Options Writeoffs: See Under "Sweetheart Deal"

In the course of researching a proposal on ways to balance the budget, I came across a piece by the decidedly liberal Institute for Taxation and Economic Policy called "Corporate Tax Incomes in the Bush Years." While it contains a good deal of misleading material, the main point is valid and worth paying attention to: the largest companies often take advantage of tax policies they helped influence in order to dramatically cut down their taxes, in ways that smaller firms cannot. I am not quite as outraged about the situation as the authors of the study; some of the policies they object to have valuable economic effects, and one in particular (accelerated depreciations) was strictly temporary and has already expired.

But many tax credits and writeoffs are unjustified, indefensible, and implicitly shift the tax burden onto small businesses and individuals for dubious benefits. Tonight I will pick on just one such writeoff, the one on exercised options.

When a company issues stock options to its employees, the strike price for those options is often well below the actual price of the stock. This is especially true for executives, who can often pick up shares at half price or less. Many companies use options, so goes the theory, to encourage employees to work for the general good of the company by tying compensation to the stock price. More often, options are employed for their stupendous tax benefits.

When the option is exercised, the option-holder purchases stock for less than market price—often considerably less. This could, in theory, depress the market price in response, especially if there are a large pool of unexercised options out there to scare away traders. Somehow our enlightened lawmakers took this idea and produced our current law: when an employee exercises a company-provided option, the company itself gets a tax writeoff equal to the difference between the strike price and the market price of the stock!

That was a bit jargon-heavy. Consider this example, which should be easier to understand:

Employee A works for XYZ company. Instead of paying A a salary of $100,000, they pay him $50,000 cash and 10 option contracts for XYZ stock which give him the right to purchase 1,000 shares of stock at $50 per share. The stock trades at $100, so he can exercise the options, immediately sell his shares on the open market, and come out with $100,000 anyway.

What's the difference? The actual salary is smaller, decreasing payroll taxes and the like. And because selling the shares on the open market depressed the price a tiny bit, XYZ can claim a tax writeoff on the $50 difference in price (i.e. $50,000) to make up for the "damage" to its market capitalization!

To be fair, often the stock options are sold back to the company for cash, in which case the writeoff bears some relationship to reality. But the writeoff is good even if the options are redeemed on the open market, and in any case the whole arrangement is often used to duck taxes and for no other reason. Now, I'm all for using the tax code to encourage behavior seen to benefit the state, within reason. But this sort of symbolic paper-juggling has no practical benefits, absorbs a great deal of time and effort for the involved parties, and has no general benefit that justifies tax advantages—especially when those companies not wealthy enough to issue stock must struggle along as best they can.

Can anyone tell me why the government should be encouraging the use of stock options as de facto salary instruments?

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