Congress to Close Stock Option Expense Tax Loophole?

The WSJ reports that Sen. Carl Levin (D. Mich) is up in arms about a tax loophole that gives technology and other heavy-option-granting companies a financial advantage over their cash-comp brethren. The loophole saves companies billions in cash taxes, and if it is closed, the tech business will become more capital intensive.

The current tax code allows companies to deduct the cost of options against taxable income when they are exercised--by treating the employee's gain on the option (the difference between the exercise and strike price) as compensation expense. This makes sense, because the cost is compensation expense. The trouble is the that, on GAAP and pro-forma income statements--the income statements that investors see--companies expense options using Black Scholes or another option valuation method. This usually results in the option income statement expense being far less than the option expense reported to the IRS (The WSJ reports that from 2002-2006, the option expense reported to the IRS was 7 times the amount reported on income statements).

There would be two ways to close this loophole: 1) force companies to show the same larger expense on their income statements as they do to the IRS (i.e., reduce GAAP profits), or 2) force companies to use Black Scholes, et al, for tax reporting. Since the latter method would result in higher taxes, it is likely the solution that Congress would pursue.

Comments

[Paul Meisel]

And they would be right, for once!

[john olagues]

Mr. Blodget, I am sorry to say does not understand nor does Senator Levine and his staff what the situation truely is.

1. When the options are exercised, the company writes off for tax prposes the intrinsic value (i.e. the difference between the exercise price and the stock's market price on the day of exercise).

2. When the options are exercised, the employee gets a current liability for the same amount that the company writes off. So the tax collector collects approximately the same from the employee as the company gets a credit.

3. The net income to the tax collector is the same as if the company paid $100,000 in cash as a salary to the employee.

4. If the Congress changes the tax collection method to tax the theoretical value of Black Scholes at grant day (appropriately discounted for the options being ESOs rather than listed calls), there would be no gain to the tax collector because the income to the employee would be the same as the deduction to the company. Therefore no gain to the tax collector.

5. The fact that the amount written off by companies for tax during the period of 2002-2007 is seven times as great as the expense against earnings during that period was expected, although the re-statement of earnings due to admitted backdating has perhaps changed that ratio. It was expected because effectively no deductions against earnings were required by FASB and the SEC prior to 2006.

6. If and when the congress wished to close the gap between expenses reported against earnings and expenses reported for tax purposes, there is an easy method.
Congress chose to use theoretical pricing models to value employee options at grant day as an expense against earnings, perhaps as a result of lobbying by accountants and optons plan designers and mathematicians who wanted to increase their revenues .

It certainly has not clarified matters. All one has to do is look at Google's 10-K and see if anyone can determine what was the company's compensation expense for the past three years. Its impossible by analysing the reported data.

Senator Levine has gathered together the same gang of tired advisors from the SEC or formerly from the SEC and executives from companies to investigate the tax gap. He will get nowhere.

John Olagues

[Augustus]

The whole problem is that no one can really know what an option may eventually be worth. However, even knowing that, the companies are required to show an expense on the reported financials when options are granted. If they are never exercised, what was the expense?

To the extent that the option is exercised, the company takes an expense for tax purposes (not public reporting) for the difference between the exercise price and the market value of the shares. As noted, the employee pays ordinary income taxes on that same amount. The individual's rate may even be quite a bit higher than the corporate rate. Sen. Levin likes that, of course.

What he wants to do is to effectively double the taxes collected on the options, compared to the current situation. He should not be allowed to vote in any general election, let alone in the US Senate.

[Paul Meisel]

Look, if Black-Scholes is good enough for GAAP, then it should be good enough for the IRS. If it isn't, then what the hell are we doing?

It doesn't double the taxes -- it recognizes revenue and expense in the same way the company does.. its a goose and gander thing.

What's wrong with paying taxes on a profit? And if the options are worthless until exercised, why do executives want them? Because they think they are getting an extra sweet deal, that's why. (And I include myself.)

If something doesn't make sense from a business point of view without preferential tax treatment, we should think about the public policy (not private gain ) reasons for doing it at all.

This wouldn't eliminate options -- it would bring them (and executive comp) back into balance. We'll all be better off without the Nardelli's, the backdaters, and the "greedy CEO" headlines.

[Augustus]

Black Scholes creates a fictional value. It was not good enough for GAAP - until it was decided that increasing the fiction in income statements was OK, considering how much fiction was already in there. And there was not another/better tool to use to come up with the estimation. Valuation of options is an exercise in complete estimation.

As to doubeling the taxes - Yes, the end result of the Levin approach would be an increase in taxes from the present system. Read what Olagues wrote above. The current system is exactly the same as when a salary is paid - you owe taxes on what you get paid - when you get the money. And the company can deduct it at the time of payment. Levin wants to not allow the deduction for the payment - so that the company's taxes are higher and the employee also pays taxes on the income.

The question is not "What's wrong with paying taxes on a profit?". That is being done when the options are exercised. The question is "Why should there be NO DEDUCTION by the company for the compensation that the company paid?" There is no preferential tax treatment. The company gets no deduction is the options are not exercised. Only when there is a known and recognized profit is there a tax payment by the employee and deduction by the company - just as when a salary is paid.

As to yur comment - "We'll all be better off without the Nardelli's, the backdaters, and the "greedy CEO" headlines." - my take is that we would be much better off without the greedy government confiscation of incomes that regularly distort the financial markets and all personal financial decisions. In the old, old days companies were valued based upon the dividend payments - cash to investors. Today it is multiples of revenues that create values - profits are often secondary. Executives are paid to pump the revenues and there may not be any cash for the compensation. Nardelli did a great job in growing the HD business. The market multiple shrank so that the stock value did not reflect his efforts. Sure, his compensation was extreme - however he did a great job in building the business.

[Paul Meisel]

I am a capitalist too..

But when the government decided $1 million was enough for CEOs, apparently most of the country agreed or the legislators would have been thrown out.

I happen to think $1 million is enough compensation for any employee or insider. You want more, take an equity stake right along side every other shareholder with the same rights, privileges, and risks.

Its not the economics that bothers me. Its the greed and lack of ethics... oh they changed the rule, lets find a new way around it .... oh those greedy legislators....

Nardelli negotiated a contract, legally, and stood by it. OK. What bothers me is wanting a contract like that.. why... did he need the money? No, it was all about his ego, forgetting about the fair treatment of shareholders who are after all his bosses. Were his results 10, 20 times better than someone else? No one could believe that multiple.

[Augustus]

No. You are not a capitalist. You seem to believe that you should be able to set what a salary for a chief executive should be by legislation. And further, you would punish those who make money on their options by using legislation and taxation to accomplish your goal.

You are simply a jealous statist. that seems to believe that the chief executive of a large corporstion should not make more than 1/10 th of what Katie Couric gets. She has employment responsibility for how many - her clothes dresser and hair dresser plus . . . ? She has to certify that what part of her operation is accurate?

[Paul Meisel]

A CEO is just an employee, with capital at risk incidentally.... the stockholders should set the salary, and the Congress gets to decide how much is deductible... they can still pay him whatever they want.

I am jealous of no one. I do think that some CEOs are probably overpaid, but that's their shareholder's business. How much tax the company pays is definitely Congress's business.

[Augustus]

Sure you are simply jealous. That is why you are calling for the effective double taxation on some who earn more than YOU believe is permissible. No deduction by the company - so that the company earnings are higher and so are the taxes - then also tax it again when the executive gets it.

Would your silly proposal apply to All contracts for services - professional atheletes, movie actors, surgeons? Your proposal is worse than the cure of the Alternative Minimum Tax.

[Paul Meisel]

It is not my proposal. It is the senator's, and he has been re-elected in a swing state for a number of terms... so I think he does not represent a lunatic fringe.

I recall a Republican president who presided over much more confiscatory tax rates...

And I pay AMT every year....

I think you need a laxative.

[Augustus]

It was you, in an earlier post, who suggested that $1,000,000 was a maximum salary that could be deducted. You don't understand what you are recommending when you recommend it - just as Sen. Levin does not with his proposal concerning compensation from options. Jealousy is common - I would not classify someone afflicted with it as a lunitic. Your comment that the Sen. probably has constitutents who may agree with him is a poor argument for the idea. Probably a lot of his constitutents would agree that the US Govt. should send search parties to Anarctica to search for Elvis.

Whether you pay AMT or not does not make it more or less equitable or mean that you find it an efficient way to adjust and collect taxes. If you are subject to it, then you pay it or go to prison. And, even with the AMT payer, the company employing them is still allowed to deduct the payment made for the compensation.

It is interesting that you avoid addressing the questions I raised about the taxation of high incomes earned by others who are not corporate executives. Since you raised the issue of some earned incomes being too high and deserving tax penalties, I would have thought you would have the solution well thought out. Perhaps the brain cramp the question brought on caused you to think of including something about "laxative" in your last response. I don'[t expect that it would do much to solve your thinking problems, but if you find that it does, send the prescription and a sample along to Sen. Levin. Let me know the price for the doses for the two of you and I will gladly reimburse you. I'd gladly pay it to help other Americans avoid the nonsense tax proposals that both of you are advocating.

[Paul Meisel]

I didn't suggest a $1 million max deduction for salary -- it is the present law. I agreed that his proposal to value option compensation for taxes in the same way corporations report it for GAAP is probably appropriate.

I am not avoiding any questions relevant to the original topic -- but if I wanted to hear more of your opinions I would just turn on Rush... he is more relevant and at least amusing.

[Augustus]

Your comment about the $1,000,000 max deduction is prety silly. It is contained in a tax law change that was known to be ineffective when it was passed when Clinton was ruling the country. Remember the deceptiveness of Bubba? Here is a very good article explaining how it transpired:
How Bill Clinton Helped Boost CEO Pay
A law he championed to curb compensation has backfired -- and pay packages have exploded
www.businessweek.com/m...

I don't agree wit the title - that Clinton is somehow responsible for the pay increases. However, I do agree that the entire effect of the law has been to fool the gullible into believing that there is somehow a cap. There never has been one and there was no intention for there to be one. The entire purpose was to allow the Pols to appear to satisfy the jealousies of the ignorant rabble.

You DID suggest that $1,000,000 was enough for any executive to earn. Dance out of that if you can. You continue to fail to address the issue of why you find it acceptable for entertainers, atheletes, writers, or artists to earn very high incomes but would only allow that for corporate executives when there is double taxation of the income. Try that laxative in supository form stuck in only one ear - it might work to allow enough gas to pass to cause a glimmer for you. A zip lock bag should be used on the other ear to catch any accidents. I'm not a medical expert so check with your physician before undertaking the remedy, OK?

As to your advocacy of the Rush Limbaugh program, I can only write that I maybe listen for an hour during a month. I'm glad that you are familiar with it and find it entertaining. Doesn't he have some twelve step program that promises to help people overcome the income envy that you display? Perhaps you can copy your writing in this thread and apply for a scholarship.