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Employee Stock Options: Tax Loophole or Tax Deduction?

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Much has been said about some of the high profile IPOs in recent years (Zynga, Facebook, Groupon, LinkedIn) questioning whether the tax deduction that the corporations are receiving is justifiable when the companies have a pre-tax income.

Facebook is an excellent example. Pre-tax, they managed to swing to a profit. After income taxes, they are to receive an approximately $500 million refund.

There are a couple of reasons for this situation:

Net Operating Loss carry forward

Net Operating Loss carry forward (not the subject of this blog post) occurs when a corporation has a loss in prior years. The Tax Code allows this loss to be offset against future profits for a certain period of time.

Equity Compensation Tax Deduction

The Tax Code allows a corporation to deduct the actual value of exercised stock options. This has become a contentious issue. Senator Carl Levin (D–MI) has proposed a bill which would eliminate the corporate tax deduction for exercised stock options.

This blog entry will focus on the arguments surrounding the debate concerning the deductibility of exercised non-qualified Employee Stock Options (ESOs).

GAAP Booked Expense versus Income Tax Expense

According to FASB ASC 718, employee stock option compensation expense is determined by generating a fair value of the option and expensing that fair value over the requisite service period. FASB does not require a specific option pricing model be utilized, but the model must contain at least the underlying stock price, exercise price, expected term, expected volatility, risk-free interest rate, and expected dividends. The compensation expense for equity compensation will be the fair value of the option multiplied by the number of options granted. There are some other calculations involved, such as the estimation of forfeitures. We will not be with estimated forfeitures for the purposes of this blog post.

The actual taxable expense when the non-qualified employee stock options are exercised is the spread between the exercise price and the fair market value of the stock on the exercise date. If the taxable expense at the time of exercise is greater than the fair value of the employee stock option that was expensed at the grant date for GAAP purposes, the company would obtain the resulting deferred tax asset and deferred tax benefit. This would result in a different income / loss bottom line number on the financial statements compared to their Federal income tax returns.

What Senator Carl Levin is proposing

Starting in 2011, Senator Carl Levin proposed the Ending Excessive Corporate Deductions for Stock Options Act. The Act, which has been reintroduced in 2012 and 2013, would require companies to book an income tax expense that would be no greater than the compensation expense (fair value of the options as of the grant date). He stated an example where Facebook CEO Mark Zuckerberg had options on Facebook stock that were expensed at $.06 per share over the prior financial years. When Facebook stock went public, the stock traded in a range from $42.00 to the low $20’s.
Currently (as of this writing), Facebook is trading at $27.13 per share. Senator Levin is suggesting that instead of the difference between $27.13 and $.06 per share ($27.07) be expensed on Facebook’s 2013 tax returns, Facebook should only be able to expense $.06 per share.

Pros and Cons of the Levin Proposal

The pros of requiring public companies such as Facebook to expense only the fair value at time of grant would be increased tax revenue to the United States Federal Government, State Governments, and Local Governments. Supporters of this proposal point out those public companies should not be able to claim a large difference ($27.07 per share) income tax expense compared to GAAP book expense ($.06 per share). Supporters state that this would bring an additional $25 billion in tax revenue over the next 10 years.

The cons are as follows: Many tech companies, including Facebook, grant stock options and equity compensation as a way to entice talented employees to work for a start-up company. Mature companies utilize equity compensation to retain employees from defecting to competitors and align to employee interests with shareholder interests. Opponents to the change in tax law would also point out that when an employee exercises a non-qualified employee stock option, they are paying individual ordinary income taxes (as high as 39.6%) on the spread between the exercise price and the fair market value of the employee stock options. Also new in 2013 is the additional Medicare Tax of 3.8% if an individual’s Modified Adjusted Gross Income (MAGI) is above $200,000 ($250,000 for married filing jointly). Ordinary Income such as non-qualified stock option exercise is also subject to Social Security Taxes, Medicare Taxes, and Federal Unemployment Taxes. This, in the opinion of many tax experts, would amount to another form of corporate double taxation, similar to the taxation of ordinary dividends.

Summary

There is much debate over the taxation of non-qualified employee stock options. This has become an important issue within the overall framework of income tax reform. Employee stock option taxation is not an issue which can be explained with “sound bites.” The topic needs to be explained properly so that all affected parties understand the potential consequences of any proposal. Although there are merits to both arguments on reforming the corporate taxation of employee stock options, a measured approach is needed so that companies would be able to continue to attract key talent and retain key employees.



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