Employee Stock Options: Tax Treatment and Tax Issues

Employee Stock Options: Tax Treatment and Tax Issues James M. Bickley Specialist in Public Finance June 15, 2012 Congressional Research Service 7-5700 www.crs.gov RL31458 CRS Report for Congress Prepared for Members and Committees of Congress Employee Stock Options: Tax Treatment and Tax Issues Summary The practice of granting a company’s employees options to purchase the company’s stock has become widespread among American businesses. Employee stock options have been praised as innovative compensation plans that help align the interests of the employees with those of the shareholders. They have also been condemned as schemes to enrich insiders and avoid company taxes. The tax code recognizes two general types of employee options, “qualified” and nonqualified. Qualified (or “statutory”) options include “incentive stock options,” which are limited to $100,000 a year for any one employee, and “employee stock purchase plans,” which are limited to $25,000 a year for any employee. Employee stock purchase plans must be offered to all fulltime employees with at least two years of service; incentive stock options may be confined to officers and highly paid employees. Qualified options are not taxed to the employee when granted or exercised (under the regular tax); tax is imposed only when the stock is sold. If the stock is held one year from purchase and two years from the granting of the option, the gain is taxed as long-term capital gain. The employer is not allowed a deduction for these options. However, if the stock is not held the required time, the employee is taxed at ordinary income tax rates and the employer is allowed a deduction. The value of incentive stock options is included in minimum taxable income for the alternative minimum tax in the year of exercise; consequently, some taxpayers are liable for taxes on “phantom” gains from the exercise of incentive stock options. On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (P.L. 110-343) was enacted. This law included provisions that provided abatement of any taxes still owed on “phantom” gains. Nonqualified options may be granted in unlimited amounts; these are the options making the news as creating large fortunes for officers and employees. They are taxed when exercised and all restrictions on selling the stock have expired, based on the difference between the price paid for the stock and its market value at exercise. The company is allowed a deduction for the same amount in the year the employee includes it in income. They are subject to employment taxes also. Although taxes are postponed on nonqualified options until they are exercised, the deduction allowed the company is also postponed, so there is generally little if any tax advantage to these options. The following seven key laws and regulations concerning stock options are described: Section 162(m)—“Excessive Remuneration,” Sarbanes-Oxley Act: Stock Option Disclosure Reforms, SEC’s 2003 Requirement of Approval of Compensation Plans, FASB Rule for Expensing Stock Options, American Jobs Creation Act of 2004 (Section 409A), IRS Schedule M-3, and SEC’s 2006 Executive Compensation Disclosure Rules. This report explains the “book-tax gap” as it relates to stock options and S. 2075 (Ending Excessive Corporate Deductions for Stock Options Act) introduced by Senator Carl Levin. U.S. businesses are subject to a dual reporting system. One set of rules applies when they report financial or “book” profits to the public. Another set of rules applies when they report taxable income to the Internal Revenue Service. The “book-tax” gap is the excess of reported financial accounting income over taxable income. This report will be updated as issues develop and any new legislation is introduced. Congressional Research Service Employee Stock Options: Tax Treatment and Tax Issues Contents Background...................................................................................................................................... 1 Definition................................................................................................................................... 1 Advantages and Disadvantages of Stock Options ..................................................................... 2 Types of Employee Stock Options ............................................................................................ 3 Qualified Stock Options................................................................................................................... 3 Incentive Stock Options............................................................................................................. 4 Employee Stock Purchase Plans................................................................................................ 4 Current Tax Treatment............................................................................................................... 4 Alternative Minimum Tax ......................................................................................................... 5 Tax-Favored Treatment.............................................................................................................. 6 Payroll Taxes ............................................................................................................................. 7 Nonqualified Stock Options............................................................................................................. 8 Tax Treatment............................................................................................................................ 8 Are Nonqualified Options Tax Favored?................................................................................... 9 Key Laws and Regulations .............................................................................................................. 9 Section 162(m)—“Excessive Remuneration” ........................................................................... 9 Sarbanes-Oxley Act: Stock Option Disclosure Reforms ......................................................... 10 SEC’s 2003 Requirement of Approval of Compensation Plans .............................................. 10 FASB Rule for Expensing Stock Options................................................................................ 10 American Jobs Creation Act of 2004 (Section 409A) ............................................................. 12 IRS Schedule M-3 ................................................................................................................... 13 SEC’s 2006 Executive Compensation Disclosure Rules ......................................................... 13 Financial (or Book) Income Versus Tax Income............................................................................ 13 Proposed Legislation in 112th Congress......................................................................................... 15 Contacts Author Contact Information........................................................................................................... 17 Congressional Research Service Employee Stock Options: Tax Treatment and Tax Issues Background The practice of granting a company’s employees, officers, and directors options to purchase the company’s stock has become widespread among American businesses.1 According to Information Technology Associates, 15% to 20% of public companies offer stock options to employees as a part of their compensation package, and over 10 million employees receive them. During the technology company boom of the 1990s, they were especially important to start-up companies, allowing them to avoid paying large cash salaries to attract talent.2 Employee stock options have been extolled as innovative compensation plans benefitting companies, stockholders, and employees.3 They have been condemned as schemes to enrich insiders at the expense of ordinary stockholders and as tax avoidance devices.4 This report explains the tax treatment of various types of employee stock options recognized by the Internal Revenue Code, examines some of the issues that have arisen because of the real and perceived tax benefits accorded employee stock options, and describes key laws and regulations concerning stock options, and discusses the “book-tax” gap as it relates to stock options and S. 1375 (Ending Excessive Corporate Deductions for Stock Options Act). Definition Employee stock options are contracts giving employees (including officers), and sometimes directors and other service providers, the right to buy the company’s common stock at a specified exercise price after a specified vesting period. The exercise price is typically the market price of the stock when the option is granted (although it can be higher or lower), the vesting period is usually two to four years, and the option is usually exercisable for a certain period, often five or 10 years. The value of the option when granted lies in the prospect that the market price of the company’s stock will increase by the time the option is exercised. (If the price falls, the option will simply not be exercised; the contract does not obligate the employee to buy the stock.) Employee stock options typically cannot be transferred, and consequently have no market value. To illustrate, suppose that Ceecorp, Inc., is a publicly held corporation whose stock is selling for $10 a share on January 1, 2004. As a part of her compensation plan, Ceecorp’s chief financial officer (CFO) was granted options on that date to buy 1,000 shares of stock for $10 a share any time over the next 10 years, subject to certain conditions. One condition was that she had to work for the company until she exercised her options. Another was that her right to the options vested over a period of four years, one-quarter each year. This meant that on January 1, 2005, she received an unrestricted right to buy 250 shares of stock for $10 a share, and so on each year until, on January 1, 2008, all of the options were fully vested and she could buy 1,000 shares if she chose. 1 The author of the first version of this report was Jack H. Taylor, consultant in business taxation. John Doerr and Rick White, “Straight Talk About Stock Options,” The Washington Post, March 12, 2002, p. A21. 3 Ibid. 4 Warren Buffett, “Stock Options and Common Sense,” The Washington Post, April 9, 2002, p. A 19; Martin A. Sullivan, “Stock Options Take $50 Billion Bite Out of Corporate Taxes,” Tax Notes, March 18, 2002, p. 1,396. 2 Congressional Research Service 1 Employee Stock Options: Tax Treatment and Tax Issues Suppose that Ceecorp’s stock had risen to $30 a share on January 1, 2005, when the CFO became vested with the right to buy 250 shares, with no further restrictions on her ownership of the stock. She could pay the company $2,500 for the 250 shares, which were at that point worth $7,500, with an immediate gain of $5,000 (ignoring taxes for the moment) in either cash if she sold the stock or property if she held on to it. She could similarly exercise the other options as they became vested or wait for later stock price changes. The options would continue to be worth extra compensation for her as long as Ceecorp’s stock was selling for more than $10 a share. When she exercised her options, the company had to be prepared to sell her the stock at the below-market exercise price. So on January 1, 2005, if she chose to buy 250 shares of Ceecorp stock, the company had to either buy 250 shares of its own stock for $7,500 or issue 250 shares of new or treasury stock that it could have sold for $7,500. When it sold these shares to the CFO for $2,500, the economic reality was the same as if it had paid her $5,000 in cash: she received additional compensation of $5,000 and Ceecorp was out $5,000 that it would have still had if she had not exercised her options. Advantages and Disadvantages of Stock Options Paying for the services of employees or directors by the use of stock options has several advantages for the companies. Start-up companies often use the method because it does not involve the immediate cash outlays that paying salaries involves; in effect, a stock option is a promise of a future payment, contingent on increases in the value of the company’s stock. It also makes the employees’ pay dependent on the performance of the company’s stock, giving them extra incentive to try to improve the company’s (or at least the stock’s) performance. Ownership of company stock is thought by many to assure that the company’s employees, officers, and directors share the interests of the company’s stockholders. Before June 15, 2005, accounting rules did not require stock options to be deducted from income in the companies’ financial statements; consequently, net profits reported to shareholders were larger than they would have been if the same amounts were paid in cash. Critics of the stock options, however, argue that the practice gives officers and directors a strong incentive to inflate stock prices and that there is no real evidence that it does improve performance. (Many of the leading users of stock options were among the companies suffering substantial stock losses in recent years.) Receiving pay in the form of stock options can be advantageous to employees as well. Stock options can be worth far more than companies could afford to pay in direct compensation, particularly successful start-up companies. Some types of stock options receive favorable income tax treatment. Receiving pay in the form of stock options serves as a form of forced savings, since the money cannot be spent until the restrictions expire. Of course, it is a risky form of pay, since the company’s stock may go down instead of up. Some employees may not want to make the outlay required to buy the stock, especially if the stock is subject to restrictions and cannot be sold immediately. And some simply may not want to invest their pay in their employer’s stock. Congressional Research Service 2 Employee Stock Options: Tax Treatment and Tax Issues Types of Employee Stock Options There are a number of variations on the general idea of an employee stock option. Some variations are due to the tax rules that govern them, and some are because of the intended use of the options by the companies granting them. This report focuses on the tax treatment of the options and the issues arising from the tax treatment; but one of the issues is whether the tax code has kept up with the proliferation of ways options can be designed. The Internal Revenue Code (IRC) recognizes two fundamental types of options. One is called “statutory” or “qualified” options because they are accorded favorable tax treatment if they meet the Code’s strict qualifications (IRC Section 421-424). Generally, the value of these options is not taxed to the employee nor deducted by the employer. The second is “nonqualified” options, which have no special tax criteria to meet, but are taxed to the employee as wage income when their value can be unambiguously established (which IRS says is when they are no longer at risk of forfeiture and can be freely transferred). They are deductible by the employer when the employee includes them in income (IRC Section 83). Some options have special features designed to do more than just compensate employees. Some, such as the employee stock purchase plans discussed below, are granted at less than the market price of the stock, to make it easier for recipients (particularly lower level employees) to buy stock. Nonqualified options are often used to reward management, and some are only exercisable if certain goals are met. “Premium” options are granted at a price higher than the current price of the stock; “performance-vested” options are not exercisable until a specific stock price is reached. “Indexed” options are repriced based on broad stock indices, to differentiate between the company’s performance and the market’s performance. There are other variations.5 Options are not the only way to use a company’s stock to compensate employees. Direct grants of stock are always possible, and can be hedged with restrictions similar to those governing the exercise of options. “Stock appreciation rights” and “phantom stock” plans pay employees the cash equivalent of the increases in the company’s stock without their actually owning any.6 These various plans have different tax consequences for companies and employees. Qualified Stock Options Two types of stock options qualify for the special tax treatment provided in IRC Section 421: incentive stock options (ISO) and employee stock purchase plans. Both types require that the recipient be an employee of the company (or its parent or subsidiary) from the time the option is granted until at least three months before the option is exercised. The option may cover stock in the company or its parent or subsidiary. Such options may not be transferrable except by bequest. 5 Shane A. Johnson and Yisong S. Tian, “The Value and Incentive Effects of Nontraditional Executive Stock Option Plans,” Journal of Financial Economics, vol. 57 (2000), pp. 3-34. 6 See Joint Committee on Taxation, Present Law and Background Relating to Executive Compensation (JCX-39-06), September 5, 2006, p. 42. Congressional Research Service 3 Employee Stock Options: Tax Treatment and Tax Issues Incentive Stock Options Incentive stock options (IRC Section 422) must be granted in accordance with a written plan approved by the shareholders. The plan must designate the number of shares to be subject to the options and specify the classes of employees eligible to participate in the plan. The option price must be no less than the market value of the stock at the time of the grant, and it must require exercise within 10 years from the time it was granted. The market value of the stock for any incentive stock options exercisable in any year is limited to $100,000 for any individual. This is the limit on the amount that receives favorable tax treatment, not on the amount that may be granted; options for stock exceeding $100,000 in market value are treated as nonqualifying options. There are additional restrictions for options granted to persons owning more than 10% of the outstanding stock. Employee Stock Purchase Plans An employee stock purchase plan (IRC Section 423) must also be a written plan approved by the shareholders, but this type of plan must generally cover all full-time employees with at least two years of service (or all except highly compensated employees). It must exclude any employee who owns (or would own after exercising the options) 5% or more of the company’s stock. The option price must be at least 85% of the fair market value of the stock either when the option is granted or when it is exercised, whichever is less. The options must be exercised within a limited time (no more than five years). The plan must not allow any employee to accrue rights to purchase more than $25,000 in stock in any year. Current Tax Treatment Both types of qualified stock options receive some tax benefit under current law. The employee recognizes no income (for regular tax purposes) when the options are granted or when they are exercised. Taxes (under the regular tax) are not imposed until the stock purchased by the employee is sold. If the stock is sold after it has been held for at least two years from the date the option was granted and one year from the date it was exercised, the difference between the market price of the stock when the option was exercised and the price for which it was sold is taxed at long-term capital gains rates. If the option price was less than 100% of the fair market value of the stock when it was granted, the difference between the exercise price and the market price (the discount) is taxed as ordinary income (when the stock is sold). Companies generally receive no deduction for qualified stock options, so the tax advantage accrues to the employee, not the employer. Companies that would not be taxable anyway, such as start-up companies not yet profitable, would care little if at all about the tax deduction and would be expected to use this method of compensation. Many companies that are taxable grant qualified stock options, however, so these options must have some advantage that outweighs the tax cost. In some cases, the companies no doubt find that rewarding their employees with qualified stock options is worth the cost; in other cases, perhaps, the officers and employees who receive the options exercise special influence over the companies’ compensation policies. If the stock is not held for the required two years from the granting of the option and one year from its exercise, special rules apply. The employee is taxed at ordinary income tax rates instead of capital gains rates on the difference between the price paid for the stock and its market value either when the option was exercised or when the stock was sold, whichever is less. The company Congressional Research Service 4 Employee Stock Options: Tax Treatment and Tax Issues is then allowed a deduction just as if the employee’s taxable gain were ordinary compensation paid in the year the stock is sold. To illustrate the tax treatment of incentive stock options, suppose that the Ceecorp’s grants to the CFO described previously were under an incentive option plan approved by the shareholders. The CFO could postpone taxation of her $5,000 gain by holding the stock until at least January 1, 2006 (one year after she bought it and two years after the options were granted). Assuming the stock was still worth $30 a share, she could realize her gain at that point and be taxed at the lower capital gains rate instead of her regular tax rate. Alternative Minimum Tax Imposing the alternative minimum tax (AMT) on qualified stock options reduces their tax advantage; for persons paying the AMT, the tax treatment is similar to the regular tax treatment of nonqualified options.7 Although the minimum tax exemptions limit the minimum tax to relatively high-income taxpayers, it does impose some burden on the otherwise tax-favored option plans. The minimum tax can make the receipt of qualified stock options an extremely complex problem. It is imposed in the year the options are exercised (and the stock is transferred without restrictions) at the AMT rates of 26% or 28%, and the basis of the stock then becomes, for AMT purposes, the market price of the stock. When the stock is sold, it will have two bases, one for the AMT and one for the regular tax. Double taxation will not result, because an alternative minimum tax credit will be available (if the employee is not again subject to the minimum tax) or an adjustment of minimum taxable income will be made (if he owes minimum tax again that year). Since taxpayers often will not know if they are subject to the minimum tax until the tax year is over, tax planning can be very difficult. Under certain circumstances, it is possible for an individual to owe the AMT on the value of incentive stock options at the time that these options are exercised. But in the same year, a subsequent decline in the value of the stock after exercise would cause the individual to owe income taxes under the AMT on “phantom” gains. There was a credit for prior year minimum taxes in excess of regular taxes that accrues when the taxpayer returns to the regular tax system, but this credit was not refundable.8 On December 20, 2006, this “unfair” situation was solved for most taxpayers by passage of the Tax Relief Act and Health Care Act of 2006 (P.L. 109-432), which made the credit for prior years’ minimum tax liability refundable. According to Sections 402 and 403 of this act, an individual’s minimum tax credit allowable for any taxable year beginning before January 1, 2013, is not less than the “AMT refundable credit amount”. The “AMT refundable credit amount” is the greater of (1) the lesser of $5,000 or the long-term unused minimum tax credit, or (2) 20 percent of the long-term unused minimum tax credit. The long-term unused minimum tax credit for any taxable year means the portion of the minimum tax credit attributable to the adjusted net minimum tax for taxable years before the 3rd taxable year 7 For a description of the alternative minimum tax, see CRS Report RL30149, The Alternative Minimum Tax for Individuals, by Steven Maguire. 8 For an analysis of this issue, see archived CRS Report RS20874, Taxes and Incentive Stock Options, by Jane G. Gravelle. Congressional Research Service 5 Employee Stock Options: Tax Treatment and Tax Issues immediately preceding the taxable year (assuming the credits are used on a first-in, first-out basis).9 On December 26, 2007, the Tax Increase Prevention Act of 2007 (P.L. 110-166) was enacted. This law provided a one-year extension of AMT relief for non-refundable personal credits to offset AMT liability for tax year 2007 and increased the individual AMT exemption amount for taxable years beginning in 2007 to $66,250, in the case of married individuals filing a joint return and surviving spouses, and $44,350 in the case of other unmarried individuals. Some taxpayers were still liable for taxes on “phantom” gains from the exercise on incentive stock options. Consequently, the enactment on October 3, 2008, of the Emergency Economic Stabilization Act of 2008 (P.L. 110-343) included additional relief for taxpayers with “phantom” gains. This act provided three changes: First, the Act requires the abatement of any tax liability attributable to the requirement to include amounts in alternative minimum taxable income due to the exercise of the ISO for taxable years ending prior to January 1, 2008, as well as related penalties and interest, to the extent that the liability remains unpaid as of October 3, 2008. Second, the Act accelerates the allowance of the long-term unused minimum tax credit allowing 50% of such amount to be used to reduce the tax liability or to create an overpayment for the tax years beginning before 2013. Third, the Act allows taxpayers a minimum tax credit for the 2008 and 2009 tax years that is refundable if not otherwise allowable in reducing current tax liability, equal to 50% or more of the related interest and penalties paid by the taxpayer prior to October 3, 2008, attributable to the exercise of incentive stock options. Thus, provided that an ISO AMT liability has resulted in a long-term unused minimum tax credit, the taxpayer may claim a total credit of 100% of the tax, penalties, and interest paid prior to October 3, 2008, attributable to the exercise of incentive stock options that resulted in those liabilities, over a two-year period.10 Tax-Favored Treatment Continuing the tax advantages that qualified stock options receive is not often raised as an issue in their tax treatment. It is often argued that giving favorable tax treatment to a limited amount of compensation in the form of options helps spread the use of options to rank-and-file workers. (Nonqualified options, which are not tax favored, are more likely to go to officers and highly paid employees.) Employee stock ownership plans are explicitly promoted as a means for workers to become owners of their companies. In addition, the cost to the government is at least partially offset by the lack of a tax deduction at the company level. There may be a corporate governance issue concerning the reason that some publicly held companies are willing to incur an unnecessary tax cost for the benefit of officers and employees. (The company could offer nonqualified stock options, which are deductible; in fact, many companies do offer both incentive and nonqualified options to the same employees.) 9 Joint Committee on Taxation, Technical Explanation of H.R. 6408, the Tax Relief and Health Care Act of 2006, as Introduced in the House on December 7, 2006, December 7, 2006, pp. 83-84. 10 Internal Revenue Service, “AMT and ISO Emergency Economic Stabilization Act of 2008 Relief,” available at http://www.irs.gov/individuals/article/0,,id=200951,00.html. Congressional Research Service 6 Employee Stock Options: Tax Treatment and Tax Issues Payroll Taxes Before 1995, qualified stock options were not considered wages for Federal Insurance Contribution Act (FICA) and Federal Unemployment Tax Act (FUTA) purposes. The Internal Revenue Service (IRS) issued a ruling in 1971 to this effect (Revenue Ruling 71-52). However, the Tax Court later ruled that they were wages for calculating the research tax credit,11 and IRS acquiesced in that decision in 1997. Subsequently, IRS said that it would be required to impose employment taxes on the options also, and it made several attempts to impose the taxes in specific cases.12 In November 2001, IRS announced a proposed regulation that would subject the value of qualified stock options (the difference between the exercise price and the market price) to FICA and FUTA taxes in the year the options are exercised. This new rule would have been effective January 1, 2003, and until that time IRS would not attempt to collect any taxes on the options. No change in income tax treatment was proposed, and income tax withholding would not have been required.13 The proposed regulation received a negative reaction in the public comments that IRS requested. Companies argued that the additional tax cost and the paperwork burden of a new accounting requirement would discourage the granting of options and make them less attractive to employees. The critics argued that Congress explicitly excluded the value of an exercised qualified stock option from income, and that something cannot be “wages” if it is not also “income.”14 On June 25, 2002, the Treasury Department and the IRS announced an indefinite extension of their administrative moratorium on qualified stock options. Pam Olson, acting Assistant Secretary for Tax Policy, stated that Given the significant administrative changes that would be required of employers to implement the proposed withholding, it is clear that a delay in the effective date is necessary to provide employers with adequate time to make the required changes. In addition, Treasury and IRS need additional time to consider the many comments we received on the proposed regulations and to decide on an appropriate course of action. Consequently, employers will not be required to implement the changes for at least two years after the regulations have been issued in final form.15 On October 22, 2004, P.L. 108-357 (American Jobs Creation Act) was signed by the President, and this law included a provision (Title 11, Subtitle F), which excluded qualified stock options from FICA and FUTA taxes. 11 Sun Microsystems, Inc., v. Commissioner, T. C. Memo. 1995-69. Sheryl Stratton, “Hearing on Stock Option Regs Should Be Livelier Than Most,” Tax Notes, May 13, 2002, p. 968. 13 Proposed Regulation REG-142686-01, Internal Revenue Bulletin 2001-49, p. 561. 14 See Stratton, op. cit. 15 U.S. Department of the Treasury, “Treasury and IRS Extend FICA and FUTA Tax Moratorium for Statutory Stock Options,” press release, June 25, 2002, p. 1. 12 Congressional Research Service 7 Employee Stock Options: Tax Treatment and Tax Issues Nonqualified Stock Options Employee options that do not qualify for tax-favored treatment are by far the most important (at least by value). Because there are no statutory limits on the amount of these options that can be offered, these are the options used to compensate corporate officers and highly paid employees. Unlike qualified options, these options can be offered to anyone “providing services” to the company, not just employees. Therefore, they can also be given to those who serve on the company’s board of directors (or even to independent contractors). When news reports and policy analysts mention options, without other qualifications, they normally mean nonqualified options. Tax Treatment Nonqualified options fall under the general rules governing the transfer of property other than money in return for services (IRC Section 83). Basically, the rule is that the recipient receives income equal to the fair market value of the property (less any amount paid for it) when he receives an unrestricted right to the property and its fair market value can be reasonably ascertained. Stock options without a “readily ascertainable market value” are specifically excepted by Section 83(e)(3). (Qualified stock options are also excluded.) In the case of nonqualified options, IRS has ruled that options that are not tradeable (as is almost always true of these options) have no “readily ascertainable market value.” Therefore, their fair market value cannot be established until they are exercised and any restrictions on the disposition of the stock have been lifted. At that time, the value of the options is equal to the difference between the exercise price and the stock’s current market price.16 (There is a provision in Section 83 (b) allowing the recipient of the options to elect to include their value in income in the year they are exercised, valuing them as if the stock were not restricted. However, no future deduction is allowed if the stock is later forfeited.) Nonqualified stock options exercised by employees are subject to FICA and FUTA taxes and income tax withholding, just as cash wages are. The company granting the options is allowed to deduct from income the same value of the options that the recipient includes in income, in the same year it is taxable to the recipient (Section 83(h)). If the options granted by Ceecorp to its CFO in our previous example were nonqualified options, there would be three notable differences from the qualified options assumed before. One is that she would have been immediately taxable on the difference between what she paid for the stock and what it was worth in the year she acquired it, so she would have owed income and FICA taxes on $5,000 in 2005. The second was that Ceecorp could deduct the $5,000 as employee compensation on its own tax return (and would also owe FICA and FUTA taxes on it). And probably most important in the real world (although not in our example), there would have been no limit on the value of the options granted, so a highly compensated officer like a chief financial officer could receive potentially large amounts of additional compensation. 16 IR Reg. 1.83-7. Congressional Research Service 8 Employee Stock Options: Tax Treatment and Tax Issues Are Nonqualified Options Tax Favored? Nonqualified options are not taxed to the recipient when they are granted or when they become vested, so receiving compensation in this form postpones the payment of taxes from when they would have been due on an equivalent amount of cash wages. However, the reason for not taxing them is the uncertainty of their actual value; the tax rules follow the practical path of postponing tax until their value is realized, as is the case with capital gains. In addition, the company’s deduction of the compensation is also postponed, being allowed only in the same year that the recipient reports the income realized. Since most of these options go to highly compensated individuals, whose marginal tax rates would often be higher than the company’s, the government probably suffers little if any revenue loss. So it could be argued that the government should be indifferent to the issue. Key Laws and Regulations17 Seven key laws and regulations relevant to employee stock options warrant discussion. Six of these laws or regulations date from 2002. Section 162(m)—“Excessive Remuneration” The Omnibus Budget Reconciliation Act of 1993 established IRC Section 162(m), titled “Certain Excessive Employee Remuneration,” which applied to the CEO and the four highest compensated officers (other than the CEO) of a publicly held corporation. For each of these “covered employees,” the publicly held corporation could only deduct, as an expense, the first $1 million of applicable remuneration. The reason for this change was that “the committee believes that excessive compensation will be reduced if the deduction for compensation ... paid to the top executives of publicly held corporations is limited to $1 million per year.”18 Exceptions to this $1 million in applicable remuneration include (1) “remuneration payable on commission basis” and (2) “other performance-based compensation.” In order to qualify for this second exception, four conditions must be met: • It is paid solely on account of the attainment of one or more performance goals. • The performance goals are determined by a compensation committee of the board of directors of the taxpayer, which is comprised solely of two or more outside directors. • The material terms under which the remuneration is to be paid, including the performance goals, are disclosed to shareholders and approved by a majority of the vote in a separate shareholder vote before the payment of such remuneration. • Before any payment of such remuneration, the compensation committee certifies that the performance goals and any other material terms were in fact satisfied.19 17 Gary Shorter of CRS contributed explanations about the Sarbanes-Oxley Act and SEC rules to this section of the report. 18 H.Rept. 103-111, p. 646. 19 IRC Sec. 162(m), (4)(C). Congressional Research Service 9 Employee Stock Options: Tax Treatment and Tax Issues Economic theory suggests that the $1 million cap on deductible compensation would increase the relative importance of performance-related compensation including stock options.20 In retrospect, the provision appears to have made stock options relatively less expensive than base salaries, bonuses, or stock grants, which were subject to the cap. The SEC amended the rules for covered employees under Section 162(m). Under the new rules, covered executives are the principal executive officer (PEO), the principal financial officer (PFO), and the three most highly compensated executives other than the PEO and PFO.21 Sarbanes-Oxley Act: Stock Option Disclosure Reforms Enacted in the wake of widespread accounting scandals at firms like Enron and WorldCom, the Sarbanes-Oxley Act of 2002 (SOX) contained a host of corporate governance and accounting regulatory reforms. Prior to SOX, firm insiders were required to disclose grants of stock options within 45 days of the end of a company’s fiscal year. SOX requires that all insider transactions in a company’s stock, including option grants, be disclosed within two business days. The requirement went into effect on August 29, 2002. SEC’s 2003 Requirement of Approval of Compensation Plans In 2003, the SEC approved changes to the listing standards of the New York Stock Exchange and the Nasdaq Stock Market that require shareholder approval of almost all equity-based compensation plans. Firms must disclose the material terms of their stock option plans, prior to obtaining shareholder approval for them. The required disclosures include the terms on which options will be granted, including whether the plan permits options to be granted with an exercise price that is below market value on the date of the grant. FASB Rule for Expensing Stock Options On March 31, 2004, the Financial Accounting Standards Board (FASB) issued a new exposure draft that would treat all forms of share-based payments to employees, including employee stock options, the same as other forms of compensation by recognizing the related cost in the income statement. The expense of the award generally would be measured at fair value at the grant date.22 On July 1, 2004, the Council of Institutional Investors (a group of 140 pension funds), voiced its concern about reports that FASB was considering delaying implementation of the planned standard on stock option compensation.23 On July 14, 2004, the National Association of 20 A National Bureau of Economic Research (NBER) study found that Section 162(m) had no significant effects on overall executive compensation because of the exemption from the cap of performance-based compensation, the ability to defer compensation, and the cap only applying to salaries of five executives. For these results, see Nancy L. Rose and Catherine Wolfram, “Regulating Executive Pay: Using the Tax Code to Influence CEO Compensation,” NBER Working Paper 7842, Cambridge, Mass.: National Bureau of Economic Research, August 2000, 47 p. 21 “Covered Employees Under Section 162(m)(3),” Notice 2007-49, Internal Revenue Service Bulletin: 2007-25, June 18, 2007. 22 Alison Bennett, “Baker Criticizes Stock Options Proposal; Announces Subcommittee Hearing in April,” Daily Tax Report, no. 62, April 1, 2004, p, GG-2. 23 Sarah Teslik, Executive Director of Council of Institutional Investors, “Letter to Director of Financial Accounting Standards Board,” July 1, 2004. Congressional Research Service 10 Employee Stock Options: Tax Treatment and Tax Issues Manufacturers, the Business Roundtable, and the U.S. Chamber of Commerce issued a joint news release stating that FASB should engage in field testing of multiple stock option valuation models and delay finalizing any standard until such testing has occurred.24 Alan Greenspan, Chairman of the Board of the Federal Reserve, endorsed FASB requiring the expensing of stock options. He stated: “Not expensing stock options may make individual firms look more profitable than they are.”25 On December 16, 2004, the FASB issued new rules requiring companies to subtract the expense of options from their earnings.26 According to press reports, these new rules would dramatically reduce the earnings of many companies that currently show this expense in footnotes.27 Initially these new rules would apply to financial statements beginning after June 15, 2005, for large publicly traded companies (or December 15, 2005, for small businesses) or the third quarter of 2005 for those large companies on a fiscal calendar year.28 But, effective April 21, 2005, the Securities and Exchange Commission (SEC) postponed the stock option expensing standard until the beginning of companies’ next fiscal year. Thus, companies with fiscal years on a calendar year basis will not have to comply with the expensing standard until the first quarter of 2006. The SEC gave three justifications for this postponement: reducing compliance costs, relieving companies from having to change their accounting systems in the middle of the fiscal year, and allowing auditors to conduct more consistent review procedures.29 On March 29, 2005, the SEC stated that public companies may choose from a number of valuation methods to estimate the fair market value of their stock options.30 In response to the FASB requirement that the cost of stock options be included as an expense on financial statements, a survey found that some companies were reducing the amount of their stock option benefits or eliminating their stock option plans.31 Another study found that 439 companies had pushed up vesting dates on their stock options to beat the December 31, 2005, deadline; consequently, these companies eliminated more than $4 billion in expenses, which would otherwise have shown up on income statements starting in 2006.32 The Securities and Exchange Commission continued to refine appropriate methodologies for the valuation of stock options.33 On December 5, 2005, Alison Spivey, associate chief accountant 24 Kurt Ritterpusch, “Options Bill Jurisdictional Issues Remain But Blunt Hopes to See Bill on Floor Soon,” Daily Tax Report, no. 135, July 15, 2004, p. G-4. 25 Alan Greenspan, Chairman of the Board of Governors of the Federal Reserve System, “Letter Responding to Senators Levin, McCain on Stock Options Accounting,” October 1, 2004. 26 Financial Accounting Standards Board, “FASB Issues Final Statement on Accounting for Share-Based Payment,” FASB News Release, December 16, 2004. 27 “FASB to Require Expensing of Options Starting Next Year,” The Wall Street Journal, vol. 224, no. 119, December 17, 2004, p. C3. 28 Ibid. 29 Securities and Exchange Commission, “Amendment to Rule 4-01(a) of Regulation S-X Regarding the Compliance Date for Statement of Financial Accounting Standards No. 123 (Revised 2004), Share-Based Payment,” 70 Federal Register 20717, April 21, 2005. 30 17 C.F.R. PART 211. 31 Andrew Blackman, “Firms Reconsider Stock Discounts for Employees,” The Wall Street Journal, vol. 246, no. 46, September 6, 2005, p. D2. 32 Ben White, “Pushing Fast-Forward on Options,” The Washington Post, December 19, 2005, p. D1. 33 Steven Marcy, “SEC Continues to Refine Determination of Valuation, Volatility Assumption in Plans,” Daily Tax Report, December 14, 2005, p. G9. Congressional Research Service 11 Employee Stock Options: Tax Treatment and Tax Issues with the SEC’s Office of Chief Accountant, issued a warning regarding volatility assumptions for valuing stock options.34 Some large U.S. companies reportedly reduced the cost of their stock options by making subjective changes in their methods used in valuing their stock options.35 In estimating the value of their stock options, companies have to make assumptions about numerous factors including volatility or the magnitude and speed of share-price swings over the life of their options.36 The cost of an option rises as its volatility increases. One study found that the volatility assumptions for 50 large companies with sales in excess of $20 billion declined by an average of 13% from 2003 to 2005.37 On October 17, 2007, the SEC approved the Zions Bancorporation’s auction process to value employee stock options. The SEC stated, Your Submissions represent significant progress towards the identification of a suitable market-based approach to valuing employee share-based payment awards. We remain committed to supporting the development of a variety of competing market-based objective measurement of the fair value of employee stock options, of which yours is an example. Of course, future auctions using the approach outlined in your Submissions must be evaluated by a company and its external auditors based upon the particular facts and circumstances to ensure that the result produces a reasonable estimate of fair value in accordance with Statement 123R.38 American Jobs Creation Act of 2004 (Section 409A) On October 22, 2004, the American Jobs Creation Act of 2004 (P.L. 108-357 ) was passed. This law included new statutory requirements under IRC Section 409A concerning deferred compensation, that is, the delay of the receipt of compensation and taxes on compensation to a future tax year. This section was included “in response to perceived abuses by executive employees in the recent wave of corporate scandals.”39 This section applies to amounts deferred in tax years that begin after December 31, 2004, and includes stock appreciation rights if the exercise price is less than the fair market value of the underlying stock on the date the stock appreciation rights are granted.40 Section 409A generally provides that amounts deferred under a nonqualified deferred compensation plan for all taxable years are currently includible in gross income to the extent not subject to substantial risk of forfeiture and not previously included in gross income, unless certain requirements are met.41 Thus, stock options, subject to 409 A, were included in income when they vested rather than when they were exercised. Consequently, IRC Section 409A reduced the tax advantage of stock options, and presumably reduced the use of stock options. 34 Ibid. Richard Waters, “Options Rule Used to Lift Earnings,” Financial Times, April 24, 2006, p. 18. 36 Steven D. Jones, “Option Expensing Leaves Room for Tallying the Volatility Factor,” The Wall Street Journal, May 2, 2006, p. C3. 37 Ibid. 38 Conrad Hewitt, Chief Accountant, SEC, Letter to James G. Livingston, Vice President of Zions Bancorporation, October 17, 2007. 39 Joni L. Andrioff, “Deferred Compensation Revolution—Tough Transition to a Statutory System,” Taxes: The Tax Magazine, vol. 83, no. 5, May 2005, p. 65. 40 Ibid., p. 66. 41 Internal Revenue Service, “Interim Guidance on the Application of Section 409A to Accelerated Payments to Satisfy Federal Conflict of Interest Requirements,” Internal Revenue Bulletin, 2006-29, July 17, 2006, p. 1. 35 Congressional Research Service 12 Employee Stock Options: Tax Treatment and Tax Issues IRS Schedule M-3 Effective December 2004, the new Schedule M-3 book-tax reconciliation replaced the old Schedule M-1 for most publicly traded and many privately held corporations with assets of $10 million or more.42 Schedule M-3 provided tax professionals with a wealth of new information to understand the book-tax gap. For example, specific differences between book and tax income could be characterized as temporary or permanent.43 SEC’s 2006 Executive Compensation Disclosure Rules In July 2006, the SEC issued new rules designed to enhance the transparency of proxy compensation disclosures for CEOs, chief financial officers (CFOs), the other three highest paid executive officers, and directors, the first such major reform since 1992.44 These rules include provisions that require companies to disclose whether they are timing options grants to make them more lucrative to executives and other employees.45 The rules require companies to present, in tabular form, the stock price on the grant date, the grant date under accounting rules, the market price on the grant date if it is greater than the exercise price, and the date the compensation committee or full board granted the award if different than the grant date for accounting purposes. In a new section of the proxy, Compensation Discussion and Analysis, management must discuss material information such as the reasons a company selects particular grant dates for awards and the methods a company uses to set the terms of awards. Financial (or Book) Income Versus Tax Income U.S. businesses are subject to a dual reporting system. One set of rules applies when they report financial or “book” profits to the public. Another set of rules applies when they report taxable income to the Internal Revenue Service.46 Under this dual reporting system businesses have an incentive to maximize their reported financial or book income and minimize their reported taxable income. This accounting gamesmanship results in a “book-tax” gap, which is the excess of reported financial accounting income over taxable income.47 Since 1993, the increased use of stock options to compensate top corporate executives increased the book-tax gap.48 One press report stated the following: In 2004, nonqualified employee stock options accounted for $40.4 billion of the total difference between financial and tax expenses. Incentive stock options accounted for another 42 Charles Boynton, Portia DeFilippes;, and Ellen Legel, “A First Look at 2004 Schedule M-3 Reporting by Large Corporations,” Tax Notes, September 11, 2006, p. 944. 43 Ibid., p. 952. 44 See CRS Report RS22583, Executive Compensation: SEC Regulations and Congressional Proposals, by Michael V. Seitzinger. 45 These new rules are stated in 17 CFR Parts 228, 229, et al., pp. 53,158-53,166. 46 Joint Committee on Taxation, Present Law and Background Relating to the Interaction of Federal Income Tax Rules and Financial Accounting Rules (JCX-13-12), February 7, 2012. Available at [www.jct.gov]. 47 Daniel L. Slaton, “Solving Stock Option Compensation: Why Book-Tax Conformity May Not Be the Answer,” Houston Business and Tax Law Journal, vol. 9, part 1, 2009, pp. 177-179. 48 In 1993, Section 162(m) of the IRC was added, which is explained in the next section of this report. Congressional Research Service 13 Employee Stock Options: Tax Treatment and Tax Issues $6.3 billion, and other equity-based compensation for $2.8 billion. In total, those three forms of equity-based compensation reduced tax net income by nearly $50 billion while having minimal impact on book income. Stock options and other equity-based compensation accounted for roughly 30 percent of the permanent reduction in tax income from book income.49 Financial accounting provides investors and regulators with information about a company’s financial condition and uses estimates to measure profits and expenses when earned. Financial accounting emphasizes consistency over time for a company’s reports, thus a company has discretion in preparing its reports.50 Since 1934, the Securities and Exchange Commission (SEC) has had authority to set financial reporting standards but has generally delegated this authority to the private sector.51 Since 1973, the Financial Accounting Standard Board (FASB) has been delegated authority by the SEC to establish Generally Accepted Accounting Principles (GAAP).52 In contrast, tax accounting emphasizes the actual receipt of payments and proceeds, and taxable income is defined as gross income minus all allowable deductions and exemptions.53 The Internal Revenue Service (IRS) has the responsibility for raising revenue; consequently, “much of the Internal Revenue Code requires uniformity in accounting for income and expenses across firms.”54 Originally, the GAAP accounting rules for stock options were of very limited scope. Because employee options were normally priced equal to the market price of the company’s stock when they were granted, they were said to have no value. The fact that they were intended to have value and therefore serve as compensation was not taken into account. As they became more popular, however, the accounting standards were modified to require some recognition of their effect on a company’s income. Rule FAS 123 required companies to estimate the value of the options when they are granted (using an option pricing model) and show that amount, called the “fair value,” as a cost over the years until the options are vested. In their published financial statements, the companies could either treat the estimated value of the options as a cost in calculating net income,55 or they could use the traditional valuing of the options (i.e., zero) in calculating net income and show the effect of deducting the estimated value in a footnote. Most companies chose to use the footnote method, but in the early 2000s many large corporations shifted to the deduction method. On December 16, 2004, FASB issued new rules requiring companies to subtract the expense of stock options from their earnings on their financial statements.56 In the very simple example used previously, Ceecorp and its CFO, the traditional valuation of the options when granted would be: the stock is selling for $10 a share, the options allow the CFO to buy it at $10 a share, so the options’ value is zero. Ceecorp, like almost all public corporations, would probably calculate its net profit on its financial statement using this valuation. Under FAS 49 Joann M. Weiner, “Closing the Other Tax Gap: The Book-Tax Income Gap,” Tax Notes, May 28, 2007, p. 856. Daniel L. Slaton, p. 179. 51 Ibid., p. 180. 52 Ibid., pp. 180-181. 53 Ibid., p. 179. 54 Ibid., p. 180. 55 This method is commonly referred to as “expensing.” 56 Laws and regulations pertaining to this discussion of the “book-tax” gap are explained in more detail in the subsequent section of this report. 50 Congressional Research Service 14 Employee Stock Options: Tax Treatment and Tax Issues 123, however, it would also use an estimating model to determine a market value. The model would estimate the likelihood that the stock would go up in value over the life of the option and take other variables into account and establish what the option might be worth on the open market when granted (if it could be marketed). So, Ceecorp might estimate that the “fair value” of the options when granted was $16 each, for a total value of $16,000, and report in a footnote to its financial statement an additional compensation cost of $4,000 each year for the four years over which the options vested. It would not account for the actual cost of the options when exercised on its income statement. But, new FASB rules require Ceecorp to report the “fair value” of the options on its financial statements. Several bills were introduced in prior Congresses to restrict the tax deduction for options because of the differences with the accounting treatment. The bills attempted to change the companies’ accounting practices, to make the cost of stock options more apparent to stockholders and investors; but the device chosen in the bills is to restrict the tax deduction allowed to the amount “treated as an expense” on the companies’ books of account. Without further changes in either the accounting rules or the tax law, however, this approach did not in fact conform the tax and book treatment. The book expense was based on the estimated value of the options when granted and is charged off over the vesting period of the options. The tax deduction, in contrast, was allowed only when the options are exercised, and would, under this approach, be limited to the smaller of the estimated or actual values. In addition, the amount deducted by the company would no longer necessarily equal the amount taxed to the individual. Proposed Legislation in 112th Congress On July 14, 2011, Senator Carl Levin introduced S. 1375, the Ending Excessive Corporate Deductions for Stock Options Act.57 In a press release, Senator Levin stated that Current stock option accounting and tax rules are out of kilter, leading corporations to report inconsistent stock option expenses on their tax returns versus their financial books, and often produce huge tax windfall for corporations that pay their executives with large stock option grants. This windfall produces excess corporate tax deductions totaling as much at $60 billion in a single year, which costs the U.S. Treasury billions of dollars a year in lost tax revenue. In effect, it’s a taxpayer subsidy for the pay of corporate executives. It’s a tax break we can no longer afford and ought to end.58 Senator Levin asserted that his bill would reduce the deficit by $25 billion over 10 years.59 In the press release, a summary of S. 1375 indicated that it would • require the corporate tax deduction for stock option compensation not to exceed the stock option book expense shown on a corporation’s financial statement; 57 Senator Sherrod Brown was an original cosponsor. Senator Carl Levin, press release, “Levin-Brown Bill Would End Corporate Stock Option Tax Break, Reduce Deficit by $25 Billion,” July 15, 2011, p. 1. 59 Ibid. 58 Congressional Research Service 15 Employee Stock Options: Tax Treatment and Tax Issues • allow corporations to deduct stock option compensation on their tax returns in the same year it is recorded on the corporate books, without waiting for the options to be exercised; • ensure research tax credits use the same method for calculating stock option pay expenses when computing wages eligible for the tax credit; • make no changes to stock option compensation rules for individuals, or for incentive stock options under Section 422 of the tax code which may be used by start-up companies and other small businesses; • create a transition rule to ensure stock options granted before the enactment date are tax deductible; and • make stock option deductions subject to the existing $1 million cap on corporate tax deductions for compensation paid to top executives of publicly held corporations.60 On February 1, 2012, Facebook, Inc. filed a registration statement with the Securities and Exchange Commission, which included its proposal to sell stock to the public.61 Subsequently, the possible tax implications of Facebook’s IPO (initial public offering) were examined. While Facebook, Inc. would not be liable for corporate income taxes, founder Mark Zuckerberg and other holders of options would be subject to individual income taxes when they exercised their options.62 Facebook’s registration statement indicated that it would receive a tax refund of up to $500 million during the first six months of 2013.63 On February 29, 2012, Senator Cal Levin issued a floor statement alleging that Facebook shareholders were benefiting from a tax loophole. The following excerpt is from his floor statement. According to its filings, when Facebook goes public, Mr. Zuckerberg plans to exercise options to purchase 120 million shares of stock for 6 cents a share. Mr. Zuckerberg’s shares, obviously, are going to be worth a great deal more than 6 cents, a total of about $7 million; they will apparently be worth more than 600 times as much, something in the neighborhood of $5 billion. Here’s where the tax loophole comes in. Under current law, Facebook can perfectly legally tell investors, the public, and regulators that the stock options he received cost the company a mere 6 cents a share—that’s the expense shown on the company’s books. But the company can also—perfectly legally later file a tax return claiming that these same options cost the company something close to what the shares actually sell for later on—perhaps $40 a share. And the company can take a tax deduction for that far larger amount. So the books show a highly profitable company—profitable, in part, because of the relatively small expense the company shows on its books for the stock options it grants to its employees. But when it comes time to pay taxes, to pay Uncle Sam, the loophole in the tax code allows the company to take a tax deduction for a far larger expense than they show on their books.64 60 Ibid., p. 2. Facebook, Inc., Form S-1, Registration Statement under the Securities Act of 1933, February 1, 2012, 198 pp. 62 Shamik Trivedi, “Will the IRS Like Facebook’s IPO?, Tax Notes, News and Analysis, February 13, 2012, p. 763. 63 Ibid. 64 Senator Carl Levin’s floor statement concerning the registration statement of Facebook, Inc. with the Securities and (continued...) 61 Congressional Research Service 16 Employee Stock Options: Tax Treatment and Tax Issues On March 5, 2012, an article in Forbes magazine presented an opposing point of view as indicated in the following excerpts. Facebook, the corporate entity … will not have to pay taxes on the amount of compensation Zuckerberg makes in the form of his options. This is the supposed “loophole” that bothers Senator Levin. Contrary to Senator Levin’s insinuation, American taxpayers aren’t going to have to make up a thing; Uncle Sam is going to be paid plenty. He’ll be paid astronomical sums of money in taxes by Mark Zuckerberg. Where’s the harm here? From the U.S. Treasury’s standpoint, it’s mostly a wash, since the Treasury will be paid handsomely regardless of whether it’s the company or its founder paying the tax.65 On May 17, 2012, the day before Facebook’s IPO, Senator Levin issued a floor statement that included the following excerpt. The stock-option loophole should have been closed long before Facebook’s stock option bonanza. But surely the case of Facebook illustrates to the Senate, to the Congress, and to the American people why we should close this loophole. If Congress were to enact the LevinSherrod Brown bill, S. 1375, it would close an unjustified corporate tax loophole that boosts executive pay at the expense of everybody else.66 Author Contact Information James M. Bickley Specialist in Public Finance jbickley@crs.loc.gov, 7-7794 (...continued) Exchange Commission, February 29, 2012. 65 Nich Schulz, “Senator Carl Levin’s Strange Tax Attack On Facebook,” Forbes, March 3, 2012. Available at http://www.forbes.com/. 66 Senator Carl Levin’s floor statement concerning Facebook’s IPO, May 17, 2012. Congressional Research Service 17