McCain, Levin Introduce Bill to Alter Tax Treatment of Stock Options

Senators John McCain and Carl Levin yesterday introduced legislation (S. 1491 - see below for link) which would radically change the way corporations deduct compensation paid to their employees in the form of stock options.

I note that we've been down this road before

Under current law, (Section 83 of the Code), a corporation deducts compensation related to a stock option granted to an employee at the time the employee exercises the option (this is correspondingly the time the employee recognizes the income). The amount of compensation expense (and therefore the amount of the deduction) is the "spread" at exercise - i.e., the difference between the fair value of the stock upon exercise and the exercise price the employee must pay.

The accounting treatment is different - and is the reason for the bill. Under accounting rules, corporations are required to book expense related to stock options upon grant and book the "fair value" of the option (determined under Black-Scholes or some other option pricing model) at the time of grant.

The book expense will often (nearly always) be less than the tax expense. From a financial accounting perspective, companies like this - they show a small expense for book purposes, which has a minor impact on earnings and then get to monetize a much larger expense via the greater tax deduction.*

a few years ago, companies were allowed, for GAAP purposes to book zero expense upon grant, on the basis that the options had no "intrisic" value at grant if they were granted out of the money or "at the money" (i.e., the exercise price was at least equal to the value of the underlying stock at grant). This changed a few years ago and now companies are (rightly) required to book comp expense based on the fair value of the options

The Levin/McCain bill would change current law and limit companies' tax deduction to the amount reported as compensation expense for book purposes.

This makes no sense to me. The employer's tax deduction is based on the compensation its employee includes in income - you have yin and yang. It's fundamental in the tax law that corporations are entitled to deduct compensation paid to their employees (so long as it is not "excessive"). This would alter that fundamental law on the basis that the accounting treatment is different; however, there is no dodge here.

Perhaps the Senators want to steer companies away from making large option grants in the first place:

By eliminating what Levin called an “excessive and outdated corporate tax deduction,” the Michigan senator said, “we would not only eliminate a tax incentive that encourages corporate boards to hand out huge executive stock option pay, but also ensure that profitable corporations do not use outsized tax deductions to escape paying their fair share of the tax burden.”Breaking that parity and tying the comp deduction to the accounting treatment

The deductions are not "outsized". They match the income that employees are reporting and paying tax on. If the link between the employee's income and the deduction is broken, the IRS will have a windfall (unless companies begin to report much higher comp expense for accounting purposes, which seems unlikely).

Perhaps I am missing something, but this strikes me as particularly unfair and silly. If the Senators want to limit stock option grants, then they should limit stock option grants - just make the $100,000 limit applicable to incentive stock options applicable to all stock options (or perhaps choose a greater limit).

Update: Man, the Tax Prof is fast

Further Update: Here is the legislation.