United States Individual Tax Site: Introduction

Introduction A summary of the range of schemes available in the US.

Employee Stock Option Plans There are numerous advantages for employees, companies, and existing shareholders when implementing an ESOP.

Profit Sharing Plans And Eligible Individual Account Plans (EIAP) An EIAP is a form of profit sharing plan which can be designed to permit up to 100% of trust assets to be invested in employer securities.

401(K) Plans A 401(k) plan permits employees to choose to defer a portion of their wages on a pre-tax basis.

Broad Stock Options: Incentive Options With an incentive stock option, a company grants the employee an option to purchase stock at some time in the future at a specified price.

Employee Stock Purchase Plans The purchase plan option gives employees an opportunity to share in the growth potential of the company's stock.

Unqualified Broad Stock Options The purchase plan option gives employees an opportunity to share in the growth potential of the company's stock.

Recent Legislative Developments The Treasury's rulings from 2004 to 2009, and legislative efforts in Congress.

Introduction

In the US there is a broad division between stock ownership schemes that benefit widely defined types of employee and attract tax benefits (called 'qualified' schemes) and discretionary schemes which receive less interesting tax treatment, often called 'broad' stock option schemes. US qualified schemes are often tied to retirement schemes under ERISA.

Several hundred large public companies provide stock option schemes to all their employees, as well as many thousands of private companies. In one survey of electronics companies, just over half the responding companies said they provide options to most or all employees, with companies under 100 employees being the most likely to do so.

However, the most typical form of employee ownership in the US is the qualified scheme known as an employee stock ownership plan, or ESOP, followed up by schemes using the 401(k) retirement structure.

Broad ownership schemes, and limited schemes for senior executives or other special categories of employee are more likely to use discretionary schemes known as incentive stock options and employee stock purchase plans, both of which receive limited tax benefits under the IRS Code.

As in some other countries, the position of an expatriate executive who becomes tax-resident and has existing overseas share options can be very negative; likewise, a resident alien (foreigner) who acquires stock options while working in the US and then returns home may be in a very complex and disadvantageous tax situation. Expert advice is essential for such individuals.

In 2003 the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) moved towards requiring equity compensation expensing, ie that share options should be charged as an expense. Both organisations applied their new standards with effect from 2005.

In June 2007, a Senate subcommittee hearing on the vexed issue of executive stock options concluded that new tax and accounting rules were needed to bring more transparency for investors regarding CEO pay, and to rein in huge and undeserved salaries enjoyed by some bosses at non-performing companies.

The hearing, held by the Senate’s Permanent Subcommittee on Investigations examined corporate accounting and tax rules that require corporations to report one set of stock option compensation figures to investors on their financial statements and completely different figures to the Internal Revenue Service on their tax returns.

Three Fortune 500 companies that were among the nine who helped the Subcommittee with its calculations contributed to the hearing, along with the Acting Commissioner of the IRS Kevin Brown, the SEC Director of Corporation Finance, and three stock option experts.

“Stock options are a major factor in the growing gap – now chasm – between executive pay and average worker pay,” said Sen. Carl Levin (D - Mich), subcommittee chairman. “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."

Levin said that nine companies examined by the subcommittee claimed stock option tax deductions over five years that exceeded their stock option expenses by more than $1 billion, or 575%, even after using tougher new accounting rules to calculate the book expense.

New (at the time) IRS data, examining tax returns for periods ending between December 2004 to June 2005, showed a stock option book-tax gap of $43 billion, "which means US companies legally reduced their taxes by billions of dollars for that period by claiming $43 billion more in stock option tax deductions than the stock option compensation amount shown on their books," Levin stated.

"Those companies did not break the law," he continued. "They are benefiting from an outdated and overly generous stock option tax rule that produces tax deductions that often far exceed the companies’ reported expenses.”

Stock options give employees the right to buy company stock at a set price for a specified period of time, usually 10 years. According to Forbes magazine, in 2006, the average pay of the chief executive officers of 500 of the largest US companies was $15.2 million. Nearly half of that amount, 48%, came from exercised stock options that produced average gains of about $7.3 million. On the high end, one CEO cashed in stock options for $290 million, another for $270 million. Forbes also published a list of 30 CEOs in 2006, who each had at least $100 million invested stock options that had yet to be exercised. In the United States, average CEO pay has grown from100 times average worker pay to nearly 400 today, according to Levin.

“Stock options are valuable and legitimate incentive tools used to reward and retain high performing executives,” said Norm Coleman (R - Minn), ranking member of the subcommittee. “However, anything can be problematic in excess, and I fear we have reached that point. It is clear that favorable tax and accounting rules have caused companies to issue far too many stock options on far too generous terms, greatly contributing to the meteoric rise in executive pay."

Publicly traded corporations are required by law to follow Generally Accepted Accounting Principles (GAAP) issued by the Financial Accounting Standards Board (FASB), which is overseen by the Securities and Exchange Commission (SEC). Until relatively recently, GAAP allowed corporations to show a zero expense on their financial statements for most stock options. In 2005, FASB issued a new accounting rule, Financial Accounting Standard (FAS) 123R, requiring companies to show an expense on their books equal to the stock options’ fair value on the date they are granted.

Under Section 83 of the tax code, first enacted in 1969, the stock option tax deduction does not reflect the expense shown on a company’s books. Instead, the stock option deduction is calculated on the date that a stock option is exercised, which is often years after it is granted. The deduction is equal to the difference between what the employee paid to exercise the option and the market value of the shares on the exercise date.

Because the accounting rule values stock options on their grant date, and the tax deduction values stock options on their exercise date, the two numbers do not match. The data indicates that, in most cases, the tax deduction exceeds the book expense. Stock options are the only type of compensation expense where companies are allowed to take a tax deduction that exceeds the expense shown on their books.

“It is time to take a serious look at whether it makes sense to have two completely different sets of stock option rules for financial accounting and tax purposes,” said Levin, “especially when the result is a revenue loss of billions of dollars.”

Levin introduced a bill, in July, 2009, to 'amend the Internal Revenue Code of 1986 to provide that corporate tax benefits based upon stock option compensation expenses be consistent with accounting expenses shown in corporate financial statements for such compensation'. The bill was referred to the Committee of Finance in the same month. No further developments on this bill have been reported.