Media Spotlight On The Corporate Tax Deduction For Stock Compensation

Many executives are now sitting on big gains in stock options that were granted when stock prices sank to extreme lows during the financial crisis of 2008 and early 2009. Not surprisingly, this has attracted attention from the news media. Skeptical business commentators wonder whether these executives are benefiting more from the overall rising tide of the stock market than from corporate achievements. In addition, the media spotlight has also singled out the corporate tax deduction. The common media view of it is exemplified by a plaintive article in The New York Times (30 Dec. 2012):

"Thanks to a quirk in tax law, companies can claim a tax deduction in future years that is much bigger than the value of the stock options when they were granted to executives. This tax break will deprive the federal government of tens of billions of dollars in revenue over the next decade."

This notion that companies are exploiting a tax loophole does not necessarily take into account the symmetry that exists in the tax code's treatment of compensation. When an employee recognizes income from any type of compensation, the company gets a tax deduction for that same amount. In some situations with stock compensation, the government gets taxes twice. First, at option exercise (or restricted stock/RSU vesting) the employee pays taxes on the grant at ordinary income rates; later, after shares have been held, capital gains rates apply at sale. This can generate tax revenue at least equal to the tax revenue that is not received when companies deduct the value of the grant from their taxable income.

Dean Baker, the co-director of the Center for Economic and Policy Research, writes in his blog that "it is not clear that this treatment is improper." While he acknowledges that companies which granted options at market lows in 2008–2009 will benefit from the current "bounceback" of stock prices, he also points out that the reverse occurred with "options issued in the years 2005–2007 that ended up being worthless" during the downturn. To him, the real issue is that "many executives were rewarded for a run-up in strike prices that had nothing to do with their performance, [but] this is a problem of corrupt corporate governance, not the tax code."

In Congress, Senator Carl Levin has regularly proposed to limit the corporate tax deduction to the amount of the earnings charge. However, this would raise other issues in linking the tax deduction to the accounting treatment of stock options. (For example, companies would deduct the accounting value of option grants that, after vesting, are never exercised because they are underwater.) Nevertheless, companies should prepare for a potential fight over the tax deduction if Congress gets serious about tax reform.