Kara Scannell and Sarah Lueck at the WSJ report Senator Levin's desire to close the book-tax gap with respect to stock option expensing.  For a long time, companies reported no compensation expense for financial accounting purposes.  Financial accounting rules now require companies to estimate the value of options at the time of grant and report that amount as a compensation expense, which reduces reported earnings.  The tax treatment of options, however, has remained the same all along.  Companies take no deduction at the time of grant.  Instead, they wait until those options are exercised, and then take a deduction for the difference between the market value of the stock and the strike price.  If the stock price appreciates and the options become valuable, then this results in a larger deduction. 

Some folks have started to wonder ... if we can value options at the time of grant for financial accounting purposes, then why not for tax purposes?  Should we allow companies to report low option values (at the time of grant) for financial accounting purposes, but high value (at the time of exercise) for tax purposes?

Book-tax conformity is an appealing concept.  But the devil is in the details.

Revenue.  First, it's worth noting that this may not be as big a revenue-raiser as Senator Levin thinks.  Under current law, options which go unexercised generate no tax deduction for the employer.  Some options never vest (employees sometimes get fired or leave the company), and not every company's stock appreciates.  If we allow a deduction at the time of grant, companies would get a deduction for the option value up front, even though some options will turn out to be worthless. 

Pigouvian Tax on Accounting Gamesmanship.  Of course, if we do get book-tax conformity, and managers care more about the earnings reported to shareholders than they do about the earnings reported to the IRS (and there's considerable evidence that this is the case) ... then managers may understate the value of the options for both book and tax purposes.  This is a nice example of reverse regulatory engineering -- the government using financial accounting incentives to restrain tax gamesmanship (and vice versa). 

Put another way, it's like a Pigouvian tax on accounting gamesmanship.  In the same way that a carbon tax would reduce unwanted carbon emissions, book-tax conformity would reduce unwanted inflated  reported earnings to shareholders.  What's dangerous, though, is that it could lead to depressed reported earnings, which can create its own problems in the capital markets.  For this to work, Congress might want to limit any proposed change to publicly-traded companies. 

Section 83 and the Matching Principle.  Second, book-tax conformity at the corporate level might conflict with the general matching principle of section 83 of the code.  Under section 83, employer deductions and employee inclusions are supposed to happen at the same time.  We don't worry so much about income deferral for employees because employers have to wait to take a deduction.

But if we accelerate the employer deduction, following the matching principle here would require that employees include the value of unvested options as income at the time of grant.  That would be quite a departure from our realization-based tax system.  This problem is conceptually identical to the problem of how to tax a profits interest in a partnership.  We know that the property is valuable to the employee at the time of grant, but its value depends on the performance of services that the employee has yet to perform.  Taxing unvested options would be similar to an endowment tax -- a tax on unrealized human capital -- rather than an income tax.   Taxing the employee up front also creates a liquidity problem.

So we'd probably have to de-couple the employer's deduction (which would occur at the time of grant) from the employee's inclusion (which would occur at the time of exercise).  Another possibility, I suppose, would be to apply my "cost-of-capital" method and impute an annual interest charge to the employee, reflecting the leverage embedded in an option.  This hardly seems worth the complexity, though.

De-coupling the timing of the employer deduction and the employee inclusion seems dangerous; tax lawyers are awfully good at exploiting these gaps.  Thinly-traded companies that don't care much about reported earnings could report high option values, generating large tax deductions. 

Summary.  In sum, we should generally strive to have both the accounting treatment of a transaction and the tax treatment of a transaction track the economics of a transaction as closely as possible.  In this case, though, it may not be possible for the tax law to get all the way there.  Stock options may be the unusual case where a book-tax gap is hard to avoid.  I'm willing to be persuaded, though, if someone can work out the mechanics in a way that makes sense. 

I'll try to work this into my "Sweat Equity" research project this summer. 

Recommended Reading:

Mihir Desai & Dhammika Dharmapala, Taxation and Corporate Governance: An Economic Approach (Summarizing the "agency cost" view of tax and corporate governance; this literature shows that tax gamesmanship and accounting gamesmanship tend to accompany one another.  Book-tax conformity, while increasing tax payments, may actually help shareholders as well by reducing managerial opportunism)

David Walker, Financial Accounting and Corporate Behavior

Victor Fleischer, Options Backdating, Tax Shelters & Corporate Culture

Link to Today's Committee Hearing

Taxation

TrackBack URL for this entry:
http://www.typepad.com/t/trackback/38673/19058164

Links to weblogs that reference Stock Options and Book-Tax Conformity: