A few weeks ago, the New York Times published a piece about the tax benefits companies are deriving from stock options granted to executives just after the market collapsed in 2008. The story was succinctly summarized in these two lines:
Thanks to a quirk in tax law, companies can claim a tax deduction in future years that is much bigger than the value of the stock options when they were granted to executives. This tax break will deprive the federal government of tens of billions of dollars in revenue over the next decade.
Stock options are typically cashed in at higher prices than they were issued. The legal oddity to which they refer gives firms a tax deduction based on the price at which they were cashed in—the higher price—rather than the lower price at which it was issued.
Anup Srivastava, an assistant professor of accounting and information management, says it’s not as straightforward as the article makes it out to be. “Yes, firms will save taxes, but IRS will more than make up for it by collecting taxes from executives,” he said.
It’s well known that people pay at higher tax rates than corporations, sometimes much higher—GE, for example, didn’t pay any taxes last year. Yet the IRS won’t lose out because of most executives who cash in stock options sell their stock right away. This means they typically have to pay the normal income tax rate on the price difference between when the option was granted and when it was cashed in, Srivastava said. Since most executives are already in the highest tax bracked—35 percent—they will end up paying the full rate. And since many firms don’t pay taxes at the statutory rate, the income generated from taxing executives’ gains on options will likely be higher than the tax savings firms can obtain at their marginal rate, he said.
“In fact, the higher the difference between prices at which options are cashed in and prices at which options were granted, the higher the benefit IRS derives,” Srivastava said. “This difference increases as the grant price becomes lower. Thus, the lower the grant prices set during the recessionary periods, the higher the ‘net’ benefit IRS derives.”
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