Tuesday, July 20, 2010

Legislation Would Align Financial Accounting for Stock Options with Federal Tax Code

Bi-partisan legislation would align the GAAP treatment of stock options under FASB financial accounting standards with how options are treated under the Internal Revenue Code. FASB rules value stock options on their grant date, while and the Code values stock options on their exercise date, two numbers that rarely match. Bolstering the need for the legislation, data recently compiled by the IRS shows that corporations who issued stock options to their executives claimed 2008 stock option tax deductions that were collectively $52 billion larger than the expenses shown on the company books for options granted during the tax year covered by the returns.

Sponsored by Senators Carl Levin and John McCain, the Ending Excessive Corporate Deductions for Stock Options Act, S 1491, would curb excessive corporate tax deductions for stock options by requiring that the corporate tax deduction for stock option compensation be no greater than the expense shown on SEC-filed corporate financial reports. The IRS data shows that current stock option accounting and tax rules are misaligned, said Sen. Levin, leading to corporations reporting inconsistent stock option expenses on their financial books versus their tax returns, and often producing huge tax windfalls for companies that pay their executives with large stock option grants.

The legislation would require the corporate tax deduction for stock option compensation to be no greater than the stock option book expense shown on a corporation’s financial statement. It would also allow companies to deduct stock option compensation in the same year it is recorded on the company books, without waiting for the options to be exercised. It would ensure that research tax credits use the same stock option deduction when computing the wages eligible for this tax credit. At the same time, the bill would make no changes to incentive stock options under Section 422 of the federal tax code, which are often used by start-up companies and other small businesses.

Importantly, S 1491 would also eliminate the favored treatment of corporate executive stock options under section 162(m) of the Code by making executive stock option deductions part of the existing $1 million cap on corporate deductions that applies to other types of compensation paid to the top executives of public companies. In 1993, Congress enacted a $1 million cap on the compensation that a corporation can deduct from its taxes so taxpayers would not be forced to subsidize excessive executive pay. However, the cap was not applied 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, the Code created a significant incentive for corporations to pay their executives with stock options. Indeed, it is very common for executives to have salaries of $1 million, while simultaneously receiving millions of dollars more in stock options. The sponsors of S 1491 believe that it is effectively meaningless to cap deductions for executive salary compensation but not also for stock options.

Currently, stock options are the only type of compensation where the federal tax code permits companies to claim a bigger deduction on their tax returns than the corresponding expense on their books. For all other types of compensation, such as cash and bonuses, the tax return deduction equals the book expense. The sole exception to this rule is stock options. In the case of stock options, the tax code allows companies to claim a tax deduction that can be two, three, ten or one hundred times larger than the expense shown on their books.

Public companies are required by law to follow Generally Accepted Accounting Principles, GAAP, issued by FASB, which is overseen by the SEC. For many years, GAAP allowed companies to issue stock options to employees and, unlike any other type of compensation, report a zero compensation expense on their books, so long as, on the grant date, the stock option’s exercise price equaled the market price at which the stock could be sold. Assigning a zero value to stock options that routinely produced huge amounts of executive pay provoked deep disagreements within the financial accounting community. In 1993, FASB proposed assigning a fair value to stock options on the date they are granted, using mathematical valuation tools. FASB proposed
further that companies include that amount as a compensation expense on their financial statements.

A battle over stock option expensing followed, involving the accounting profession, the
corporate community, FASB, the SEC, and Congress. In the end, after years of negotiation, FASB issued Financial Accounting Standard 123R, which was endorsed by the SEC and became mandatory for all publicly traded corporations in 2005. In essence, FAS 123R requires all companies to record a compensation expense equal to the fair value on grant date of all stock options provided to an employee in exchange for the employee’s services. The details of this accounting standard are complex, because they reflect an effort to accommodate varying viewpoints on the true cost of stock options. Companies are allowed to use a variety of mathematical models to calculate a stock option’s fair value. Option grants that vest over time are expensed over the specified period so that, for example, a stock option which vests over four years results in 25 percent of the cost being expensed each year. If a stock option grant never vests, the rule allows any previously booked expense to be recovered. On the other hand, stock options that do vest are required to be fully expensed, even if never exercised, because the compensation was actually awarded. These and other provisions of this accounting standard reflect painstaking judgments on how to show a stock option’s value.

During the years the battle raged over stock option accounting, relatively little attention was paid to the taxation of stock options. Enacted in 1969, Section 83 of Code is the key statutory provision. It essentially provides that, when an employee exercises compensatory stock options, the employee must report as income the difference between what the employee paid to exercise the options and the market value of the stock received. The corporation can then take a mirror deduction for whatever amount of income the employee realized.

Stock option accounting and federal tax regulations have evolved separately over the years and are now at odds with each other. Accounting rules require companies to expense stock options on their books on the grant date. Tax rules provide that companies deduct stock option expenses on the exercise date. Companies have to report the grant date expense to investors on their financial statements, and the exercise date expense on their tax returns. The financial statements report on all stock options granted during the year, while the tax returns report on all stock options exercised during the year. Thus, company financial statements and tax returns identify expenses for different groups of stock options, using different valuation methods, and resulting in widely divergent stock option expenses for the same year.

The legislation would bring stock option accounting and the Code into alignment so that the two would apply in a consistent manner. It would accomplish that goal by requiring the corporate stock option tax deduction to be no greater than the stock option expenses shown on the corporate books each year. The legislation would end the use of the current stock option deduction under Section 83 of the Code, which allows corporations to deduct stock option expenses when exercised in an amount equal to the income declared by the individual exercising the option and replace it with a new Section 162(q), which would require companies to deduct the stock option expenses shown on their books each year.

Finally, the legislation 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 make it clear that the new tax deduction would not apply to any stock option exercised prior to the date of enactment. The bill would also allow the old Section 83 deduction rules to apply to any option which was vested prior to the effective date of FAS, 123R, June 15, 2005 for most companies and exercised after the date of enactment.

For stock options that vested after the effective date of FAS 123R and were exercised after the date of enactment, the bill employs another rule. Under FAS 123R, these corporations 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 bill would allow corporations to take an immediate tax deduction in the first year that the bill 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).