Levin Takes Aim at Stock Option Deductions

Stock option expensing and related tax deductions are "out of whack," says the senator, who wants companies to report the same amount to both investors and the IRS.

Once, stock options seemed a source of almost infinite wealth. Today, they seem to be the source of endless accounting debates.

In the latest twist, Sen. Carl Levin (D-Mich.) is blaming the way companies account for stock options expenses and deduct taxes for them as a major contributor to the U.S. tax gap — that is, the gap between the income that companies report on their financial statements and the income they report to the IRS. Levin is working on a bill that could require companies to report the same stock option expense to both investors and tax authorities.

Levin unsuccessfully introduced similar legislation in 1997 and 2003, but could gain more traction in the Democrat-led Congress. This time, Levin can count on increased public awareness of stock option issues, thanks to formal investigations of improperly granted stock options and the heightened scrutiny of executive pay by influential investor groups that followed disclosures of high severance packages for outgoing CEOs of poorly performing companies. Rep. Barney Frank has already re-introduced a bill designed to pare down excessive executive compensation that passed the House earlier this year. That legislation would give shareholders a nonbinding, advisory vote on executives’ pay packages.

Because of differences between tax and GAAP accounting, companies typically report different financial results to investors and the IRS. In a hearing of the Permanent Subcommittee on Investigations on Tuesday, however, Levin said stock options are the only form of compensation method that allows companies to report two different sets of figures on their financial statements and their tax returns. “In most cases, the resulting tax deduction has far exceeded the expense shown on the company books,” he said.

Under GAAP, companies account for stock-option expense based on the fair value of the options at the date they are granted to the employee and amortize that amount over the vesting period. However, the company’s tax deduction is not taken until the employee exercises the options — at which point the company’s deduction mirrors whatever amount the employee declares as income from the exercised options. If the stock performed well over the life of the option, the company is likely to deduct an amount that is higher than the amount expensed for GAAP purposes.

At the same time, companies can take a financial hit from options that remain underwater — that is, options that expire before the stock price makes them worth exercising. In that case, companies record a fair value expense under GAAP, but never get to deduct the expense from their taxes. “The possible financial impact on an individual company of a large number of unexercised stock options is additional evidence that stock option accounting and tax rules are out of kilter,” Levin said Tuesday.

Under Levin’s plan, the annual tax deduction would match the expenses shown on the company’s books in the same year. Thus, companies would receive their deduction earlier, and they could deduct stock options that have vested but will never be exercised. “It would treat stock options in the same manner as every other form of corporate compensation by allowing a deduction in the same year that the compensation was granted,” he said.

There’s a certain irony to the idea that stock options are one of the largest causes of a gap between GAAP and tax accounting. There is widespread agreement that the proliferation of stock options was the $1 million cap on the tax deductibility of top executives’ salaries put in place by Congress in 1993. That change to the tax code limited the amount companies could deduct for their executives’ cash compensation but exempted one compensation tool: stock options. In fact, noted Sen. Norm Coleman (R-Minn.), the committee’s ranking member, that effort drove stock option use — and the gap between the pay of executives and the average worker — to historic highs.

Indeed, until recently, companies were not required to record any expense at all for at-the-money stock option grants, making the subsequent tax deduction for option expenses all the more lucrative. In 2005, despite fierce resistance from much of the business community, the Financial Accounting Standards Board required publicly traded companies to expense their stock options and carry the charge on their balance sheets by January 1, 2006, under FAS 123R.

Based on IRS tax returns before companies were required to use FAS 123R, the book-to-tax difference between December 2004 and June 2005 totaled $43 billion. This number — calculated from M-3 Schedules, where large companies reconcile their books and tax return figures with the IRS — will likely decrease in future years now that 123R requires companies to record an expense when options are granted, according to Kevin Brown, IRS acting commissioner.

John White, director of the Securities and Exchange Commission’s Division of Corporate Finance, cautioned the committee on basing assumptions on data collected before FAS 123R went into effect. He listed several issues the committee should keep in mind when making comparisons between taxes and financial statements, including: the stock-option expense is based on fair value but the tax deduction is based on intrinsic value at the exercise date; and the decision to grant an option and to exercise it are made by two different parties (employer and employee, respectively).

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