Memorandum

 

To:	Friends of ABC
From:	John Endean
Date:	February 26, 2002

RE: "Ending the Double Standard for Stock Options Act"

Senators Carl Levin and John McCain recently introduced S. 1940, the "Ending the Double Standard for Stock Options Act." I'm not much of a legislative handicapper, but friends of mine who are tell me that S. 1940 has a chance of passing the Senate. Before it is voted on, the bill is worth a second, skeptical, look. I'm not interested here in what the bill might mean for the distribution of stock options, but what it would portend for the corporate income tax.

Stock options are a right conferred by a corporation to individuals (usually employees) to purchase a stated amount of the company's stock at some specified future period, at an agreed upon price per share -- the "strike price." The strike price is usually the price of the company's stock on the day the option is conferred. Recipients of stock options hope that the corporation's share price will rise over time so that when they are free to exercise their options they can acquire the stock at a discount (the difference between the current price and the original strike price).

When employees exercise their stock options, they must report as income the difference between the current price of the stock and the strike price and pay tax on that difference at the individual rate. The corporation, in the meantime, takes a deduction on its corporate tax bill for the same amount. The tax treatment is thus symmetrical and the difference between the current stock price and the strike price is, as a result, taxed once and only once.

Senators Levin and McCain would break this symmetry by discouraging corporations from taking the deduction, thereby imposing a second layer of taxation on exercised options. Why do they want to do that? It has nothing to do with tax policy per se. The answer is that they want to influence the accounting treatment of stock options.

At present, for accounting purposes, corporations do not have to expense the value of stock options when conferred. The Senators, who happen to dislike this accounting rule (FAS 123, to be exact), would permit the corporate tax deduction only to the extent that a corporation has previously expensed those options on its P&L statement. Corporations that do not expense options for accounting purposes could not take the tax deduction when those options are exercised.

If this proposal rings a faint bell, it should. In 1997, the two Senators introduced similar legislation, S. 576. That bill created a brief stir before dropping out of sight. This time around, the Senators have tried to add juice to their bill by associating it with legislative reform efforts launched in the wake of the Enron fiasco.¹ Enron is a great bloody shirt, and it's hard to blame the Senators for waving it, even though stock options accounting had nothing to do with that firm's collapse.  

Some might wonder why the Senators have resorted to the legislative equivalent of a bank shot to change the accounting for stock options. Why not just propose a law mandating that companies expense the options they issue instead of monkeying around with the tax code to coerce companies toward the same goal?

I suppose the Senators want to avoid being accused of trying to legislate accounting standards. The setting of accounting standards in this country falls to the Securities and Exchange Commission (SEC) and, through the SEC, to the Financial Accounting Standards Board (FASB). FASB and its acolytes are very jealous of the Board's prerogatives. No one, however, questions Congress's power to change the tax code. By focusing on the tax treatment of options, Senators Levin and McCain can thus alter the application of an existing accounting standard without quite seeming to. ²  

Of course, we can all think of instances when Congress has tweaked the tax code to encourage specific kinds of behavior. That impulse, applied over the years in innumerable ways, is one of the main reasons that the corporate income tax in particular is such a complex mess. The Levin-McCain stock options bill fits neatly into this long tradition of mucking up the tax system to achieve non-revenue-raising ends.

And make no mistake: if enacted, S. 1940 would create inequities and confusion. To begin with, as I have already noted, it would apply a double tax to exercised options - once at the personal level and again at the corporate level.

Second, it raises the possibility - a near certainty, actually - that companies with similar stock options policies and similar earnings would have different tax bills and different P&L statements. Company A, for example, might choose to expense its stock options with the intention of enjoying a future tax deduction when the options are exercised. Company B, on the other hand, might take the opposite course. It might forego the future tax deduction in order to avoid expensing its options at issuance. The result would be a considerable loss in the comparability of the financial statements of the two firms and a corresponding increase in confusion for individual investors. Isn't that supposed to be a bad thing?

Along these lines, it is also quite probable that S. 1940 would favor larger, older corporations over younger, midsize and small firms. Big companies that have been around for a while have typically accrued all sorts of credits, net operating losses, and other goodies that permit them to reduce, and often eliminate, their corporate tax liabilities.³ And they have the lobbying power to create for themselves more of such benefits to enable them to manage their tax payments. They are thus in a position to avoid expensing their stock options at issuance and to avoid suffering a tax penalty down the road for doing so. Smaller companies, and, in particular, start-ups, do not possess this sort of, shall we say, flexibility. They will be the firms that Levin-McCain will kick in the teeth.  

These are only the obvious problems raised by S. 1940. The deeper problems will become evident if the bill passes and the tax and compensation experts at the big companies and the hotshot consulting firms get down to work. I'm not a lawyer so I'm not smart enough to know what sort of game playing will occur. I do know that when you give a company the choice of paying a tax or accepting a deduction, as the Levin-McCain bill does, game playing will go on. On tax matters, the private sector is always smarter than the public sector.

In saying all this, I'm not criticizing either Senator Levin or Senator McCain for their impatience with the current standard for accounting for stock options, although I do disagree with them. It just seems to me that there are standard-setting bodies - the International Accounting Standards Board (IASB) and the FASB - that are well equipped to revisit the existing standard. In recent testimony before the Senate Banking Committee, the head of the IASB made it clear that his group was well down the road toward doing just that.

Why not let this process proceed without legislative intrusion? Why complicate further the corporate income tax, which is already, in so many ways, a failed instrument? The Senate, despite the furor over Enron, would be wise to reject S. 1940.

¹  In 1997, the Senators were concerned about "excessive" CEO compensation. They believed top-heavy options policies, particularly at very large corporations, encouraged that excess. The 1997 bill contained a very important exception not present in the new legislation. It would have retained the deduction for companies that did not expense their options if those companies distributed options broadly throughout their workforce. And, coincidentally enough, throughout the 1990s, the distribution of stock options at many American corporations did broaden markedly, a development the Senators apparently no longer value. ²  I doubt that many are taken in by this. But Levin and McCain are unlikely to be hammered for trying to change existing accounting standards. That's because, based on my highly unscientific survey, most of the establishment press believes stock options should be expensed. See, e.g., Sebastian Mallaby "The Options Outrage," The Washington Post, February 25, 2002, p. A 23. Mr. Mallaby performs the neat trick of criticizing Silicon Valley for its opposition to the FASB's efforts, in the 1990s, to force the expensing of stock options while praising Senator Levin for trying to "close the options loophole." But surely both efforts to influence accounting rules have much in common, their main difference being the not insignificant fact that Mr. Mallaby agrees with one side and disagrees with the other. ³  I remind the reader, perhaps superfluously, that corporations do not actually "pay" the corporate income tax. Only people can pay taxes; corporations merely collect it. More about this in a forthcoming, much-feared, much-anticipated memorandum.

Home

Policy Statements

Press Releases

For more information about membership in American Business Conference or about our advocacy, contact Andre Thomas or email: abc@americanbusinessconference.org

American Business Conference
1730 K Street, NW Suite 1200
Washington, D.C 20006
202-822-9300
202-467-4070 Fax

This page was last updated 02/26/2002 and designed by www.cobbwebbs.com.