense on their books, but would have been unable to take a tax deduction until the executive actually exercised the option. For these options, the draft would allow companies to take an immediate tax deduction, in the first year that the legislation is in effect, for all of the expenses shown on their books with respect to these options. This catch-up deduction in the first year after enactment would enable corporations, in the following years, to begin with a clean slate so that their tax returns the next year would reflect their actual stock option book expenses for that same year. After that catch-up year, all stock option expenses incurred by a company each year would be reflected in their annual tax deductions under the new Section 162(q).

Finally, the draft contains a transition rule for applying the new Section 162(q) stock option tax deduction to existing and future stock option grants. This transition rule would clarify that the new tax deduction would not apply to any stock option exercised prior to the date of enactment of the legislation.