The Senate Homeland Security & Governmental Affairs Permanent Subcommittee on Investigations held a hearing Tuesday focusing on stock options and the "book-tax accounting gap." Corporations sometimes compensate employees (particularly executives) with options to buy stock at a set price. The employee can wait to exercise the option until after the value of the stock has increased beyond that price, thus enjoying a substantial benefit.
When stock options are exercised, employees report the difference between the value of the stock and the exercise price as taxable wages, and corporations take a corresponding tax deduction. Until recently, however, companies didn't have to reduce the profits they report to their shareholders by the cost of the stock options.
Many people, including us, complained that it didn't make sense for companies to treat stock options inconsistently for tax purposes versus shareholder-reporting purposes. As a result of these complaints, new rules now require companies to lower their "book" profits somewhat to take account of options. But the book write-offs are still considerably less than what they take as tax deductions. That's because the oddly-designed rules require the value of the stock options for book purposes to be calculated - or guessed at - when the options are issued, while the tax deductions reflect the actual value when the options are exercised.
Senator Carl Levin (D-MI), chair of the subcommittee, stated in a press release that "Companies pay their executives with stock options in part because, right now, those stock options often generate huge tax deductions that are 2, 3, even 10 times larger than the stock option expense shown on the company books." According to calculations made by his staff using IRS data, firms deducted $43 billion that was not included in financial books in this manner between December 2004 to June 2005. He argued that this is especially problematic now because it seems to fuel the widening difference in pay for executives compared to rank and file workers. Levin said he plans to introduce legislation this fall to require companies to treat stock options the same for both book and tax purposes.