ITEP and three tax topics

The Institute on Taxation and Economic Policy’s (ITEP) report The 35 Percent Corporate Tax Myth said the following:

- Most big corporations give their executives (and sometimes other employees) options to buy the company’s stock at a favorable price in the future. When those options are exercised, companies can take a tax deduction for the difference between what the employees pay for the stock and what it’s worth.

- Such stock options reduce their taxes by generating phantom “costs” these corporations never incur.

- This non-cash “expense” should not be deductible for either tax or book (GAAP reporting to shareholders) purposes.

- Tax breaks such as stock options lower the corporations “effective” tax rate well below the main corporate rate on taxable income. Such rate was 35% before the Tax Cuts and Jobs Act reduced it to 21%.

ITEP has said this in a few other reports and articles, such as this one, which includes: “One tax loophole that Facebook has led the pack in exploiting is the “stock option loophole.” Facebook and other big corporations often compensate their executives with stock options (options to purchase shares of company stock at a discounted rate). When those options are exercised, the company is allowed to deduct from its taxable income the difference between the value of the shares and what the employee pays for the stock, even though the company doesn’t have to spend anything to provide the stock option to its executives.”

The tax deduction part is true. But the quote gives the impression there is only one method a corporation can use to fulfill its part. That is, the corporation creates new shares and incurs no expense. However, there are three methods.

Method 1. Like I said here, the corporation can buy the shares on the market. The employee pays the exercise price. The corporation pay the rest – market price minus exercise price. That’s a current cash expense to the corporation.

Method 2. The corporation can transfer to the employee shares that it already purchased on the market in anticipation of employees exercising options or by a stock repurchase/buyback. This is not a current cash expense, but it was a cash expense. Such purchased stock is often called treasury stock. It’s carried at historical cost. It seems the appropriate tax deduction should be the lesser of (a) historical cost and (b) market price minus exercise price. The phrase “not a current cash expense” downplays this method.

Method 3. The corporation can issue new shares. Suppose the employee’s exercise price is $40 and the share price is $100. The corporation in effect sells each share discounted $60. Cash and capital each increase $40. There is no expense akin to $60 paying the employee a cash bonus. So it raises the question, what justifies a $60 tax deduction as compensation akin to paying the employee a $60 salary bonus?

Current tax law treats all three alike. Which method a company uses may not be fully revealed in a 10-K. It seems to me that ITEP’s view is correct about Method 3, and it is likely the method companies such as Facebook, Google, and Apple have most often used. (Facebook had large share repurchases in 2018, but not in the years addressed by ITEP.) But they might also have used Method 2. Given the tax treatment, why wouldn't a company always use Method 3? Because it dilutes the stock, reducing earnings per share (EPS is widely tracked by investors).

Onto the second topic, I did not find anywhere ITEP criticizing the double taxation of stock dividends. The dividends are taxable to the receiving shareholder, and corporations are not allowed to deduct them -- unlike interest paid -- when calculating taxable income. Assume $100 of pre-tax earnings the corporation wants to use for a dividend, the corporate tax rate is 21%, and the shareholder’s tax rate is 23.8%. Since $21 + $79*23.8% = $39.80, the combined tax rate is 39.8%. The Bush tax cuts of 2003 partly reduced the degree of double taxation when it made qualified dividends taxable at the lower capital gains tax rates.

Onto the third topic, I found one ITEP blog about the taxation of “carried interest” here. I agree with the author’s view of it being a loophole that should be closed.

ITEP is politically liberal. It and its sister organization Citizens for Tax Justice often favor tax breaks for middle and lower income individuals and families.