December 30, 2011
The NYT had an interesting piece on a provision in the tax code that allows companies to write off the value of exercised options as employee compensation. This is deducted from profits and reduces their taxes accordingly.
It is not clear that this treatment is improper. In principle, the value that the company is paying the executives getting options is the value of the option at the time it is issued. For example, if a company’s stock is current valued at $10, an option to buy the stock at any point in the next five years for $10 a share, may be worth $5. In principle, an award of 1 million options would then be worth $5 million. This is what the company should deduct from its profit at the time the options are issued.
However, the story described in this piece is that companies don’t make any deduction from profits when they issue the options (meaning they pay more in taxes in the year of issuance then they actually should), but then deduct the value of options when they are redeemed. This means that if the stock price rises to $30, in this case the company would deduct the $20 million gain on the options (one million $30 shares being sold to the executive for $10) from its taxes. As the piece notes, this is not very different from a situation in which the company just paid the executive with $20 million in stock.
In principle, this tax treatment should be symmetric with the tax treatment where the value of the options is deducted from profits at the time they are issued. The article notes many cases with executives getting large windfalls and companies thereby getting large write-offs due to bounceback from the low stock prices of 2008-2009. While this is true, there were many options issued in the years 2005-2007 that ended up being worthless since the current value of the stock is below the strike price.
There is an issue that many executives were rewarded for a run-up in strike prices that had nothing to do with their performance, however this is a problem of corrupt corporate governance, not the tax code. It is easy to write contracts that would only reward executives for their performance relative to a reference group so that they do not benefit from an economy-wide improvement. However, this is rarely done because corporate boards are often appointed by top management and have little incentive to reduce their pay.
It is likely that stock options cause problems in national income accounting, since this is one of the ways in which capital gains income is likely to end up being recorded as normal income, leading to an overstatement of the income side measure of GDP when the stock market rises rapidly.