Noting that stock options are the only type of compensation where the federal tax code lets a company deduct more than the expense shown on in its financial statements, Senators Carl Levin (D-MI) and Sherrod Brown (D-OH) have introduced legislation aligning the GAAP treatment of stock options under FASB financial accounting standards with how options are treated under the Internal Revenue Code. Importantly, the Ending Excessive Corporate Deductions for Stock Options Act, S 1375, would also eliminate the Code’s 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 Section 162(m). The Senators believe that the $1 million cap on salary deductibility is effectively meaningless without including stock options. (see Cong. Record, July 14, 2011, pps. 4616-4620.
U.S. stock option accounting standards and federal tax regulations are at odds with each other. FASB accounting standards require companies to expense stock options on their books on the grant date. Federal tax regulations require companies to deduct stock option expenses on the exercise date. Companies 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 the stock options granted during the year, while the tax returns report on the stock options exercised during the year. In short, company financial statements and tax returns use different valuation methods, and value resulting in widely divergent stock option expenses for the same year.
FASB rules value stock options on their grant date, while the Code values stock options on their exercise date, two numbers that rarely match. Over a five year period, from 2005 to 2009, the latest year for which data is available, IRS tax return data shows that corporate stock option tax deductions have exceeded corporate book expenses by billions of dollars every year, with the size of the excess tax deductions varying from $12 billion to $61 billion per year.
While calculating the cost of stock options may sound straightforward, noted Senator Levin, for years companies and their accountants engaged FASB in a battle over how companies should record stock option compensation expenses on their books. Public companies must follow US GAAP, which are issued by FASB which is, in turn, overseen by the SEC. For many years, GAAP allowed U.S. 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
Then FASB issued a new accounting standard, which was endorsed by the SEC and became mandatory for all publicly traded corporations in 2005, requiring 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.
During the years the battle raged over stock option accounting, relatively little attention was paid to the taxation of stock options. Section 83 of the Code, first enacted in 1969 and still in place after four decades, 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.
For example, suppose a company gave options to an executive to buy 1 million shares of the company stock at $10 per share. Suppose, five years later, the executive exercised the options when the stock was selling at $30 per share. The executive’s income would be $20 per share for a total of $20 million. The executive would declare $20 million as ordinary income, and in the same year, the company could take a tax deduction for $20 million.
According to the Senators, the two main problems with this approach are: first, that the deduction amount is out of sync and usually significantly greater than the expense shown on the corporate books years earlier and, second, the $20 million in ordinary income obtained by the executive did not come from the corporation itself.
In fact, rather than pay the executive the $20 million, the corporation actually received money from the executive who paid to exercise the option and purchase the related stock.
In most cases, said Senator Levin, the $20 million was actually paid by unrelated parties on the stock market who bought the stock from the executive. Yet the federal tax code currently allows the corporation to declare the $20 million paid by third parties as its own business expense and take it as a tax deduction. The reasoning behind this approach has been that the exercise date value was the only way to get certainty regarding the value of the stock options for tax deduction purposes. In the Senators’ view, that reasoning lost its persuasive character once consensus was reached on how to calculate the value of stock option compensation on the date the stock options are granted.
The legislation would bring stock option accounting and tax rules into alignment, so that the two sets of rules would apply in a consistent manner. It would accomplish that goal simply by requiring the corporate stock option tax deduction to reflect the stock option expenses as shown on the corporate books each year.
Specifically, the measure would end 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, replacing it with a new Section 162(q), which would require companies to deduct the stock option expenses as shown on their books each year.
The legislation would require that, when the company gives away something of value, it reflects that expense on its books and claims that same expense in the same year on its tax return. The company, and the government, would not have to wait to see if and when the stock options given to executives were exercised. As with any other form of compensation, the company would use FASB accounting standards to determine the value of what it is giving away, and take the equivalent tax deduction in the year the compensation was provided.
The legislation would apply only to corporate stock option deductions; noted the Senators, it would make no changes to the rules that apply to individuals who receive stock options as part of their compensation. Those individuals would still report their compensation in the year they exercise 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 corporation.
It is also important to note that the legislation would not affect current tax provisions providing favored tax treatment to incentive stock options under Section 422 of the tax Code. Under that section, 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.
Finally, the legislation contains what the Senators characterize as a generous transition rule for applying the new Section 162(q) stock option tax deduction to existing and future stock option grants. Essentially, this transition rule would ensure that stock options issued prior to the enactment date of the legislation would remain tax deductible and ensure all corporations can start deducting stock option expenses on a yearly schedule.
The transition rule would allow the old Section 83 deduction rules to apply to any option which was vested prior to the effective date of the new stock option accounting standard rule and exercised after the date of enactment. The effective date of the new standard is June 15, 2005 for most corporations, and December 31, 2005 for most small businesses. Prior to the effective date, most corporations 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 the new Section 162(q). For that reason, the bill 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 and were exercised after the date of enactment, the bill takes another tack. 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 those options, the legislation would allow corporations to take an immediate tax deduction, in the first year that the measure 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.