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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Comments (8)

1. Posted by Jake on September 28, 2007 @ 19:17 | Permalink

Vic neatly points out that a 2/3 policy solution is the best we can hope for. This paper is something to look forward to.

2. Posted by M. Hodak on September 29, 2007 @ 10:41 | Permalink

I'd be interested in an example of the type of gamesmanship you (or Levin) are presuming happens under the current book/tax discrepancy with regards to FAS123R compliance.

3. Posted by Vic on September 29, 2007 @ 16:36 | Permalink

It's been alleged that companies lowball the option expense by, for example, assuming low volatility in the input to the model. Because the tax deduction is measured later, at realization, the lowball estimate for acct purposes does not limit the tax deduction.

4. Posted by Michael Guttentag on September 30, 2007 @ 10:24 | Permalink

I am with Marc Hodak in wondering whether the current situation that allows some “regulatory arbitrage between the tax and financial accounting systems” is sufficiently problematic to merit legislative action. My recollection is that requiring book/tax parity is the exception and not the rule, and my guess would be that this particular disparity is not an especially large financial issue (any evidence?). If anything, it seems like an accounting ruling on appropriate option cost pricing could address the problem. I know this is the conclusion that you two expect to reach, but I’m not sure it’s worth a full paper to get there.

5. Posted by Jake on September 30, 2007 @ 16:50 | Permalink

Book/tax parity is the rule, not the exception. Section 446(a) of the Code provides:

(a) General rule.--Taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books.

Of course, Congress hoses up this general principle by prescribing a myriad of exceptions.

As to whether there is evidence that differing book/tax treatment of stock options is a significant financial issue, one might check out the tax footnotes in the financial statements published by companies that use stock options. Often the difference is sufficiently material as to require a footnote disclosure of the book/tax disparity.

6. Posted by M. Hodak on September 30, 2007 @ 19:19 | Permalink

I'll start by saying that I agree with Vic's conclusion that goals (2) and (3) should dominate, i.e., the book/tax differential should be left alone. But the reason I agree has to do with the irrelevance of the book/tax gamesmanship, at least when it comes to this accounting rule.

As someone who advises companies on incentive compensation matters, I can take the "alleged" out of Vic's comment and state positively that most companies game to minimize their reported "cost" of options. But as someone who works for the shareholders, not the managers, I don't care, except for the amount of time managers might be wasting trying to disguise a non-cash expense instead of actually running a business.

Jake's post that the difference between book and tax treatments being footnoted because it's material (or vice versa) is not really true. It would be footnoted if the discrepancy was just a few dollars simply because it's required by the SEC. It's a testament to how much incentive compensation costs have gotten politicized, not to their materiality.

The fact is that no sophisticated shareholder is helped or hurt by this accounting rule, so any gamesmanship about a non-cash event is largely academic. Gamesmanship around an event with cash flow implications, like tax timing, has real consequences for everyone. That's why I agree with Vic's conclusion (if not his reasoning in this particular case).

7. Posted by Jake on October 1, 2007 @ 20:28 | Permalink

M. Hodak evidently has never had to draft the tax footnote in a 10-K, and accept responsibility for it.

I otherwise agree that sophisticated investors generally should pay no serious attention to the choice of an accounting rule for employee stock options (other than tax considerations).

8. Posted by importance of taxes on July 26, 2012 @ 21:02 | Permalink

Hi Victor, thanks for sharing, i learn a lot from this post. I will definite re share this. Looking 4ward for more post from you

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