As I write this blog, the buzz is escalating around the imminent IPO of social media site Twitter. I don’t think there’s been this much anticipation for an IPO since Facebook joined the ranks of public companies last year. It’s like the perfect storm of variables – stock compensation, hot IPO, and the prospect of significant wealth. Yet, with every party there are “party poopers”, and the Twitter party is no different. That’s why I wasn’t entirely surprised when Senators Levin and McCain tried to crash the party yesterday with a joint statement pushing once again to eliminate the corporate tax deductions on stock compensation.
What is it this time?
It’s likely the Senators are following the lead of Citizens for Tax Justice (a left-leaning tax activist and research group), who earlier this week released results of an analysis of 11 public companies and Twitter, suggesting that the cumulative corporate tax deductions in the coming years for these 12 companies would be in the billions of dollars. So what is new and different in the latest argument that companies are somehow avoiding paying taxes on stock compensation and that this “loophole” should be avoided? Well, not much. There have been many NASPP Blogs on this topic in the past, so I’ll let you catch up on the nuances of the corporate tax deduction through those. The latest justification the Senators offer for ending this perfectly reasonable deduction appears to be that “…given the deficit and damaging sequester cuts facing this country, this corporate stock option tax deduction is the kind of tax loophole that ought to be closed.” Huh? Now this is the solution to a slew of other fiscal issues?
Another Battle in a Long War…
Senator Levin has been waging this battle for years, so it seems every time there is a new opportunity, he’ll raise the issue again, with a new twist. The reality is, and this is often overlooked in media analysis of the Senators’ calls to action, for every dollar of corporate tax deduction taken for stock compensation transactions, there is a dollar that is taxable income to an employee. Companies are not “avoiding” paying tax – the tax is being paid by the employee. Another tidbit I’ll point out is that starting January 1, 2013, the maximum individual tax rate was increased to 39.6% – higher than the highest corporate rate of 35%. So by taxing the individual rather than corporations on significant stock compensation gains, the IRS actually is likely to fare better. For example, if Mark Zuckerberg of Facebook makes $1 billion in stock compensation gains he would theoretically be taxed at 39.6% on the vast majority of his gains. Facebook would get a corresponding $1 billion tax deduction, reducing the company’s taxable income (which, let’s hypothetically say is taxed at 35%). I’m simplifying this – but you get the gist.
How Does Financial Reporting Factor In?
Another argument the Senators are raising (and not for the first time) is that stock compensation tax deductions should not exceed the amount of accounting expense recorded by the company in its financial statements. To that I say “who cares?”. Accounting and tax are two completely different animals, with completely different intents. It’s reasonable and common for the two to be misaligned.
Moving On…
I’m guessing that this latest effort by the two Senators will be short lived, just as in prior instances. Let’s hope so, or I’ll have to invest in a larger bandwagon and bigger megaphone, because I vehemently disagree with Senators Levin and McCain on this issue. I’m also getting kind of tired of the party crashing. Can’t we just bask in the enjoyment of another successful stock compensation IPO without the grumbling about corporate tax deductions? It’s time to move on.
Earlier this week, Barb blogged about her two cents on Facebook’s IPO. I know I’ve said it before, but I’ll say it again – it’s hard not to get caught up in the hype of a hugely anticipated IPO because we do stock compensation for a living. I feel like this is what it’s all about – we’re supposed to be excited about these things – this is the proof that all these dreams of riches from stock compensation can actually pay out. Of course, I do realize that Facebook’s IPO is sort of like winning the stock compensation lottery – this outcome can’t be replicated in every company, and we shouldn’t promote it like that. Yet, we can quietly relish all of the attention and focus on the rewards that stock compensation will generate for Facebook employees. So, in today’s blog, I add my $0.02 as well – bringing the total perspective on Facebook’s IPO to a whopping four cents this week.
Google Alert Overdrive
My Google alerts are brimming to the rim with Facebook references. I’m pretty sure that’s been the only topic of discussion this past week. It’s like everywhere I turn – the evening news, my inbox, the newspaper – it’s all Facebook references. Okay, so now I’m guilty of contributing to that, but we have to indulge a little, right? The nice part of receiving Google alerts is that I get snippets of a lot of different information. I wanted to share some of the interesting and fun tidbits that I encountered this week during the overload.
Test Your Knowledge
By now many of us have heard about some of the more “famous” IPO shareholders. Among them is the artist who painted the Facebook headquarters that was brought into the limelight earlier this year because he holds millions in stock options. Who else has won the Facebook lottery? Fast Company magazine had a piece last week, covering the list of “The Facebook IPO Players Club“. So, test your knowledge – who were some of the lesser publicized folks on that list? One is none other than Reid Hoffman, cofounder and Executive Chairman of LinkedIn. Apparently he recognized Facebook’s potential in the early days and is credited with introducing Mark Zuckerberg to Facebook’s first real investor. It’s said that he personally invested $40,000 in Facebook, earning him a rumored 0.5% stake. You can browse the full list for more details.
Senator Levin Gets Involved
What would a stock option windfall be without Senator Levin chiming in about the evils of the corresponding corporate tax deduction? For those who are wondering what I’m talking about, Barb has blogged about Senator Levin’s many efforts to repeal the corporate tax deduction that companies receive relative to stock options. Facebook’s IPO certainly did not escape Senator Levin’s watchful eye; in fact, in a statement from the Senate floor, he labeled Facebook as another example of why the “tax loophole” that allows companies to take stock related tax deductions should be closed. Will he ever give up? Not this week, and not this IPO.
Lawsuits Already? Really?
With so much hype around the IPO, the unfortunate thing is that there is room for failed expectations. As this blog goes to print, word is emerging that shareholders are already filing lawsuits. I won’t go into the publicized details (or speculative details) about why in today’s blog. I can’t help but think, though, about all those Facebook employees who still can’t touch their stock compensation for several months, and wonder how bumpy the ride to riches will be. Lock ups can certainly put a damper on the stock compensation windfall dream; we’ve seen it before – paper windfalls obliterated overnight by a declining stock price. Hopefully Facebook won’t face too much turmoil and it will only be a matter of time before employees convert their paper gains into reality. After all, we all love a good fairy tale and I, for one, would love to see a happy ending.
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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Just before the turning of the New Year, the New York Times printed an article about the potential for large cash windfalls to CEOs who received mega-sized stock option grants during the lowest points of the stock market downturn in 2008 and 2009. Judging from the number of Google Alerts that subsequently came to my inbox on this topic, it seems the article stirred some strong opinions, particularly about the corresponding potential corporate tax deductions.
High Value Non Qualified Stock Option Exercise = Hefty Corporate Tax Deduction
In summary, during the lowest points of stock market performance, many companies issued larger-than-usual stock option grants to their executives. Now, with the market on the rebound, and barring a relapse, many of these grants are well in-the-money and primed to generate huge windfalls of cash for the executives upon exercise. Hand in hand with large cash gains for the executive would be a hefty tax deduction for the company. Estimates run in the billions in terms of shares granted and potential dollars in gains resulting from the grants in question. According to the article, “of the billions of shares worth of options issued after the crisis, only about 11 million have thus far been exercised, according to data compiled by InsiderScore, a consulting firm that compiles regulatory filings on insider stock sales.” This seems to indicate that most of the potential windfall is still on paper, and there may be many significant stock option exercises to come.
What’s the Buzz?
Critics of the stock option tax deduction provisions within the Internal Revenue Code are already vocalizing dissent over the possibility that many companies may drastically reduce, or altogether eliminate, their tax liability due to the large sized deductions that would accompany such significant executive gains. Barbara blogged about a similar concept back in September. As I thought about this possibility, it occurred to me that this is not the only time in history that large windfalls equaled large deductions. In fact, anytime there is an uptick in a company’s stock and a stock option appreciates, there is value. This could be in parallel with market conditions, or simply because a company is performing well, or both. When that value is recognized in the form of an exercise of a non-qualified stock option, the company receives a corresponding tax deduction. Since executives are usually the employees with the largest stock grants, it’s likely that the largest corporate tax deductions typically originate from executive transactions. This isn’t a new trend.
Déjà Vu
I’m thinking back to the 1990s up through 2000 when the stock market was bullish, and feeling like I’ve been here before. Which prompts me to say “so what?” Now, before I get dozens of emails correcting me on statement, the “what” that is different in this situation is that it seems many of the stock options granted in 2008 and 2009 were particularly oversized, seemingly because of the state of the economy and miserable market conditions. In addition, many of those grants were free of performance conditions, which means that the potential windfall in many cases may be a pure reflection of a market rebound, and has nothing to do with the executive or company’s performance. That thought has stirred some buzz, and it seems likely to continue as more paper gains translate into real cash through exercises. It seems that time is upon us, or not too far into the future. This will be a topic that is bound to generate some buzz in the coming months. I wonder if Senator Levin will use this as yet another opportunity to try and get his bill (limiting stock option tax deductions to the expense recognized for them) through Congress. It seems like 2012 may be a year of epic stock option gains; we’ll just have to wait and see.