article is reprinted with permission from the
March 29, 1993
New York Law Journal.
© 1993 NLP IP Company.
Proposed Tax Changes; Stock Options
By Joseph E. Bachelder
TODAY'S COLUMN focuses on the following developments: (1) new tax rules proposed in the President's economic program and (2) the status of the issue of whether there should be a financial statement charge for employee stock options.
Proposed New Tax Rules
The President's economic program, if enacted as proposed, would introduce a number of changes in the tax law that would affect executive compensation.
Tax Rates on Executives
For an executive earning more than $250,000 in currently taxable compensation, the marginal federal income tax rate would rise to 39.6 percent, an increase of 27.7 percent from the current marginal rate of 31 percent. 1 This rate is composed of a new marginal income tax rate of 36 percent plus a surtax of 10 percent. In addition, such executive would be subject to a federal Medicare tax rate of 1.45 percent (the current cap of $135,000 on income subject to the tax would be removed). Thus, the aggregate marginal federal tax rate for such executive would become 41.05 percent. The effective date of the proposed changes would be on after Jan. 1. 1993.
Following is a table showing the federal, state and local taxes for an executive who is a resident of New York City if his ordinary income subject to federal, state and local taxes is (i) $100,000, (ii) $250,000, (iii) $500,000 or (iv) $1 million. 2
|Effect of New Tax Proposal|
|Ordinary Income Subject to Federal, State and Local Income Taxes||$100,000||$250,000||$500,000||$1,000,000|
|Federal, State and Local Income Taxes Under Current Rates||$21,582||$73,223||$160,098||$338,076|
|Federal, State and Local Taxes Under Proposal*||$21,582||$77,612||$183,957||$405,734|
|Percent Increase in Aggregate Taxes||0%||5.99%||14.90%||20.01%|
* Includes increase in Medicare tax.
Tax Deductions for Corporations
The proposed new tax rules would include a provision eliminating a deduction for compensation of more than $1 million unless it is "linked to productivity." 3
The Administration's economic program does not explain what is meant by compensation "linked to productivity." The Treasury Department has stated that "there is concern that current law does not provide significant incentives for corporations to link compensation to business performance" and that Treasury "is reviewing appropriate standards regarding this exception." 4 In response to questions presented by the Senate Finance Committee, Treasury Secretary Lloyd Bentsen said that the department is "still in the process of developing the specific guidelines for the proposal" and that the department's goal "is to provide a strong tax incentive for corporations to link executive pay more closely with long-term performance in the business." 5
It is somewhat early to speculate on how this proposal will affect executive compensation planning. Assuming a serious effort is made by the Administration to enact this proposal (there is limited revenue-raising potential in the legislation -- the President's report indicates $600 million in the next five years) 6 -- its bite will be reduced by the "productivity" exemption. Among the questions is whether productivity includes growth in share value of the employer. It it does, stock options and restricted stock presumably would be exempted.
Accounting for Stock Options
In 1982 the Accounting Principles Board issued APB Opinion No. 25, "Accounting for Stock Issued to Employees," which contained, among other things, the accounting principle that an employee stock option with an exercise price equal to the fair market value of the underlying stock at the date of grant did not result in a charge against earnings. This was the rule before APB No. 25, and it has been the rule since.
Part of the debate in the preparation of APB No. 25 was over whether an employee stock option was susceptible to valuation at time of grant. If it were not susceptible to valuation how could a charge against earnings be made at that time?
Today -- more than 20 years after APB No. 25 was adopted (and nearly 40 years after Accounting Research Bulletin No. 43, the predecessor to APB No. 25, was adopted) -- the rule continues to be that no charge is made against employer earnings for the grant of stock option with an exercise price equal to the fair market value at date of grant.
The accounting profession's current rule-setters -- the Financial Accounting Standards Board (the FASB) -- are revisiting this stock option issue. Following is a summary of the issue's history since APB No. 25 was adopted in 1972 and the status of the current review.
The late 1970s and into the 1980s
The FASB, successor to the APB, studied that matter carefully in the late 1970s and in the 1980s. After Nearly a decade of study, the FASB tabled the issue of whether stock options could be valued and charged to earnings. (Other related issues also were put aside.) After the set-aside by the FASB, the issue remained dormant in the late 1980s and into the early 1990s.
June 4, 1991
Senator Carl Levin, D-Mich., introduced a bill in the Senate that, among other things, would require stock options to be valued and charged against earnings. 7 This bill was introduced in the midst of a recession and when executive compensation was being subjected to close scrutiny, and criticism, in the media.
Senator Levin held hearings on his bill. He suggested that unless the FASB and/or the Securities and Exchange Commission did something in support of his proposal on stock options, he would press for passage of his legislation to require a charge against earnings for stock options. At the hearing James J. Leisenring, vice chairman of the FASB, indicated a study of the subject was under way at the FASB but would not speculate as to when the study would be completed.
The FASB began scheduling quite regularly the stock option valuation and accounting charge issues at its meetings. A staff task force began close study of the subject. A task force of executive compensation consultants, accountants and others (Stock Compensation Task Force) also was assembled and was invited to make comments at FASB meetings.
Members of the FASB and its staff appeared to be heading toward an exposure draft, expected in the first part of 1993, that would adopt the position that stock options should be valued and become a charge against earnings based on date of grant value. A good deal of debate centered around how to value a stock option at the time of grant.
In support of the direction the FASB seemed to be taking were institutional shareholder groups such as the United Shareholders Association, institutional shareholders such as the California Public Employees' Retirement System (CalPERS) and such corporate gadflies as Graef Crystal.
In opposition to the FASB's apparent direction was the Business Roundtable and many public corporations with a stake in employee stock options. A broad-based view expressed by many U.S. corporations was that employee stock options were no more subject to valuation than they had been at the time of prior reviews of the subject.
The SEC (having adopted its own rules, effective for the 1993 proxy season, requiring disclosure with required estimates of the value of stock option grants in proxy statements) sat on the sidelines, so to speak, letting the FASB address the accounting issue.
A substantial distance continued to exist between the position of major corporate groups, such as the Business Roundtable, and the position of the advocates of change such as public institutional shareholders and Senator Levin.
On Feb. 19, the FASB met with the Stock Compensation Task Force. A compromise of sorts was put forward by a number of groups.
Under the suggested compromise, instead of a charge against earnings, grants of stock options would appear in a table in the footnotes to the financial statements. This table -- a "cousin" of the Stock Option Grant Table now required by the SEC to be included in proxy statements -- would disclose stock option grants for the year being reported together with a display of values under three methods: (i) assuming 5 percent growth in company stock values over the option term, (ii) assuming a 10 percent growth in company stock values over the option term and (iii) using a valuation based on the Black-Scholes model. As proposed, all three methods have differences in methodology from the methodology used by the SEC in its proxy statement disclose rules. 8
Among those supporting the proposal made at the Feb. 19 meeting are numerous institutional shareholders, a number of major U.S. corporations and the Big Six accounting firms. At the March 10 meeting of the FASB, a group of consultants specializing in executive compensation indicated their support of a modified version of the disclosure approach suggested to the FASB at the Feb. 19 meeting.
In the meantime, the FASB continues to deliberate on the issues in its effort to prepare a new accounting principle that would require a charge against earings for employee stock options. Its next scheduled meeting on the subject is April 7.
It also should be noted that Senator Levin reintroduced a bill on Jan. 28 that would compel an accounting charge if the FASB does not promptly adopt such a rule. 9
The 20-Year Process
Following are some observations on this 20-year deliberative process and the current status of the FASB project:
1. As already noted, on a number of occasions in the past, before introduction of Senator Levin's bill in June 1991, the rule-setters for the accounting profession have concluded that an employee stock option cannot, practically speaking, be given meaningful valuation and therefor should not be subject to a charge against earnings when granted. These numerous occasions have spanned more than 40 years.
2. There appears little difference in the issue of valuation of employee stock options today from the issue over the past 40 years. An employee stock option typically (i) is subject to continued employment requirements before it becomes exercisable, (ii) is virtually non-transferable and (iii) is subject to forfeiture upon termination of employment (with certain modifications depending upon the nature of the termination). It is difficult to accept an argument that such an entitlement is susceptible to meaningful valuation at time of grant. 10
3. The SEC, itself an agent of the political pressure exerted by Senator Levin's bill, adopted rules for proxy statement disclosure purposes that require a value be placed on stock option grants based on future annual growth assumptions of 5 percent and 10 percent over the terms of the options. This is an effort by the SEC to prescribe a value for options. 11 The SEC also permits the use of the Black-Scholes model, or similar methodology, for estimating the value of an option at time of grant.
4. What really motivates the FASB at this point appears to be a political factor. What will become of Senator Levin's bill if something is not done -- promptly?
5. The compromise as suggested by various groups at the February and March meetings of the FASB -- putting a valuation on an option grant in a disclosure table to the financial statements -- begs the question as to whether stock options are susceptible to valuation. It is an obvious effort to deflect the FASB from what is perceived as a far worse result for U.S. corporations: a requirement that they charge earnings with some arbitrary value developed by the FASB based on the Black-Scholes model or some other methodology. (Even worse would be a charge against earnings based on option spread at time of option exercise -- a result the FASB thus far has quite clearly evidenced an intent to avoid.)
A consequence of the proposed compromise, if adopted by the FASB, could be an opening of the door to members of Congress with a distaste for stock options to argue that nonqualified stock options should not result in ordinary expense deductions for Federal income tax purposes. Such a tax result would be a major blow to after-tax earnings as well as cash flow for U.S. corporations.
At the present time, it is difficult to forecast what the FASB will decide. An exposure draft of a new accounting principle should be ready for comments this year -- some suggest as early as May or June. Many corporations no doubt are considering the grant of stock options in the early part of 1993 with the hope (but not certainty) that the effective date of whatever new rule the FASB adopts will not precede the issuance of the exposure draft.
1 "Administration Revenue Proposals" at 32-35 (Feb. 25, 1993) (reprinted in Report No. 37, Special Supplement to 37 Daily Tax Report (BNA) S-12 -- S-13 (Feb. 26, 1993)) (Proposals). The tax rate is for a married taxpayer filing a joint income tax return.
2 The assumptions are that (i) all taxpayers are married and filing joint income tax returns, (ii) Schedule A deductions take into account the reduction of the Schedule A amounts imposed by IRC §68 and (iii) personal exemptions are net of phase-out rules under IRC §151(d).
3 Proposals at 40.
5 Hearing on the President's economic program before the Senate Finance Committee, 103d Cong., 1st Sess. (Feb. 24, 1993) (statement of Lloyd Bentsen, Secretary, U.S. Treasury Department) (quoted in The Reuter Transcript Report [Feb. 24, 1993]).
6 "A Vision of Change for America" at 139 (Table 6, Appendix) (Feb. 17, 1993) (reprinted in Report No. 32, Special Supplement, 32 Daily Tax Report [BNA] S-66 [Feb. 19, 1993]). The Joint Committee on Taxation considers this proposal to have a "negligible revenue effect." See "[Preliminary] Estimated Budget Effect of the President's Tax Proposals," Joint Committee on Taxation at 1 [Feb. 26, 1993] [reprinted in 41 Daily Tax Report [BNA] L-2 [March 4, 1993]).
7 S. 1198, 102d Cong., 1st Sess. (Jun. 4, 1991).
8 See 17 CFR §229.402(c) (Item 402[c] of Regulation S-K) (recently amended by 57 Fed. Reg. 48,125, 48,153-54 [Oct. 21, 1992]).
9 S. 259, 103d Cong., 1st Sess. (Jan. 28, 1993).
10 Both Congress and the Treasury Department have recognized that many compensatory stock options have no "readily ascertainable fair market value." See IRC §§83(e)(3) and 83(e)(4) and Treas. Reg. §§1.83-3(a)(2) and 1.83-7. Moreover, the Eighth Circuit has affirmed a Tax Court case that rejected option pricing models as determinative of a "readily ascertainable fair market value" based on Congressional intent. See generally Pagel Inc. v. Commissioner, 91 T.C. 200
11 See supra note 8. (1988), aff'd, 905 F2d 1190 (8th Cir. 1990).