Back in August, I blogged about Senator Levin’s most recent efforts attacking the tax deduction companies claim for stock options (“Senator Levin, Still Trying,” August 9, 2011), then in September, I blogged about a study on CEOs that made more than their companies paid in taxes, which was clearly aimed at supporting Senator Levin’s position (“Corp Taxes and CEO Compensation,” September 16, 2011). Now, with the news that Facebook may be entitled to a significant tax deduction as a result of stock options awarded to founder, Mark Zuckerberg, Senator Levin gave a speech in Congress about the evils of tax deductions for stock options and again introduced legislation to limit the company tax deduction (“Senator Levin Calls for Congress to Close ‘Facebook’ Tax Loophole,” by Carl Franzen, TPN, March 1, 2012).
The Rebuttal to Senator Levin When I read this stuff, I get so frustrated I lose the ability to speak coherently and just sputter out half-sentences of outrage. Luckily, however, the folks that write the Executive Pay Matters blog at Towers Perrin are much more articulate than I am. On January 23, James Scannella pointed out a number of weaknesses in Senator Levin’s arguments (“Is It Time for a Change in the Tax Treatment of Stock Options“). A few highlights from the blog:
The company is only getting a tax deduction because the executive is paying tax on the same income–making the transaction, at worst, tax neutral for the U.S. government. It’s even possible that the executive is paying tax at a higher rate than the company would.
It isn’t necessary for compensation to be paid in cash for it to result in a tax deduction; there are other instances where non-cash compensation results in a tax deduction that no one seems outraged about.
It also isn’t uncommon for the accounting expense for compensation to be misaligned with the tax expense. The two sets of rules serve very different purposes. This, in and of itself, isn’t a argument that the tax deduction is wrong or a loophole.
Scannella also points out that, in Towers Watson’s experience, decisions regarding how and how much to pay executives are rarely driven by the timing or amount of the company’s tax deduction. Just as ASC 718 wasn’t the end of stock compensation, this legislation probably wouldn’t be either. And it could have the effect of steering more companies towards service-based restricted stock, a result that shareholders probably wouldn’t be too keen on.
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A new study reporting that some CEOs make more than their companies pay in taxes has been making a splash in the media lately. Today I offer some comments on the study.
Executive Excess 2011: The Massive CEO Rewards for Tax Dodging The study looked at the 100 highest paid CEOs in the US and found that 25 of them earned more than their companies paid in taxes. The study also found that the average pay of the 25 CEOs exceeded the average pay of CEOs at all Fortune 500 companies, but, as one criticism of the study points out: “any subset of the 100 highest-paid CEOs in the country is going to have higher average pay than S&P 500 CEOs in general,” so this isn’t exactly groundbreaking.
The study also emphasizes that most of the 25 companies received tax refunds. Maybe I’m missing something here, but I thought getting a tax refund means you paid too much in tax, the IRS earned interest on your money all year, and then gave your excess payment back without interest at the end of the year. The companies that didn’t get a tax refund were the clever ones because they earned interest on their money all year, rather than the IRS–they aren’t necessarily paying their CEOs any less.
Compensation Apples to Tax Oranges
One problem I have with this study is that CEO pay isn’t directly related to the company’s tax bill. The two amounts really have nothing to do with each other. In fact, amounts paid to the CEO are an expense to the company; expenses reduce the company’s profitability which in turn reduces the amount the company pays in taxes.
Companies that aren’t profitable don’t pay any taxes. If CEO pay shouldn’t exceed the company’s tax bill, does this mean that CEOs at companies that aren’t realizing a profit shouldn’t be paid anything? That’s really going to put a damper on the start-up market.
Don’t get me wrong, I agree with the principle that many CEOs of public companies are paid excessively–I’m just not sure that the company’s tax bill is the appropriate yardstick by which we should determine what is excessive.
Is Senator Levin Behind This?
The study includes a special side bar (on pg 7) that explains how stock options contribute to this problem by producing a tax deduction for the corporation that differs from the expense recognized for the option–something Senator Carl Levin has been trying to change for years (see my August 9 blog, “Senator Levin, Still Trying“).
The study says that “The amount of compensation the executive receives on the exercise date is often substantially more than the book expense of the options…” I take issue with this statement. I’ve never seen any data to back it up, I don’t see any data backing it up in this study, and I know that many options end up underwater or result in a spread at exercise that is less than the grant date fair value. In fact, I’d love to see an analysis comparing grant date fair value to spread at exercise for a wide range of stock options at a wide range of companies, if anyone out there wants to take the project on.
CEOs Pay Taxes Too
One reason why compensation results in a tax deduction for the company is that the individual receiving the compensation pays taxes on it. So, while the company might be getting a tax break, the CEOs are still paying tax, probably a lot of tax.
NQSO exercises are certainly subject to tax. The US corporate tax rate for large public companies is around 34% to 35% (at least according to Wikipedia–I know nothing about corporate tax rates). The highest federal marginal income tax rate in the US is 35% and I have to believe that the CEOs in the study are paying tax at this rate (plus they are paying FICA taxes and the company is paying matching FICA taxes on the income). So whether the company pays tax on the income or the CEO does, it seems like the tax revenue is about the same (maybe slightly higher when the CEO is paying the tax because of FICA).
For example, let’s say that a company earns a profit $100 million and the CEO of the company holds an NQSO with a spread of $1 million. If the CEO doesn’t exercise the option, the company pays tax on $1 billion. If the CEO does exercise the option, the company pays tax on $99 million, but the CEO pays tax on the $1 million spread–at possibly a slightly higher rate than company would have paid. Tax revenue for the US federal government is about the same either way.
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.
Earlier this summer, Senator Carl Levin (D-MI), introduced another bill that would limit corporate tax deductions for stock options to the expense recognized for them, the “Ending Excessive Corporate Deductions for Stock Options Act.” His cohort on this year’s bill is Senator Sherrod Brown (D-Ohio) (Senator Claire McCaskill, D-OH, has also signed on since the bill was introduced).
A Bi-Annual Event I say “this year’s bill” because this is becoming a bi-annual event. Levin has been introducing bills like this for at least the past 20 years. He didn’t even bother to change the name of the bill this year. In fact, just for kicks, I did a redline comparison of this bill to his 2009 bill; the two bills are almost exactly the same. His co-sponsors have varied over the years but often include Senator John McCain (R-AZ).
The bill would limit the tax deduction corporations could take for stock options to the amount of expense recognized for them (i.e., the grant date fair value). According to Levin’s press release, this would raise $24.6 billion in tax revenue over the next ten years (assuming, apparently, that the market doesn’t have too many more days like yesterday). The press release states that Levin has released IRS data showing that, from 2005 to 2009, corporations took tax deductions that were “billions of dollars” greater than the expenses shown on their financial statements.
This is surprising to me because I’m not sure how the IRS would even have this data. The tax deductions companies took in those years would relate to options that were granted in prior years–many may have been granted before FAS 123(R) (now ASC 718) even went into effect. Comparing the tax deduction the company claimed to the option expense for that year is not a valid comparison.
You can usually get an idea of whether a company’s tax deductions for stock compensation exceed the expense recorded for it from their financial statements, but most of the financial statements I’ve seen only provide this information in aggregate for all types of arrangements the company offers–stock options, restricted stock, RSUs, performance awards, ESPP, etc. Levin’s bill only applies to stock options.
Section 162(m)–No More Free Pass
The bill would also make stock options subject to the limitation on corporate tax deductions under Section 162(m). Currently, stock options are exempt from the limit by virtue of being considered inherently performance-based (because the stock price must appreciate for the option to deliver a benefit). This clearly would raise revenue–maybe that’s where a good chunk of the $25 billion comes from. What was the tax deduction your company claimed for the options exercised by your NEOs last year?
Given that, after twenty years, Levin still hasn’t had any success with this agenda, I think chances are nothing will happen with this bill either, so I don’t expect it to be a hot topic at this year’s NASPP Conference. But you can catch up on all hottest tax topics–straight from the IRS–with the session “The IRS Speaks” at the 19th Annual NASPP Conference.
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NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.
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