Permanent Subcommittee on Investigations Holds Hearing on Executive Stock Options

New Data Shows Outsized Tax Deductions Compared to Booked Expenses

WASHINGTON – Tomorrow, Sen. Carl Levin, D-Mich., and Norm Coleman, R-Minn., Chairman and Ranking Member of the Senate’s Permanent Subcommittee on Investigations, will hold a hearing entitled, “Executive Stock Options: Should the IRS and Stockholders Be Given Different Information?” The hearing will examine 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 (IRS) on their tax returns. “Stock options are a major factor in the growing gap – now chasm – between executive pay and average worker pay,” said Levin. “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. For example, nine companies we examined 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, has identified a massive stock option book-tax gap of $43 billion, which means U.S. 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. Those companies did not break the law; they are benefitting from an outdated and overly generous stock option tax rule that produces tax deductions that often far exceed the companies’ reported expenses.” “Stock options are valuable and legitimate incentive tools used to reward and retain high performing executives,” said Coleman. “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. While I would agree that exceptional performance demands exceptional pay, it is troubling to investors when mediocrity is rewarded with a king’s ransom. It is imperative that companies take steps to ensure that top executives’ pay is fair and deserved. This requires that companies open their compensation decisions to shareholder scrutiny by providing clear and complete disclosures of executive pay to investors.” 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, for the chief executive officers (CEOs) at 500 of the largest U.S. companies, average CEO pay in 2006 was $15.2 million, including an average gain of $7.3 million from exercised stock options, which provided about 48% of the total. CEO pay is now estimated at nearly 400 times average worker pay, compared to a pay gap of 300 times in 2004, and 100 times in 1990. 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. At the hearing, the IRS will present newly available information on the size of the stock option book-tax difference. Data from a new M-3 Schedule required to be filed by large corporations shows that corporate tax returns for periods ending between December 31, 2004, and June 30, 2005, reported stock option tax deductions that were collectively $43 billion larger than the amounts shown on company books for options granted during the tax year covered by the returns. The $43 billion was about 30% of the entire book-tax difference reported by companies on the M-3. The IRS also found that 82% of the $43 billion book-tax difference was attributable to just 250 companies. The M-3 data does not reflect the new stock option accounting rule that requires stock option expensing beginning in 2006. To understand how the new accounting rule would affect the book-tax difference, the Subcommittee asked nine corporations to calculate what their book expense would have been under FAS 123R for options exercised between 2002 and 2006, and compare that expense to their tax deductions. That analysis showed the tax deductions for the nine companies combined were over $1 billion, or 575%, larger than their book expense, even under the new rule. The hearing will hear from three Fortune 500 companies that were among the nine who helped the Subcommittee with its calculations, the Acting Commissioner of the IRS, the SEC Director of Corporation Finance, and three stock option experts. “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.” Contact: Tara Andringa 202-228-3685 Tara_Andringa@levin.senate.gov