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National Taxpayers Union, April 16, 2002
The Levin-McCain
Stock Option Tax Hike:
An Option Americans Can’t Afford
NTU Issue Brief 135 by Donald L. Luskin
To some taxpayers, the term "stock option" may conjure up old-fashioned
images of "fringe benefit" packages that only seem to apply to high-flying
corporate executives. The reality is, options simply amount to one form of
compensation in addition to, or in lieu of, an employee’s salary – they
provide the right to buy a given quantity of shares in company stock in the
future, but locking in today’s price.
In our modern, dynamic economy, stock options are increasingly important for
millions of workers throughout the private sector, whether in manufacturing,
services, or technology. Options give everyone a stake in the success of
American business. But now a new tax threat is emerging to endanger this
highly successful and flexible component of the American Dream.
For years reformers have tried to get companies that issue stock options to
be more forthcoming about the cost of those options in their financial
statements. Senate Bill 1940 – "The Ending the Double Standard for Stock
Options Act" sponsored by Michigan Democrat Carl Levin, Arizona Republican
John McCain, and three other Senators – masquerades as a post-Enron reform
designed to ensure that options expenses are duly reported.
But S. 1940 is in fact a stealth tax increase, and a gigantic one. And it’s
an incentive to new forms of corruption by executives and auditors.
S. 1940 would increase Cisco’s taxes by $1.16 billion based on last year’s
numbers. It would increase Oracle’s taxes by $988 million. It would increase
Sun Microsystems’ taxes by $636 million. It would raise the taxes of any
company that issues options, whether or not it’s in the technology industry.
Worst of all, S. 1940 would hit innovative start-ups the hardest – they’re
the ones who have to issue options because they can’t afford to compete for
talent with cash compensation. And it is precisely those companies that are
the engines of American growth and job creation. It’s hard to imagine a more
punitive tax policy for an economy struggling to come out of a recession.
S. 1940 works by addressing differences between how accounting rules and tax
laws treat options. Currently, companies are not required to report options
expenses at all under accounting rules set by the private Financial
Accounting Standards Board. But under entirely separate tax laws set by
Congress, they can nevertheless deduct options expenses.
The legislation resolves this supposed "double standard" by limiting a
company’s tax deduction to whatever options expense it reports in its
financial statements.
Today section 83(h) of the Internal Revenue Code allows companies to deduct
from taxable income the difference between an option’s exercise price and
the company’s stock price at the time the option is exercised – the option’s
"intrinsic value." For example, Cisco’s tax savings in Fiscal Year 2001 for
options exercised on 133 million shares with a weighted-average exercise
price of 7.43 was $1.755 billion.
Cisco deserves that deduction, because it issued stock to option-holders at
7.43 when the actual stock price was much higher. It’s not specifically
disclosed, but a reasonable guess is that the total expense giving rise to
this deduction was about $5.0 billion. That’s what it cost Cisco
shareholders to honor the company’s options obligations to hard-working
employees, and that’s the same amount for which those employees were liable
for personal income taxes or capital gains taxes.
S. 1940 would change the Internal Revenue Code by limiting a company’s tax
deduction to "the amount the taxpayer has treated as an expense for the
purpose of ascertaining income, profit, or loss in a report or statement to
shareholders..." On the surface it would seem that all a company would have
to do to preserve today’s tax deductions would be to report as an expense
whatever amount they are now deducting.
It would make the earnings they report to Wall Street each quarter look
worse, but there would be no real difference in their actual cash earnings.
But here’s the dirty trick at the heart of S. 1940: companies can't do that
– they can’t just make up accounting rules in order to get tax deductions.
That’s what Enron did, and that’s what we’re supposed to be stopping!
Honest companies are bound by the strict rules of "Generally Accepted
Accounting Principles" – or GAAP – set by the Financial Accounting Standards
Board. And there's no way under GAAP that honest companies will get the
deductions they are used to, and the deductions they deserve.
Under GAAP there are only two ways to report options expenses. One is the
"intrinsic value method" given by Accounting Principles Board Opinion No.
25. Because an option issued with its exercise price set at the current
stock price has no intrinsic value, the expense of issuing it is zero. When
it is exercised the company makes no cash outlay, so that’s a zero expense,
too. This is the method virtually all companies are already using today in
order to justify reporting a zero options expense. And zero is not a very
attractive tax deduction.
The only permissible alternative under GAAP is the "fair value method" given
by Financial Accounting Standards Board Statement No. 123. Under this
method, a company estimates the value of options when they are issued using
a computerized option pricing model – such as the Black Scholes model – and
then applies that value as an expense spread evenly over the option’s life.
Returning to Cisco as an example, Fiscal Year 2001 "fair value" option
expenses would have been $1.7 billion. That’s a lot less than the actual
economic expense of $5.0 billion, and it gives rise to a commensurately
smaller tax deduction: Cisco’s tax savings would fall from $1.755 billion to
$592 million – an effective tax increase of 1.163 billion dollars.
To put all these complicated accounting ideas in a nutshell, S. 1940 will
raise taxes by limiting the deduction for options to the lower "fair value"
when they are issued, rather than the higher "intrinsic value" when they are
exercised. If it’s not clear to you why options are worth more when they are
exercised than when they are issued, just ask yourself this question: why do
people want options in the first place? Of course, it is because they expect
them to be worth more in the future when they will be exercised than they
were in the past when they were issued.
What’s more, switching the tax deduction to "fair value" at the time of
issue creates incentives for corruption. The cost of exercise is an
objective fact. But a purely theoretical model, on which even financial
academics can’t agree, calculates "fair value". It must be fed subjective
forecasts from executives and auditors before it can come up with results.
Considering the huge tax increase that companies would bear under S. 1940,
executives would be tempted to jigger those subjective forecasts to produce
the biggest deduction they could get away with declaring.
And finally, S. 1940 raises troubling Constitutional issues. By explicitly
tying tax deductions to whatever accounting policies are set for companies
by the Financial Accounting Standards Board, Congress would be delegating to
the private FASB the power to write tax law at will. It is not proper for
Congress to delegate that power.
The issue of disclosure requirements for corporate options expenses is a
matter for further debate. There are many perspectives on this separate
regulatory issue that require careful deliberation before moving forward.
But legislating a massive corporate tax increase that would hit hardest
America’s most innovative and competitive companies – hidden under the guise
of post-Enron financial reform – would be a tragic error and a great
injustice. S. 1940 is a risky policy "option" that Congress (not to mention
the nation’s taxpayers) literally cannot afford to exercise.
About the Author
Donald L. Luskin is an Adjunct Scholar for National Taxpayers Union (NTU)
and is Chief Investment Officer of Trend Macrolytics, LLC, an independent
economics research firm serving institutional investors. Mr. Luskin welcomes
comments at
don@trendmacro.com. The
335,000-member National Taxpayers Union is a non-profit, non-partisan
citizen organization founded in 1969 to work for lower taxes, less wasteful
spending, less regulation, and accountable government at all levels. More
information on NTU’s work is available online at
www.ntu.org.
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