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US Lawmakers Want Changes To Stock Option Accounting Rules

by Leroy Baker, Tax-News.com, New York

07 June 2007


A Senate subcommittee hearing on the vexed issue of executive stock options has concluded that new tax and accounting rules are needed to bring more transparency for investors regarding CEO pay, and to rein in huge and undeserved salaries enjoyed by some bosses at non-performing companies.

The hearing, held by the Senate’s Permanent Subcommittee on Investigations examined corporate accounting and tax rules that require corporations to report one set of stock option compensation figures to investors on their financial statements and completely different figures to the Internal Revenue Service on their tax returns.

Three Fortune 500 companies that were among the nine who helped the Subcommittee with its calculations contributed to the hearing, along with the Acting Commissioner of the IRS Kevin Brown, the SEC Director of Corporation Finance, and three stock option experts.

“Stock options are a major factor in the growing gap – now chasm – between executive pay and average worker pay,” said Sen. Carl Levin (D - Mich), subcommittee chairman. “Companies pay their executives with stock options in part because, right now, those stock options often generate huge tax deductions that are 2, 3, even 10 times larger than the stock option expense shown on the company books."

Levin said that nine companies examined by the subcommittee claimed stock option tax deductions over five years that exceeded their stock option expenses by more than $1 billion, or 575%, even after using tougher new accounting rules to calculate the book expense.

New IRS data, examining tax returns for periods ending between December 2004 to June 2005, shows a stock option book-tax gap of $43 billion, "which means US companies legally reduced their taxes by billions of dollars for that period by claiming $43 billion more in stock option tax deductions than the stock option compensation amount shown on their books," Levin stated.

"Those companies did not break the law," he continued. "They are benefiting from an outdated and overly generous stock option tax rule that produces tax deductions that often far exceed the companies’ reported expenses.”

Stock options give employees the right to buy company stock at a set price for a specified period of time, usually 10 years. According to Forbes magazine, in 2006, the average pay of the chief executive officers of 500 of the largest US companies was $15.2 million. Nearly half of that amount, 48%, came from exercised stock options that produced average gains of about $7.3 million. On the high end, one CEO cashed in stock options for $290 million, another for $270 million. Forbes also published a list of 30 CEOs in 2006, who each had at least $100 million invested stock options that had yet to be exercised. In the United States, average CEO pay has grown from100 times average worker pay to nearly 400 today, according to Levin.

“Stock options are valuable and legitimate incentive tools used to reward and retain high performing executives,” said Norm Coleman (R - Minn), ranking member of the subcommittee. “However, anything can be problematic in excess, and I fear we have reached that point. It is clear that favorable tax and accounting rules have caused companies to issue far too many stock options on far too generous terms, greatly contributing to the meteoric rise in executive pay."

Publicly traded corporations are required by law to follow Generally Accepted Accounting Principles (GAAP) issued by the Financial Accounting Standards Board (FASB), which is overseen by the Securities and Exchange Commission (SEC). Until recently, GAAP allowed corporations to show a zero expense on their financial statements for most stock options. In 2005, FASB issued a new accounting rule, Financial Accounting Standard (FAS) 123R, requiring companies to show an expense on their books equal to the stock options’ fair value on the date they are granted.

Under Section 83 of the tax code, first enacted in 1969, the stock option tax deduction does not reflect the expense shown on a company’s books. Instead, the stock option deduction is calculated on the date that a stock option is exercised, which is often years after it is granted. The deduction is equal to the difference between what the employee paid to exercise the option and the market value of the shares on the exercise date.

Because the accounting rule values stock options on their grant date, and the tax deduction values stock options on their exercise date, the two numbers do not match. The data indicates that, in most cases, the tax deduction exceeds the book expense. Stock options are the only type of compensation expense where companies are allowed to take a tax deduction that exceeds the expense shown on their books.

“It is time to take a serious look at whether it makes sense to have two completely different sets of stock option rules for financial accounting and tax purposes,” said Levin, “especially when the result is a revenue loss of billions of dollars.”

A comprehensive report in our Intelligence Report series examining Expatriate Taxation and Reward Structures is available in the Lowtax Library at http://www.lowtaxlibrary.com/asp/subs_reports.asp and a description of the report can be seen at http://www.lowtaxlibrary.com/asp/description_report10.asp

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