ITEP and employee stock options

Two days ago ITEP published another article about employee stock options: How Congress Can Stop Corporations from Using Stock Options to Dodge Taxes. One of its authors did a separate blogpost the same day, New Report from ITEP Explores the Stock Options Tax Dodge. It only echoes a part of the article.
  

My December 8 post commented on ITEP’s previous articles about employee stock options. I stated three methods a corporation could use to supply the stock the employee receives upon exercise of the option. This latest ITEPS article was again written as if there is only one method, which I labeled Method 3, in which the corporation issues new stock. The employee pays the exercise price.

In some cases, perhaps most for the 25 companies the ITEP article shows in Table 1, the company used Method 3. If so, I think ITEP has a legitimate complaint – the tax deduction the corporation gets upon exercise is excessive. However, it is not so for Method 1 and partly not so for Method 2, which I explained on December 8.

The authors support the Levin-McCain proposal, or something like it, to reform the amount of tax deduction a corporation gets. They propose this: “If the Levin-McCain proposal had been in effect in the hypothetical described above, the corporation at issue would have reported a $10 million stock option compensation expense for book purposes and deducted the exact same amount from its taxable income in the year when the options were granted. The book expense and tax deduction would have matched. The book expense and the tax deduction would have been taken in the same year. No more valuation gaps, no more timing differences, no more excessive tax deductions” (my bold).

It shifts the taxable event from the exercise date – when the value of the option is known – to the grant date – when the future value of the option is very uncertain. That's radical and nutty. First, they propose eliminating a non-cash expense, but invoke a different non-cash expense. Second, for GAAP accounting companies start accruing an expense for employee stock options when the grant is made. Upon exercise more accounting is required to recognize what the option turns out to be actually worth and the corporation’s actual cost. In contrast, the authors propose to ignore entirely what happens upon exercise for the employer’s taxes. They ignore or are unaware of what happens with GAAP accounting upon exercise. “It is time to require the same type of symmetry for stock options: the book expense and tax deduction should match. After all, in our example, the $50 million in income to the employee is irrelevant to the compensation cost of the employer, which was reported at $10 million at the time the compensation was awarded [the option was granted] to the employee years earlier.”

This is nutty for the following reasons as well.

1. Suppose an option expires worthless (market price of stock less than exercise price). The corporation gets a tax deduction when the option is granted, but the corporation never incurs an actual expense. 

2. Suppose an employee gets a grant and later quits when all or part of the option is not vested. The corporation gets a tax deduction when the option is granted, but the corporation never incurs an actual expense for the non-vested part.

3. Suppose the share price skyrockets, the option is exercised, and the employer uses Method 1 or Method 2. The employer buys the stock when the price is much more than the exercise price. The employer pays a lot to meet its obligation – share price at purchase minus exercise price. It’s an actual and significant expense, but ITEP proposes no tax deduction for it.