September 28, 2007
Book/Tax Conformity for Stock Options
Posted by Victor Fleischer

Senator Levin introduced new legislation today on the tax treatment of stock options.  Under current law, companies take a financial accounting expense for stock options up front, when the options are granted (or ratably over the vesting period).  But they take a tax deduction later, when the options are exercised.  Levin's bill would harmonize the tax and financial accounting treatment.  So far so good.

But there is a bad side effect of Levin's proposal.  He may be replacing one gamesmanship opportunity with another.  Specifically, Levin's proposal severs the traditional link (in section 83(h)) between the employer's tax deduction and the employee's tax inclusion.  This too is an important matching principle that restrains gamesmanship.  By accelerating the tax deduction for the corporation to match its financial accounting expense but leaving the deferral for the employee's tax inclusion in place, Levin's proposal creates a new arbitrage opportunity which might be worse than the status quo. 

David Walker and I are writing a paper on this (tentatively) titled "The Paradox of Executive Compensation Book/Tax Conformity."  We don't yet have an SSRN-worthy draft, but here's the basic idea:

We should resist the allure of book/tax conformity, at least in the context of executive compensation. Conformity between the tax and financial accounting treatment of executive compensation seems appealing because it would restrain certain types of gamesmanship. Managers could continue to massage reported earnings, or to minimize corporate taxes, but they could not do both at the same time. By focusing on gamesmanship by the employer, however, book-tax conformity proponents overlook other elements critical to the integrity of our existing approach to taxing executive compensation, such as the importance of preserving tax rules that match the executive’s timing of income with the employer’s deduction.

Consider three potential policy goals in the context of executive compensation: (1) book/tax conformity, (2) matching the employer’s tax deduction with the employee’s inclusion, and (3) preserving a realization-based system for individual taxpayers. This Article argues that we cannot achieve all three of these goals at the same time. Rather, we must choose only two. The first goal, book/tax conformity, prevents regulatory arbitrage between the tax and financial accounting systems. The second goal prevents regulatory arbitrage between the tax treatment of employers and employees. The third goal, preserving the realization doctrine, makes the tax system more administrable and furthers other tax policy goals. Shifting toward book-tax conformity might reduce gamesmanship in one area but would increase arbitrage opportunities in another area. In light of this trade-off and other consistency considerations, we conclude that the status quo—which forgoes book/tax conformity in favor of employer-employee matching in a realization-based tax system—remains the best policy option.

Any comments or suggestions would be most appreciated.

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