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Recent
Legislative Developments
Expensed
or otherwise, stock options have been a fruitful
source of controversy over the years, and the
Treasury has made numerous moves to clamp down
on what it sees as abusive aspects of option
issuance.
In July, 2003 the Treasury announced the
closure of a tax loophole promoted to executives
enabling them to defer income tax on stock option
gains beyond the exercise of the option. The
method employed to execute this scheme involves
the transfer of stock options to a family member
or family-owned limited partnership in which
the executive has a significant interest. The
executive then receives a long term unsecured
note in exchange whilst the relative exercises
the option, stating that they will not recognize
any gains until it is subsequently sold and
then only if the proceeds are more than the
price paid for the option and the exercise price.
The scheme's promoters claim that no tax needs
to be paid on the option until payments are
made on the long term note. The Treasury Department
says: "The IRS will challenge the executive’s
claim that income from the exercise of the stock
options can be deferred. The regulations, which
are effective immediately, prevent an executive
or any other person from claiming tax deferral
from the transfer of options to a related party."
In December, the Treasury announced new guidance
concerning changes to certain executive compensation
rules brought about by recently passed tax legislation.
The legislation surrounding deferred compensation
plans was tightened as one of the revenue-saving
measures contained in the corporate tax bill
passed by Congress in October. By placing access
restrictions on monies contained in deferred
compensation plans, lawmakers are hoping to
prevent a repeat of some of the abuses witnessed
in the Enron affair, when several executives
siphoned off assets from deferred accounts shortly
before the firm went bust. The new rules aimed
to make it more difficult for a beneficiary
to take out money from such a plan without incurring
a 20% penalty. To avoid this penalty, it was
thought likely that the rules would stipulate
that deferred payments must be made only at
specified times, such as the end of employment
or death, whilst executives classed as ‘key
employees’ may not be able to receive deferred
compensation for six months after ending their
job with a company. The new rules were expected
to prompt a wholesale review of executive compensation
schemes to determine what forms of pay would
be caught by the revised legislation.
In February, 2004, the US Treasury Department
and the IRS issued a revenue ruling that would
shut down an aggressive transaction involving
the exercise of stock options by corporate insiders
using debt financing provided by the corporation.
In these transactions, typically the corporate
insider will exercise options he or she holds
by giving the company a promissory note. If
the value of the stock later falls below the
face amount of the note, the company may agree
to reduce the insider’s debt. Certain individuals
have claimed that this debt reduction does not
result in taxable income.
In January, 2005, the Treasury issued a ruling
to shut down abusive transactions involving
‘S corporation ESOPs’ (employee stock ownership
plans) classifying such investments as listed
transactions for the purposes of tax shelter
disclosure. According to a Treasury statement:
“The ruling shuts down transactions that move
business profits of the S corporation away from
the ESOP, so that rank-and-file employees do
not benefit from the arrangement. For example,
the ruling prohibits using stock options on
a subsidiary to drain value out of the ESOP
for the benefit of the S corporation’s former
owners or key employees.” Treasury Assistant
Secretary for Tax Policy Pam Olson observed:
"Congress recognized the potential for attempts
to circumvent the rules and specifically authorized
Treasury and IRS to prevent it. This notice
does just that, imposing a 50% excise tax on
the option holders in cases where rank-and-file
ESOP participants are deprived of the business
profits."
In July, 2005, the United States government
dropped its proposal to assess Social Security
payroll taxes on incentive stock options. The
proposal, first released in November 2001, would
have affected incentive stock options and options
under employee stock purchase share plans, both
otherwise known as 'statutory stock options.'
However, the proposal attracted much opposition
from businesses, which objected to the onerous
record-keeping burden the measures would bring.
The proposal called for Social Security taxes
to be applied to statutory stock options exercised
on or after January 1, 2003. However, the withdrawal
of the proposal by the US Treasury Department
and the Internal Revenue Service would have
little practical effect, as a moratorium on
the options tax proposal was extended indefinitely
in 2002. The 2004 American Jobs Creation Act
also effectively excluded these stock options
from payroll taxes.
In July, 2005, the IRS also announced a "robust"
response to the executive stock option initiative,
a scheme which allowed corporate executives
and their companies to settle disputed stock
option transactions regarded as abusive by the
IRS. Under the disputed stock option scheme,
executives attempted to defer tax on stock option
income for up to 30 years. The settlement required
executives to include 100 percent of their stock
option compensation in income, pay applicable
interest, income and employment taxes and pay
a 10-percent penalty.
“When we announced this initiative in February,
we wanted to give corporations and executives
a chance to turn the page and make things right,”
stated IRS Commissioner at the time, Mark W.
Everson. “The vast majority of those involved
chose to come forward under the settlement’s
tough terms. The response reflects higher standards
for corporate governance and less tolerance
for abusive tax transactions," he added. Of
124 executives identified, 10 were determined
not to have participated in the abusive transaction.
Of the remaining 114, 80 executives elected
to participate under the terms of the settlement
offer. Fifteen other executives reached agreement
through the audit process. Nineteen individuals
did not elect to participate. Those who declined
to participate in the settlement offer are either
under audit or had other pending criminal tax
investigations.
Those executives who elected to participate
or otherwise resolved their tax liability had
$500 million in potential income adjustments.
The IRS estimated that the 19 executives who
did not participate in the settlement offer
underreported their income by more than $400
million. Of 46 corporations identified, four
were found to have correctly reported the transaction
on their returns. Of the remaining 42 corporate
participants in the transaction, 33 elected
to participate in the settlement initiative.
Four corporations had passed the statute of
limitations for audit although their related
officers elected to participate in the initiative.
Five corporate taxpayers elected not to participate.
The settlement initiative attracted four new
companies and seven executives that had not
previously been known to the IRS.
In August, 2005, the IRS announced that international
companies would be unable to claim tax deductions
for dividends paid on shares held by American
employees under stock ownership plans as a result
of new regulations released by the US Treasury
Department.
According
to the regulations, only the parent company
can claim the deduction, which will mean the
elimination of employee stock ownership plans
for US subsidiaries of foreign companies.
The
regulations also state that no companies, regardless
of where they are based, can deduct the cost
of repurchasing shares sold to employers under
an employee stock ownership plan.
The
proposed regulations, which would go into effect
after a comment period, were aimed at a 2003
U.S. Ninth Circuit Court of Appeals ruling,
which agreed with Idaho-based paper and wood
products company Boise Cascade Corp. that the
firm could treat a stock buyback as a dividend
and therefore claim a tax break.
The
IRS had denied the refund, and had served notice
to other companies that it intended to contest
similar deductions in other districts.
In 2006, the President Bush's Tax Panel recommended
abolishing the AMT; both of the Tax Panel's
recommended options for reform include axing
the AMT, and there was an AMT patch in the 2006
Tax Reconciliation Act signed by the President
in May. But the Panel's proposals remained just
that, and in 2009 fundamental reform of the
AMT seems as far away as ever.
Meanwhile,
more and more US taxpayers are falling foul
of the provision in AMT legislation that applies
income tax to gains on exercise of ISO's (Incentive
Stock Options) - and the tax remains due whatever
the eventual value of the exercised options.
Many people received and exercised options during
the high-tech boom before 2001, and are now
being pursued by the IRS for tax even though
the underlying shares may have lost all or most
of their value. Horror stories abound of families
being forced into bankruptcy as a result.
In January 2007, US Senators Max Baucus
(D-Mont.) and Chuck Grassley (R-Iowa) introduced
legislation on the first day of the 110th Congress
to repeal the individual alternative minimum
tax beginning in the 2007 tax year.
“This
bill is really a bellwether for one of the Finance
Committee’s biggest priorities this year.
The new Congress intends to provide tax relief
to middle-income Americans in a fiscally responsible
way, and the AMT is the right place to start,”
stated Baucus, the chair of the Finance Committee.
“It’s time not only to stop this
stealth tax for 2007, but to look for longer-term
solutions that are actually financially feasible.
Grassley
added: “We’ve kept more taxpayers
out of the AMT every year for the last six years,
and the AMT needs to be repealed for good. The
tax has long outlived its usefulness."
Grassley
warned fellow lawmakers not to fall into certain
"traps" when considering AMT repeal,
particularly counting the revenue that AMT raises.
"It’s
ridiculous to rely on revenue that was never
supposed to be collected in the first place.
Another trap is raising taxes to ‘pay’
for AMT repeal. It’s unfair to raise taxes
to repeal something with serious unintended
consequences like the AMT," he argued.
"The
bipartisan Senate bill introduced in the last
Congress shows plenty of interest in AMT repeal.
Its 21 co-sponsors give momentum for the new
Congress," he added.
Then in June of 2007, Senator Grassley put
forward a proposal for a 'safeharbor' mechanism
to prevent millions of new US taxpayers having
to calculate estimated tax under the Alternative
Minimum Tax system.
"The
tax has not decreased the number of people who
are able to legally eliminate all of their income
tax liability. The only thing the Alternative
Minimum Tax does successfully is pull in a vast
amount of money for the federal government.
This is especially ironic in that the Alternative
Minimum Tax was conceived primarily to promote
tax fairness, and not to raise revenue,"
Grassley remarked.
He
went on to add that: "I am going to be
introducing legislation that will provide taxpayers
a safeharbor from being punished for the fact
that Congress has failed to deal with the AMT."
Under
Grassley's proposal, in calculating their estimated
tax, a taxpayer would be permitted to disregard
the alternative minimum tax if the individual
was not liable for the alternative minimum tax
for the preceding tax year. "So if you
didn’t have to pay AMT last year we aren’t
going to penalize you if you don’t file
estimated taxes for AMT this year. Just because
Congress can’t do its job, doesn’t
mean the taxpayer should be punished,"
he remarked.
House
Democrats were reportedly going to propose a
'surtax' on wealthy individuals to pay for the
removal of AMT on the increasing number of middle
income taxpayers now caught in the system's
trap. However, Grassley was firmly of the view
that Congress should not be trying to replace
revenues that were never intended to be collected.
Grassley
argued that the best solution to the problem
was his “Individual Alternative Minimum
Tax Repeal Act of 2007,” introduced with
Senate Finance Committee Chairman Max Baucus,
and Senators Crapo, Kyl and Schumer.
"That
solution is to permanently repeal the tax without
offsetting revenues that would not be collected
as a result of repeal. Revenues projected to
be collected by the Alternative Minimum Tax
are revenues the tax was never meant to collect,
and that would only be collected through error.
To make offsetting a condition for repeal is
to commit to reshape a problem without actually
solving it," Grassley told the Senate.
A
further temporary AMT 'patch' was put in place
in December 2007, increasing the exemption amount,
amongst other provisions. However, a permanent
fix seemed as far away as ever.
Also in June 2007, a Senate subcommittee
hearing on the vexed issue of executive stock
options concluded that new tax and accounting
rules are 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
IRS data, examining tax returns for periods
ending between December 2004 to June 2005, shows
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 from 100 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 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.
With regard to the Alternative Minimum Tax,
temporary 'patches' have been put in place on
a regular basis to increase the exemption amount,
the last being in 2009, USD46,700 for single
individuals. However, in 2010 the exemption
amount was reduced to USD33,750 for single individuals.
A permanent fix for the AMT is seemingly as
far away as ever.
In September 2008, a bipartisan group of Congressmen
secured a commitment from the IRS to suspend
the collection of AMT liabilities, including
interest and penalties, that arose from employees’
exercising of incentive stock options.
Senator
Chuck Grassley, one of the leading exponents
of the campaign, said that the suspension gives
Congress time to enact legislation that would
ease these burdens on affected taxpayers.
“Taxpayers
in this situation faced a lot of income tax
on very little income,” Grassley said.
“There’s bipartisan consensus to
fix the problem. By holding off on collections,
the IRS is giving Congress time to act without
making things worse for the affected families.
On
July 3, Grassley and Senate and House colleagues
wrote to IRS Commissioner Doug Shulman, asking
for a suspension of liability and penalty collections
in incentive stock option AMT cases. In turn,
Shulman notified Grassley and his Congressional
colleagues that the agency was offering the
suspension.
Under
current law ISO AMT families are entitled to
use refundable credits into the future to compensate
for what they owe now. However, they are pressed
to pay their current liabilities immediately,
without regard for the refundable credits.
"These
families are facing the garnishments of wages,
foreclosures of homes, seizures of retirement
accounts, and all the other tools available
to the IRS to settle uncollected tax debts,"
the lawmakers pointed out in their letter to
Shulman.
"There
is now a very broad bipartisan consensus to
abate all interest and penalties attributable
to ISO AMT liabilities and permit taxpayers
to apply the full amount of their future refundable
credits towards the entirety of their current
ISO AMT liabilities," the letter added.
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