Congress to Close Stock-Option Tax Loophole?

WSJ reporting that Sen. Carl Levin (D. Mich) is up in arms about a tax loophole that gives technology and other heavy-option-granting companies a financial advantage over their cash-comp brethren.  The loophole saves companies billions in cash taxes, and if it is closed, the tech business will become more capital intensive.

The current tax code allows companies to deduct the cost of options against taxable income when they are exercised--by treating the employee's gain on the option (the difference between the exercise and strike price) as compensation expense.  This makes sense, because the cost is compensation expense.  The trouble is the that, on GAAP and pro-forma income statements--the income statements that investors see--companies expense options using Black Scholes or another option valuation method.  This usually results in the option income statement expense being far less than the option expense reported to the IRS (The WSJ reports that from 2002-2006, the option expense reported to the IRS was 7 times the amount reported on income statements).

There would be two ways to close this loophole: 1) force companies to show the same larger expense on their income statements as they do to the IRS (i.e., reduce GAAP profits), or 2) force companies to use Black Scholes, et al, for tax reporting.  Since the latter method would result in higher taxes, it is likely the solution that Congress would pursue. 

Comments

[Tijana Dvornic]

Interesting that this is now all of a sudden becoming an issue. I would be interested to hear any opinions on why this is the case.

First off, this has been reality for a while, and also to a much greater extent than it is today. In fact it is only recently that accounting rules have been revised to require companies to deduct any option related compensation expense at all on their reported income statements.

Second off, it would be nice if option expensing was the only line item whose amount diverges greatly between the investor/accoutning books and the tax books. For instance, the (deliberately devised) differences between depreciation rules alone cause enormous differences between the tax and book bottom line. And directly contrary to the option "goodies", accelerated depreciation for tax purposes benefits capital intesive companies (for instance auto makers).

I don't know how much the option expense deduction can be seen as a loophole - as the post correctly points out, this expense is in fact compensation expense and so it is properly deductible. The issue really is about the book/tax divergence and this has been a hot topic in tax literature and academia for some time. Personally I think that shrinking the gap would be a good thing, the problem politically seems to be that since you have to start somewhere, someone is always worse of initially. So, should we focus on tech companies or auto companies? I suppose the answer to that question is well beyond the scope of this comment, but it is still improtant to get the initial question right.

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