The Advisors' Blog

– Broc Romanek, CompensationStandards.com

The repercussions for those boards that rushed during the ’08-’09 market crash to dole out outsized option packages to their executives continues in the form of this front-page article in Friday’s NY Times. Hopefully, boards (and their advisors) will remember all this negative publicity if we experience a similar downturn this year – otherwise we will wind up with legislation that could well kill off options altogether as noted at the end of this blog from William Tysse of McGuire Woods, repeated below:

Are “tax breaks” from stock options a “windfall” for corporations?

The New York Times seems to think so. Their argument runs as follows:

Thanks to a quirk in tax law, companies can claim a tax deduction in future years that is much bigger than the value of the stock options when they were granted to executives. This tax break will deprive the federal government of tens of billions of dollars in revenue over the next decade….

In Washington, where executive pay and taxes are highly charged issues, some critics in Congress have long sought to eliminate this tax benefit, saying it is bad policy to let companies claim such large deductions for stock options without having to make any cash outlay….

A stock option entitles its owner to buy a share of company stock at a set price over a specified period. The corporate tax savings stem from the fact that executives typically cash in stock options at a much higher price than the initial value that companies report to shareholders when they are granted.

But companies are then allowed a tax deduction for that higher price.

(Somewhat later, the article does get around to acknowledging that the employees who exercise the options are also taxed at that higher price — often at individual rates higher than the corporate rate.)

The proposal that the article seems to advocate — i.e., to allow companies a deduction for only the accounting expense of the option, instead of the gain recognized on exercise — raises a number of questions:

– Should companies be allowed this deduction as expense is recognized, even if the option ultimately expires unexercised, because for instance the employee terminates when the option is underwater?
– Should individuals be taxed only on the accounting expense as well — regardless of when (or indeed if) they exercise the options, and regardless of the actual gain they realize upon exercise?
– What economic difference is there between “cash outlays” and share outlays that would justify this disparate treatment? Although the article focuses on options, wouldn’t the same logic apply to other forms of stock-based compensation, such as restricted stock? And wouldn’t this change, if implemented, simply push companies to pay the same compensation in cash instead of shares? Is that a desirable policy result?

Although it doesn’t attempt to grapple with any of these issues, the article does go on to note that legislation to enact this change has been floating around in Congress for years, but has never gone anywhere. Despite this, budget shortfalls and election year politics may nevertheless conspire to turn 2012 into the year that this change finally becomes law. And that would likely spell the end of stock options for good.