Expired stock options tax deduction
If you receive an option to buy stock as payment for your services, you may have income when you receive the option, when you exercise the option, or when you dispose of the option or stock received when you exercise the option. There are two types of stock options:
Options granted under an employee stock purchase plan or an incentive stock option (ISO) plan are statutory stock options . Stock options that are granted neither under an employee stock purchase plan nor an ISO plan are nonstatutory stock options .
Refer to Publication 525, Taxable and Nontaxable Income , for assistance in determining whether you've been granted a statutory or a nonstatutory stock option.
Statutory Stock Options.
If your employer grants you a statutory stock option, you generally don't include any amount in your gross income when you receive or exercise the option. However, you may be subject to alternative minimum tax in the year you exercise an ISO. For more information, refer to the Form 6251 (PDF). You have taxable income or deductible loss when you sell the stock you bought by exercising the option. You generally treat this amount as a capital gain or loss. However, if you don't meet special holding period requirements, you'll have to treat income from the sale as ordinary income. Add these amounts, which are treated as wages, to the basis of the stock in determining the gain or loss on the stock's disposition. Refer to Publication 525 for specific details on the type of stock option, as well as rules for when income is reported and how income is reported for income tax purposes.
Incentive Stock Option - After exercising an ISO, you should receive from your employer a Form 3921 (PDF), Exercise of an Incentive Stock Option Under Section 422(b) . This form will report important dates and values needed to determine the correct amount of capital and ordinary income (if applicable) to be reported on your return.
Employee Stock Purchase Plan - After your first transfer or sale of stock acquired by exercising an option granted under an employee stock purchase plan, you should receive from your employer a Form 3922 (PDF), Transfer of Stock Acquired Through an Employee Stock Purchase Plan under Section 423(c) . This form will report important dates and values needed to determine the correct amount of capital and ordinary income to be reported on your return.
Nonstatutory Stock Options.
If your employer grants you a nonstatutory stock option, the amount of income to include and the time to include it depends on whether the fair market value of the option can be readily determined .
Readily Determined Fair Market Value - If an option is actively traded on an established market, you can readily determine the fair market value of the option. Refer to Publication 525 for other circumstances under which you can readily determine the fair market value of an option and the rules to determine when you should report income for an option with a readily determinable fair market value.
Not Readily Determined Fair Market Value - Most nonstatutory options don't have a readily determinable fair market value. For nonstatutory options without a readily determinable fair market value, there's no taxable event when the option is granted but you must include in income the fair market value of the stock received on exercise, less the amount paid, when you exercise the option. You have taxable income or deductible loss when you sell the stock you received by exercising the option. You generally treat this amount as a capital gain or loss. For specific information and reporting requirements, refer to Publication 525.
Taxes and Stock Options.
A Senate hearing on Tuesday will examine the fact that many companies get a much bigger tax deduction for their employee stock options than they report on their income statements to shareholders. Senator Carl Levin, Democrat of Michigan, thinks this is costing the Treasury a lot of money.
That is arguable at best, given that the executives who cash in those options pay a lot of taxes on the profits.
But there is still a case for changing the law. Now employees do not pay taxes on options until they cash them in, and then the company gets an identical deduction. If the option expires worthless, the company gets no deduction, and the employee has no profits on which to pay taxes.
Here is an alternative. Tax the employee on the value of the option when issued. Then, when the option is exercised, or expires worthless, the employee would have a taxable gain (or loss) equal to the difference between the value when issued and the value when exercised.
The company would get a tax deduction for the value of the option, which, as I argued in my column last week, would give the company an incentive not to low-ball the value.
But there is another virtue to that idea. Assume that the companies that are the most successful are the ones whose share prices go up the most. (I know, that is not always the case, but there must be some correlation.) The companies that are struggling end up getting no tax deduction for the options they hand out, while the companies that are making the most money get huge deductions. That part of the tax law is regressive: Your company pays more taxes if it does badly than if it does well.
With normal forms of compensation, when the company makes the payment it knows what the tax deduction will be. For options it does not.
Comments are no longer being accepted.
Great idea! Since there’s no longer any meaningful linkage between executive pay and company earnings, anything we can do prevent the dilution of shareholder value is worthwhile.
Stupid idea, Floyd. The reason for deferring employee taxation on stock options was to encourage companies to provide them to technical, manegerial, and other special skills employees, or at least to make the practice viable. Among other benefits, this allowed start up companies that were underfinanced to afford more and better talented employees by spreading the risk and rewards among such a work force. If options are taxed when issued, many such employees will be unable to raise the cash needed to keep them, and will in fact be worse off if the options turn out to be a worthless investment. Under this latter scenario, money paid by the employee in taxes on the options that could instead have gone into a tax deferred IRA or 401(K) is lost.
Giving the employee the taxable loss if the option expires worthless is, well, worthless, because in my experience the option usually becomes worthless when the company has gone out of business and you’re trying to get by on one-third your former income level and nearly maxed out credit cards, looking for another job. There simply isn’t enough income during a taxable period like that to make the loss worth while.
If you want to take in more taxes, raise income and capital gains tax rates, which are currently far too low for upper income and corporate taxpayers.
I am not surprised that you would like to take issue with the one part of the Internal Revenue Code that actually makes sense! The theory is quite simple, generally, if someone pays taxes on income, the source of the income can deduct the taxes. When an employee is taxed on income from the exercise of a stock option, the company that issued the stock options can deduct the same amount. If a company does not do well and the company’s stock goes down, the employee’s options are worthless, the employee has no income and the company should not have a deduction.
While our progressive income tax system is inherently unfair and burdensome to anyone who actually has a job and works for a living, the only thing fair about it is, that in most cases, it is predicated on a “wherewithal to pay” concept, i. e., taxes are not due until you receive the cash from the income being taxed so that you can pay the taxes. Taxing someone on a phantom paper gain would be ridiculous.
You do raise an interesting point though and that is that the true value of a stock option is not known until it is exercised. Any amount recorded under the accounting rules for compensation expense is meaningless and is at best a wild guess. Everyone agrees that a stock option has value but there is just no reliable way to measure it at issuance. Fortunately, our wealth redistribution system (or income tax system,) recognizes that you can only redistribute a percentage of what someone has actually been paid.
You would have been better of suggesting that the accounting rules should be changed to only record compensation expense on the date that options are exercised and the compensation is known and estimable. Even huge paper gains on unexercised vested stock options can disappear in seconds if something awful, such as Hillary Clinton being elected president, were to occur.
Please let me know if you would like me to do your taxes.
David M. Citranglo, CPA.
Thank you for your generous offer to do my taxes. I’ll pass.
It is worth noting that when restricted stock is given to employees, they owe taxes when the stock vests, even if they do not cash it in, and I am just suggesting treating options the same way. Options have value when they vest, which is why they are treated as an expense at that time.
It would be inconvenient to tax the value of options when they vest, but it is logical. Companies might feel called upon to provide cash to help offset the tax, but some routinely do that now (for top executives if not for others) when they provide taxable benefits such as life insurance.
I have considered the idea of recognizing option expense when options are exercised, as you suggest, but that would produce truly absurd results. Microsoft in the 1980’s would have been recorded as paying million-dollar salaries to secretaries. That was not what the options were worth when they were granted, or what was intended by the company.
You deem a progressive tax system to be “inherently unfair.” But is it fairer to give a huge corporate tax deduction to a compamy that prospered, as Microsoft did, and thereby allow it to avoid paying any taxes, but to deny a deduction to a company that struggled and as a result had its options expire unexercised?
I was not being completely generous, I was hoping that you would introduce me to Maureen Dowd.
I do not think we will ever get to a good answer on employee stock option valuation for financial reporting purposes.
Taxing options when they vest would be better than taxing them at issuance, at a value derived from an option pricing model and I agree that most employers will just pick up the taxes.
In regards to your last paragraph, if the company issued options at the fair market value on the date of issuance and they expired unexercised were they ever really worth anything? Additionally, the struggling company would probably not have to pay taxes anyway since they would have no income. Finally, the tax deduction that Microsoft received for the exercise of employee stock options (which is equal to the amount of cash compensation that the employees received) resulted in an amount of ordinary income being realized by the employees that exercised the options equal to the deduction, the same as any other paycheck – seems fair to me.
Your assertion that a company whose stock fails to rise is probably losing money anyway is not always accurate, I can assure you. And, yes, stock options have value when they are issued, even if they lose that value later. It makes no more sense to give a company a deduction for the rise in the value of its options than it does to give it a deduction for the rise of the value of the underlying stock, even if that rise does lead to the payment of capital gains taxes by shareholders.
Re: NQO for Real Folks and comments on Blog Postings.
Taxing the value of the right to purchase stock at the market price the date of the grant make no sense!! No one will ever accept options, where would they get the money to pay the tax on the right to puchase something partially vesting over 4 years?
And since capital losses are limited to 3,000 how would one deal with that?
The options if they ever come into the black are taxed as salary for the profit. So most folks have to do a buy/sell to pay the taxes and purcase price.
When the effective tax rate is about 40, one has to exercise at lower price then hold any excess share to get capital gains vs keeping the options unexercised.
Your taxation idea would essentially be as bad as AMT on ICO’s and then the market crashed.
And how do you adjust for Blackbox trading and short sellers?
Time to rethink unless you meant to include only certain types of Executives.
Also, many plans now use RSU instead of Restriced Stock options themselves. They vest over 4 years and “lapse” at one certain date, meaning they are automatically exercised at the market price on the Lapse date. The entire value is taxable as ordinary income and the companies do a buy/sell for the taxes and issue the net of tax shares since there is no purchase price to be paid.
But you have to hold the net share a year for Long term capital gain treatment also.
I was wondering when someone would finish the thought for Warren Buffett. What a great system.
First companies are forced by the ethics police to declare an overpriced expense for stock options, diminishing their earnings for financial accounting purposes by an amount that way overstates the actual value of the thing the employees get. Buffett drove, and cheers, this result, but I always suspected not for the Good Old Fashioned Omaha-nian Morality reason commonly attributed to that fine gent.
Buffett understands that companies are ultimately about fundamental value, which is to say, the actual realizable cash value of what they own. There is nothing more realizable for cash value, than cash.
Buffett, and any other fundamental value maven, doesn’t really care whether the grant of stock options is washed through the income statement. They don’t like dilution, sure, but dilution is dilution whether it’s realized in the income statement or not. The option doesn’t affect cash till its exercised either way.
But the Buffetts have succeeded in getting the whole American economy to overvalue stock options for financial accounting purposes – in the name of truth, right, ethics, morality, and the American way. Who cares if those nasty scheming cheating corporations have to overvalue equity compensation? Way to stick it to the man.
Now we start to see the next step, and the real endgame to the strategy. Because now — having convinced most business writers that “expensing options” is logical, and having cloaked the fact that options are being way overvalued for such expensing in the arcania of FASB’s BS and the social power of calling any businessman who objects a greedy whiner — they are ready to collect.
And how to collect? By turning that inflated expense into cold hard cash — fundamental value — through a tax reduction.
It’s really elegant. All they had to do was set up the logic, and they could count on you and the business press to see it, and tout it. The tax legislators don’t care. In fact it likely has the effect of a net increase in collections — moving the value of the option from companies (who might or might not have income to be taxed) onto employees (who essentially always will). The morality police get to go on thinking that objectors to this highly logical step are all overpaid CEO whiners. Way to stick it to the man!! Again.
The Buffetts laugh all the way to the bank, having brilliantly finessed the whole system (Gates and Buffett love their Bridge.)
Only the social values of widespread worker ownership of companies they work for, and anything resembling an “ownership society”, are the losers. Because no employee wants to be given a right that costs him money in taxes today that he can’t sell, can’t trade, can’t exercise, and that is statistically uncomfortably likely to be ultimately worthless to him.
When stock options become overvalued it is of course bad for those who buy stock options. But what about the other side? Price increases always come along with both losers and winners. Its just like with infaltion. The losers are the consumers.
Well, in the stock option game the losers are the option buyers. But the option sellers make their money! And I hope you all know that you too can act as an option seller.
But first become familiar with those kinds of Option Strategies.
What's Next.
Previous Post.
Featured Contributors.
Floyd Norris , the chief financial correspondent of The New York Times, covers the world of finance and economics.
Binyamin Appelbaum covers business and economic topics for the Washington bureau of The New York Times.
Shaila Dewan is an economics reporter for The New York Times.
Annie Lowrey covers economic policy for the Washington bureau of The New York Times.
Eduardo Porter is the Economic Scene columnist for The New York Times.
Nelson D. Schwartz is an economics reporter for The New York Times.
Daily Economists.
Each day, Economix offers perspectives from expert contributors.
Bruce Bartlett.
Former Treasury Official.
Jared Bernstein.
Center on Budget and Policy Priorities.
Nancy Folbre.
University of Massachusetts-Amherst.
Simon Johnson.
M. I.T./Peterson Institute.
Casey B. Mulligan.
University of Chicago.
Uwe E. Reinhardt.
Princeton University.
Phillip Swagel.
University of Maryland.
Laura D'Andrea Tyson.
University of California, Berkeley.
Recent Posts.
Economix Meets the Gales of Change.
Economix is coming to an end, but it will be succeeded by The Upshot, a new politics, policy and economics site. Read more…
Mortgage Reform Is Worth the Small Extra Cost to Borrowers.
The higher cost for borrowers in a Senate bill reforming Fannie Mae and Freddie Mac corresponds to the protection for taxpayers that was missing in the old system, writes an economist. Read more…
In Europe, Auto Sales Are Still Low, But They Are Rising.
New car sales are up by more than 10 percent in Ireland, Greece, Spain and Portugal, which signals stronger economic growth there, even if sales are still far below 2007 levels. Read more…
The End of Our Financial Illusions.
Much progress has been made on overseeing the largest banks, but a good deal more must be done to toughen standards and end government subsidies, an economist writes. Read more…
Stealth Taxes Are Still Income Taxes.
The Affordable Care Act imposes economic burdens that are the equivalent of taxes, an economist writes. Read more…
Can I Claim the Loss on Unexercised Stock Options?
Losses on stock options can become a tax deduction.
Pensionist rechnet image by Digitalpress from Fotolia.
More Articles.
A stock option is a contract that gives the holder the right to buy or sell a specific quantity of a stock at a particular price on or before a specific date. Options can be sold to another investor, exercised through purchase or sale of the stock or allowed to expire unexercised. Losses on options transactions can be a tax deduction.
When Options Expire.
When the holder of a stock option to buy or sell shares allows the option to expire unexercised because the stock price never reached the exercise point, he has lost the money he paid for the option. Internal Revenue Service rules treat the expiration of a stock option as equivalent to a sale of the option for zero dollars on the date it expired unexercised.
How You Lose.
Expiration of unexercised stock options creates a capital loss equal to the purchase price of the options. The capital loss will be a short-term loss if you held the options for less than a year, and a long-term loss if you held them for more than a year. For instance, if you bought stock options in April for $5,000 that expired unexercised in October, you would have a $5,000 short-term capital loss on stock options for the tax year.
Claiming Loss.
You claim your loss on the unexercised stock options on Form 8949, which feeds into Schedule D where you calculate your net capital loss or gain from all your investments combined. You subtract your $5,000 short-term loss on unexpired stock options first from any net short-term capital gains on other investments, then from any net long-term capital gains. If your end up with a net capital loss, you have a tax deduction.
Taking Deduction.
If your only investment in the tax year involved the unexercised stock options on which you lost $5,000, you would end the year with a $5,000 capital loss. You claim the $5,000 loss on Line 16 of Schedule D, but you don’t get to deduct the entire loss in the current year. Current IRS rules limit your tax deduction for capital losses to $3,000 in any one year, so you can only deduct $3,000 from your ordinary income in the current year. You carry the remaining $2,000 in losses forward to next year. When carried over, the $2,000 capital loss will first offset any capital gains next year, then it will offset ordinary income.
References (2)
Photo Credits.
Pensionist rechnet image by Digitalpress from Fotolia.
About the Author.
Herb Kirchhoff has more than three decades of hands-on experience as an avid garden hobbyist and home handyman. Since retiring from the news business in 2008, Kirchhoff takes care of a 12-acre rural Michigan lakefront property and applies his experience to his vegetable and flower gardens and home repair and renovation projects.
Recommended Articles.
Related Articles.
Free: Money Sense E-newsletter.
Each week, Zack's e-newsletter will address topics such as retirement, savings, loans, mortgages, tax and investment strategies, and more.
Editor's Picks.
Zacks Research is Reported On:
Zacks Investment Research.
is an A+ Rated BBB.
Logo BBB (Better Business Bureau)
Copyright © Zacks Investment Research.
At the center of everything we do is a strong commitment to independent research and sharing its profitable discoveries with investors. This dedication to giving investors a trading advantage led to the creation of our proven Zacks Rank stock-rating system. Since 1986 it has nearly tripled the S&P 500 with an average gain of +26% per year. These returns cover a period from 1986-2011 and were examined and attested by Baker Tilly, an independent accounting firm.
Visit performance for information about the performance numbers displayed above.
NYSE and AMEX data is at least 20 minutes delayed. NASDAQ data is at least 15 minutes delayed.
Dead For Tax Reasons.
A blog about taxes, expenditures, and all things in between. Neither pro - nor anti-tax.
Repealing the Employee Stock Option Deduction and Unanswered Questions.
As you all know, the federal NDP announced on Friday it would repeal the employee stock option deduction and reallocate the savings to support low and middle income earners. I have long been writing about this deduction and would like to think this policy idea is founded, at least in part, on my work (work that is joint with Daniel Sandler who wrote the book on venture capital and tax incentives). If it is, it makes me feel at least someone is listening at least some of the time.
I thought I would give you some background information in this area and allow you to form your own thoughts. I certainly understand that not everyone has a good grasp on this very technical issues. I’ll go right back to basics so even those of you without any knowledge in this area can get informed. As a result, this will be a long post and is based on a number of papers that I have coauthored in this area.
In addition, I have some question for the NDP that do indeed need to be answered.
What is an Employee Stock option?
A stock option is a financial instrument which provides the holder the right, but not the obligation, to buy or sell stock of a corporation within a stated period of time at a specified price, commonly referred to as the “strike price”.
There are a number of significant differences between employee stock options and standard stock options that you can trade in the open market.
Unlike standard stock options, employee stock options are not traded publicly on an exchange, but rather are granted pursuant to a private contract with the board of directors or compensation committee of the firm serving as the writers of the option and the executive (employee) acting as the holder of the option. Employee stock options must often be held for a pre-specified vesting period before they can be exercised (usually 3 -5 years during which time the employee cannot sell or transfer the options), which is not present in standard stock options. The option period of an employee stock option can be quite lengthy (e. g., ten years), which is longer than standard stock options. The option period is the period of time that the holder has the right to buy stock of the corporation. Fourth, the option period of an employee stock option is often curtailed in the event that employment is terminated or the employee dies. Employee stock options are usually (and often required to be) granted at-the-money, meaning that the strike price of the option equals the market price of the underlying stock on the day of the option grant, whereas a traditional stock option is issued out-of-the-money, meaning that the strike price of the option exceeds the market price of the underlying stock.
It is important to understand that employee stock options are a form of compensation. Rather than be paid in bonus or salary, employees forgo these forms of immediate compensation in exchange for future compensation (at least that is true for stock options granted either at or out-of-the money) that comes from stock options. Stock options have become the s ingle largest component of compensation among senior executives at large publicly traded companies in North America.
What is the Canadian Tax Treatment of Stock Options?
Compared to most countries, the personal income taxation of employee stock options in Canada is notably less complex and more generous from the employee’s perspective. Since 1972, all employee stock options share the same general tax treatment in two respects.
Unlike other employment income (e. g. annual salary or bonus income), which is taxable in the year it is received, there are no tax consequences when stock options are granted or when they vest. Rather, under subsection 7(1) of the ITA, a tax liability does not arise until the year the option is exercised. The amount that must be included in income from employment upon exercise is equal to the difference between the fair market value of the stock on the date the option is exercised and the strike price. Upon the sale of the stock acquired pursuant to the option, the difference between the proceeds of disposition of the stock and the fair market value of the stock on the date the option is exercised is taxed as a capital gain or capital loss, as the case may be. Under section 38 of the ITA, the taxable portion of a capital gain or capital loss is one-half of the capital gain or capital loss.
For options issued by a public corporation (employee stock options can also be issued by a Canadian-controlled private corporation (“CCPC”) and the taxation history and treatment of these options differs from those issued by a public corporation. I do not consider the tax treatment of options issued by CCPCs in this blog post), there were two significant tax changes to this base tax treatment: the changes made in 1984 and 2000. The employee stock option deduction is related to the 1984 change.
In order to encourage the use of stock options as a compensation mechanism, the 1984 federal budget introduced paragraph 110(1)(d) of the ITA. Under paragraph 110(1)(d), if a Canadian public company grants stock options to an employee, and the strike price is at least equal to the fair market value of the underlying share on the day the option was granted, the employee receiving the options is able to deduct 50 percent of the stock option benefit. The application of the deduction means that the income benefit obtained from stock options is taxed at the same rate as capital gains (and thus at a lower rate than that applicable to ordinary income).
Motivating the 1984 federal tax change was the desire “to encourage more widespread use of employee stock option plans” (1984 Budget Plan, p. 7). Employee stock options are generally believed to assist in the alignment of incentives of company executives and workers with that of company shareholders. By aligning the incentives of employees with shareholders, employees have a stake in increasing their company’s value (and hence, share price) and must be entrepreneurial and innovative to do so. (This is actually the exact motivation for Gordon Gekko’s Greed is Good Speech). By increasing the productivity and ultimately growth of their company, the hope would be for overall higher rates of economic growth and prosperity.
That is all pretty technical so I think an example would be helpful. Employee A (most likely a CEO or VP) is employed at a publicly traded company in Canada and is the recipient of an option grant for 100,000 shares. The grant is dated as having been made on January 1 when the share price was $15 and that is set as the strike price. Assume that the individual faces a combined federal and provincial marginal tax rate of 45% and assume that the options vest after one year, meaning that the employee must hold the options for at least one year.
On January 2 the following year the employee elects to exercise these options just as the vesting period expires. The company’s stock is now currently trading at $20. The employee exercises 100,000 options and sells the obtained shares from the exercise on the same day (more than 90 per cent of executive stock options are exercised and sold on the same day) which were granted with a specified (exercise) price of $15. The exercised shares are valued at $1.5-million (100,000 options at $15 a share) and the sale is valued at $2-million (100,000 options at $20 a share). That is, the employee pays $1.5 million for shares that they then immediately sell for $2 million. The employee derives an employment income benefit valued at the difference of these two amounts, which is $500,000.
If the full $500,000 were taxed, as it should be because it is income, the employee would pay $225,000 in taxes leaving her with after tax income from the stock options of $275,000. But because of the special deduction, she only pays tax on $250,000 of the income benefit for a total of $112,500 paid in tax. That is, with the special deduction, the employee pays $112,500 less in tax than she would otherwise.
Let’s be clear: This $500,000 is not a capital gain. A capital gain only accrues if shares are bought and then held because there is an element of risk associated with the holding the shares. By buying and selling the shares on the same day, the employee is simply realizing the income benefit that had been attached to the awarded stock options. It is simply deferred employment compensation .
We have lots of forms of deferred employment income, mostly performance-based employment income that are taxed as regular income. So it is not the presence of the deferral that dictates this special treatment.
Did the Tax Change Do It Job?
The intent of 110(1)(d) was to encourage the use of employee stock option plans to promote economic growth and prosperity. Did it do this?
First the view that employee stock options drive productivity is not a view that is still widely held. There is no real evidence that employee stock options actually have any discernable effect on employee productivity. For example, Ittner, Lambert, and Larcker (2003) are unable to show that rapid growth of companies is due to employees working harder and more innovatively. Oyer and Schaefer (2005) demonstrate that option awards to non-executive employees are not only too small to provide any incentives but that few of these lower level employees have the necessary authority to make the types of decisions and affect the changes necessary to greatly increase productivity.
Second, while we know that stock option plans took off in the 80s and 90s, there is no reason to think that this was due to the deduction. Why?
This tax regime favors the recipient, the employee, rather than the supplier, the company. It provides no direct impetus for a company to create employee stock option plans or increase the supply of stock options available under such plans which was the intent of the change. However, assuming the existence of a stock option plan, it does increase the after-tax value of stock options to the employee, particularly when compared to wage and salary income, and may lead to increased take up by employees. The use of employee stock options in the United States has increased at a much faster rate and risen to a far higher level than in Canada, despite a more limited tax preference in the United States. The most common type of stock option in the United States is a non-qualified stock option (NSO), which accounts for more than 95% of all employee stock options in the United States (Hall & Liebman, 2000), and these are taxed as ordinary income. It is often asserted that the key driver to the use of NSOs as a component of employee compensation has been the ability of the issuing company to deduct the expense even though the company is not out of pocket (Malwani, 2003, p. 1231). Canadian companies are not permitted such a deduction. The use of employee stock options throughout North America, particularly in ICT companies, is highly correlated with the large increases in the stock market during the 1990s. During this time, recipients could expect to more than offset the higher wages they would have earned without the option plan while employers reduced their compensation costs, which is a particular draw for companies with limited or negative revenues like many ICT companies at the time.
Unintended Consequences.
Section 110(1)(d) rewards option manipulation practices, practices that have been shown to have been widespread at least in the US. In order for an individual to qualify for the deduction the employee stock option must be granted such that the strike price is at least equal to the fair market value of the underlying share the day the option was granted. This is, if the stock is trading at $15 on the day of the option grant, the exercise price of the stock option must be equal to or greater than $15. That is, there is a clear tax advantage to stock options that are granted not-in-the-money or at least reported as such .
Backdating is the act of using hindsight to select a date for a stock option grant after that date has occurred, and then claiming to have granted the options on that earlier date, in order to take advantage of the historical price performance of a company’s stock. In practice this would involve looking back to find a local low point for the underlying stock relative to the current day’s stock price and choosing that low point as the option’s grant date. Hence, the act of reporting options that are granted in-the-money as being not in-the-money, (i. e. backdating), is an act of tax evasion in Canada . In the context of employee stock options, Canada has devised a system that rewards risky and fraudulent behaviour.
The backdating of options has become a significant policy issue due to its suspected prevalence. US research has shown that backdating was quite prevalent (e. g. Lie, 2005; Heron & Lie, 2007). Some estimates indicate that approximately 20% of executive stock option grants appear to have been backdated (Heron, Lie, & Perry 2007, p. 22) and at least 30% of companies that granted options to executives appear to have manipulated one or more of their grants (Heron & Lie, 2009). In addition, close to 200 companies (some Canadian) have been investigated by the SEC and the U. S. Justice Department (Collins, Gong, & Li, 2009, p. 403), many companies have had to restate earnings, a number of company executives have been forced to resign after admitting to backdating options, and criminal investigations have been launched against several key insiders.
Despite this data, only one Canadian company has undergone an investigation that resulted in information which the CRA used to reassess some employees that exercised suspicious stock option awards. In addition, at least four other Canadian companies have quietly announced that they found practices consistent with backdating, but it is not clear whether this has resulted in their employees being reassessed by CRA.
Questions for the NDP.
Employee stock options are a poor, indeed perverse, form of executive compensation. The preferential tax treatment of options only exacerbates this problem. By getting rid of the deduction, we are eliminating this tax loophole that disproportionately benefits the wealthy elite and rewards fraudulent behaviour.
But eliminating the deduction under paragraph 110(1)(d) is not the end of this issue. Two questions that remain are:
when the tax benefit from stock options should be reported, and Whether the employer should be permitted an offsetting deduction that is currently not allowed in Canada because of the presence of 110(1)(d)
Both of these questions need to be addressed by the NDP in their policy and I have not seen them discussed.
We could look to the accounting treatment of stock options for a way forward for taxing stock options. Until recently, Canadian and U. S. firms did not have to recognize a compensation expense for stock options that were granted not-in-the-money and were not performance-based because the options could be accounted for using the intrinsic value method. The intrinsic value of a stock option is the amount by which the price of the underlying stock exceeds the exercise price at the grant date. Provided that the option was granted not-in-the-money, it had no intrinsic value. When options were granted in-the-money, the intrinsic value of the options at the grant date must be amortized over the option vesting period. Therefore, firms that favoured compensation in the form of not-in-the-money stock options (or that least that were reported to be not-in-the-money) over cash remuneration reported higher book income.
In 1995, the U. S. Financial Accounting Standards Board (FASB) issued a statement encouraging but not requiring companies to use the fair value method. The fair value method requires that stock options be expensed based on their fair market value at the time of issuance (and amortized over the vesting period) even if the options are not-in-the-money. Option pricing models, such as a modified Black-Scholes or Binomial model, can be used to determine the fair market value of options on their grant date. A similar non-mandatory move was made by the Canadian Institute of Chartered Accountants (CICA) in late 2001. However, in the period following corporate scandals such as Enron, both Canada and the U. S. have made the fair value method mandatory. In Canada, firms have been required to use the fair value method for financial periods beginning on or after January 1, 2004 while the U. S. rule applies for financial periods beginning on or after June 15, 2005.
I do not think it would be inappropriate for the tax treatment of options to match the current accounting treatment: that is, taxing options at grant. Since employment income is taxed on a received rather than earned basis, an employee should not be required to include an amount in income prior to having an unconditional legal right to exercise the options: that is, when the options ves t. On the day the options vest, the employee does indeed receive something of value; they have the unconditional legal right to that income making the vesting time to be appropriate for taxation. How do you value the options when they vest? Option pricing models are now sufficiently robust that they can determine an option’s value at that time with a reasonable degree of accuracy.
With respect to the corporate deduction, it is important to remember that employee compensation is a cost incurred by the company and section 110(1)(d) was used in lieu of the company deduction. If 110(1)(d) is repealed, the employer should instead be allowed to now take the deduction and that this deduction be incurred at the same time and for the same amount as the employee’s tax liability.
The final issue that remains for me is when will any policy makers, the securities regulators, or the CRA recognize the importance of the backdating issue and begin investigations into this practice and demanding the repayment of taxes owed as a result of this fraudulent behavior. Employees who receive backdated stock options should be reassessed not only to deny any deduction claimed under paragraph 110(1)(d), but also to include the full stock option benefit in an earlier year than that in which the employee reported the benefit for tax purposes. Such reassessment would also include interest, compounded daily at a relatively high rate. Furthermore, if the executive knew of the backdating, he or she may be subject to gross negligence penalties and could even be charged with tax evasion. It is time to get serious on this issue, even if the practices are in the past (a claim which I doubt).
Share this:
Related.
Post navigation.
7 thoughts on “ Repealing the Employee Stock Option Deduction and Unanswered Questions ”
Why (other than cabalistic reasons) are money people so fond of might-have-beens and “deemed” transactions & dates. During the tax year, I buy stock for sums shown on brokers confirmation, to a total $X; during same period, I sell stock to a total of $Y. This gives me (at least, in plain language) an addition to my income for that year of $(Y-X). At tax time I then dutifully declare a total income of $Z as attested to by confirmations, pay-stubs etc, on which I pay tax according to prevailing scale. Why does it have to be any more complicated? What does it matter that my employer gave me a good deal? Or that I might have done differently & made more (or less)?
The point about deductability is a good one and one that is completely missed in the NDP proposal. They’re counting on the elimination of the favourable treatment under 110(1)(d) to raise revenue. OK. But how realistic is that assumption?
If they allow the deduction of stock option “expenses” then, in all likelihood, the additional tax revenue collected from employees will be offset by the value of the new deduction to the employer. Indeed, since the corporate tax rate is generally greater than 50% of the top marginal individual tax rate (though that’s changing in some provinces), this could actually be a revenue loser for the federal (and provincial) governments. Perversely (at least for an NDP proposal), that would be a change that would increase taxes on employees (admitedly of the high-income variety), but reduce taxes on their corporate employers.
On the other hand, if they don’t all0w the deductibility of stock option “expenses” (consistent with the general scheme of the act that the issuance of shares are not an “expense”), then stock options will be replaced with other forms of cash equity linked compensation (stock appreciation rights, phantom stock plans, deferred stock plans, etc.), where the costs are deductible to the employer even if the treatment is less favourable for employees. Again, it’s not clear that such a change would be, on net, a revenue raiser for the federal or provincial government.
I’m fairly agnostic about the merits of the current treatment of stock options (and recognize that reasonable arguments can be made either way), but if the NDP wants to change that treatment, they need to be realistic about what the likely responses are and the implications those response will have on revenue.
Stock options are already being replaced by RSUs which are preferred by shareholders and the corporation.
[…] (with some conditions) for special tax treatment of their compensation. Lindsay Tedds wrote a great backgrounder on the taxation of employee stock options. I’m going to assume you’ve all read that piece and skip over the technical rudiments that […]
You contradict yourself in this article.
“A capital gain only accrues if shares are bought and then held because there is an element of risk associated with the holding the shares.”
“Rather than be paid in bonus or salary, employees forgo these forms of immediate compensation in exchange for future compensation ”
By forgoing salary, employees who get options risk the guaranteed salary with the hopes of the stock prices increasing before their options expire. If the stock price does not increase before the options expire the employees are left with NOTHING. Therefore the element of risk exists by sacraficing guaranteed salary.
Deferred compensation is not a capital gain.
[…] (with some conditions) for special tax treatment of their compensation. Lindsay Tedds wrote a great backgrounder on the taxation of employee stock options. I’m going to assume you’ve all read that piece and skip over the technical rudiments that […]
Leave a Reply Cancel reply.
October 2017 (1) June 2017 (1) April 2017 (6) February 2017 (1) October 2016 (1) September 2016 (1) August 2016 (2) July 2016 (1) April 2016 (2) March 2016 (3) February 2016 (4) January 2016 (3) December 2015 (2) October 2015 (1) August 2015 (1) July 2015 (4) June 2015 (6) May 2015 (1) April 2015 (2) March 2015 (1) February 2015 (9) January 2015 (2) November 2014 (3) August 2014 (2) July 2014 (1) June 2014 (4) May 2014 (4) April 2014 (9) March 2014 (6) February 2014 (11) January 2014 (7) December 2013 (9)
Follow me on Twitter.
Blogs I Follow.
Small posts about Big Data.
You have questions, I have answers!
A blog about taxes, expenditures, and all things in between. Neither pro - nor anti-tax.
A blog about taxes, expenditures, and all things in between. Neither pro - nor anti-tax.
Free Markets and Social Justice.
A blog about taxes, expenditures, and all things in between. Neither pro - nor anti-tax.
A blog about taxes, expenditures, and all things in between. Neither pro - nor anti-tax.
A blog about taxes, expenditures, and all things in between. Neither pro - nor anti-tax.
A blog about taxes, expenditures, and all things in between. Neither pro - nor anti-tax.
A blog about taxes, expenditures, and all things in between. Neither pro - nor anti-tax.
A blog about taxes, expenditures, and all things in between. Neither pro - nor anti-tax.
A blog about taxes, expenditures, and all things in between. Neither pro - nor anti-tax.
Tracking retractions as a window into the scientific process.
Economic insight and analysis from The Wall Street Journal.
A blog about taxes, expenditures, and all things in between. Neither pro - nor anti-tax.
A blog about taxes, expenditures, and all things in between. Neither pro - nor anti-tax.
Miles Corak writes on economics that matters.
A blog about taxes, expenditures, and all things in between. Neither pro - nor anti-tax.
