How Should Tax Reform Treat Employee Stock and Options?

The tax treatment of employee stock and options raises a classic Goldilocks problem. We want to tax this compensation neither too much or too little. In a recent policy brief, I consider three questions about how to strike that balance.

Do companies get excessive tax deductions for employee stock and options?

This concern rocketed to prominence in 2012 when Facebook went public. Its employees earned billions from their stock options and restricted stock units. The company, in turn, got billions in tax deductions, reducing its income taxes for years.

Those deductions outraged some observers who asked how Facebook could get billions in tax write-offs when its financial statements showed much lower compensation costs. Lawmakers on both sides of the aisle denounced the “stock option loophole” and proposed limiting these deductions.

While there are good reasons for Congress to worry about companies gaming the tax code, this is not one. The tax deductions that companies receive for employee stock and options are, with few exceptions, just like those for cash wages, salaries, and bonuses.

Here is an example: Suppose Esther has 1,000 options from her employer, Acme, Inc. Each allows her to buy a share of Acme stock for $10. If Esther exercises her options when Acme stock is worth $15, she pays $10,000 for stock worth $15,000 and thus has a $5,000 gain. Esther pays ordinary income taxes on the $5,000 while Acme deducts $5,000 as compensation. And both Esther and Acme pay payroll taxes on the $5,000.

Esther’s stock options are taxed just as if she received a $5,000 cash bonus. The deduction for Acme, just like the deduction for Facebook, is an integral part of our income tax system. Employees pay income taxes on their compensation, and businesses get a corresponding deduction. Lawmakers should maintain the parallel treatment of cash and equity compensation in any tax reform.

Does taxing options at exercise pose a special challenge for employees of private companies?

Employees owe income and payroll taxes when they exercise most options. That’s not a problem for employees who have easy access to the cash they need to pay their tax bill. But it can be a problem for employees who find themselves option rich and cash poor.  Employees of publicly traded companies can always cover their tax bill by selling stock. But employees of private companies often can’t. This problem is rare, but has reportedly become more common as successful start-ups stay private longer.

A bipartisan group of lawmakers has proposed to solve the problem with the Empowering Employees through Stock Ownership Act. The bill allows employees of privately-held firms to defer their taxes from exercising options for up to seven years or until their stock becomes liquid, whichever comes first.

Deferral of tax payments would help solve the liquidity problem. But it also would give equity compensation a notable advantage over cash compensation. Deferral of tax payments would be valuable for all employees, not only those with limited liquidity. Even taxpayers who have available cash would welcome the chance to defer their taxes for several years. Charging interest on the amount of deferred taxes would be one way to maintain some balance between cash and equity compensation.  (In essence, this approach would treat the deferral of tax payments as a loan from the IRS.)

Does the AMT pose a special burden for employees who receive incentive stock options?

Employees who get a special type of stock option—known as incentive stock options—face a different tax structure. ISO gains are taxed at capital gains tax rates, not ordinary income rates. And taxes aren’t due until the employee sells their stock, which could be long after they first exercise their options. That’s a big advantage for employees. But businesses don’t get a tax deduction for the compensation. Since the loss to firms is usually larger than the gain to employees, ISOs are rare. (This could change if Congress cuts the corporate rate much more than individual rates in a coming tax bill.)

But there’s a catch. Under the Alternative Minimum Tax, ISO gains are taxed when exercised. This creates an unwelcome surprise for employees who are unaware of the AMT and its accelerated tax on ISOs. Indeed, it can create financial hardship when stock prices fall, leaving taxpayers with a big tax bill on gains that have since evaporated.

This problem was especially severe during the financial crisis. Congress responded by temporarily exempting ISO gains from the AMT. That exemption has long since lapsed. Congress could permanently fix the problem by repealing the AMT, as the GOP framework and many other plans propose.

Stock options create some unusual challenges for tax writers, and they’ll have to be careful to be sure they are treated fairly relative to other forms of compensation to avoid creating incentives for tax-motivated compensation schemes.