Carl Levin: Stock Option Tax Loophole Must Be Closed

October 5, 2007 -- Stock options are a key part of the compensation paid to U.S. corporate executives, making up nearly half of what the 500 largest U.S. companies paid their CEOs in 2006, according to Forbes magazine. Part of the reason is a costly glitch in our tax code that allows companies to recoup a sizable portion of their stock option pay at the expense of Uncle Sam.

Stock options are essentially contracts that give employees the right to buy company stock at a set price for a specified period of time. When issued, the company places a value on those options and enters that value on their books as an expense. After the options are exercised by the employee, the company claims a tax deduction which is usually far higher than the expense they put on their books when the options were granted.

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Companies aren’t cheating on their taxes when they claim a bigger stock option tax deduction than their actual book expense. Current tax rules provide for that. But the result of this mismatch is that companies receive a tax deduction from the IRS that can be double, triple or even ten times larger than what they report on their own books to investors and stockholders. There is no other form of compensation for which the tax deduction may be larger than the expense shown on a company’s books.

The Permanent Subcommittee on Investigations, which I chair, held a hearing in June and found that nine companies (who voluntarily cooperated with the inquiry) claimed over $1 billion more in stock option tax deductions than they would have showed as expenses on their books under current accounting rules.

For instance, one company, Occidental Petroleum, took a $353 million tax deduction from stock options cashed in by its CEO over the last five years, even though under current accounting rules the same stock options would have shown a maximum book expense of $29 million.

Those nine companies aren’t alone. The IRS has determined that, in 2004, U.S. corporations claimed a total of $43 billion more in stock option tax deductions than they showed as expenses on their books, helping them avoid paying billions of dollars in taxes in that one year alone.

This corporate tax break creates an incentive for companies to provide their executives with larger and larger stock option grants: the bigger the stock option pay for executives, the bigger the tax deduction for the company. Someone has to make up for all that lost tax revenue; that’s the rest of us.

That’s why I recently introduced a bill to end the stock option double standard that is fueling sky-high executive pay and depriving the Treasury of much-needed revenue. It’s called the Ending Corporate Tax Favors for Stock Options Act. This legislation would require companies to match their stock option tax deductions with the amount shown on the financial reports they file with the Securities and Exchange Commission.

The famed American banker J.P. Morgan once said that CEO pay should not exceed 20 times what the average worker receives. Today, the average CEO is paid nearly 400 times as much as the average worker, a towering difference that can be explained in part by stock option tax and accounting rules that are out of kilter.

Our tax code shouldn’t be subsidizing stock option pay through generous tax deductions. It’s time to treat stock options like other forms of compensation and require the corporate tax deduction to match, not exceed, the book expense.

Source: Carl Levin