Tax

Facebook’s Multi-Billion Dollar Tax Break on Executive Stock Options

Posted by Paul McConnell on February 18, 2013  /   Posted in Compensation Committees

blue boxesThere has been a lot written recently about Facebook’s multi-billion dollar tax break from the tax deduction for the cost of executive stock options and share awards.  Stock awards such as these are taxed to executives as compensation based on their value at the time of exercise (options) or vesting (shares), and the employer gets a corresponding deduction for the compensation expense, even though no cash was expended.  Facebook’s phenomenal growth in value from its private company days (when most of these grants were made) makes the resulting deduction very large, particularly compared to its operating income.  The publicity regarding this little understood section of the tax code will likely lead to calls for limiting or eliminating these deductions.  In our opinion, this is treating the symptom, not the disease.

The fundamental problem is that in the eyes of the IRS, stock grants are treated as compensation by the employer rather than as an investment by the executive.    In the example below we contrast tax treatment of a warrant issued by a company as a “sweetener” in a stock offering to a identical situation where a stock option is issued by the same company to an executive.  In both instances, we assume the option is priced at $10 (strike price), exercised at $20, and with the underlying share sold after one year at $24.  For simplicity, we assume corporate tax of 35%, individual tax of 40% and capital gains of 20%.

Comparison of IRS Treatment: Investors vs. Employees

Employer Treatment

Investor/Executive

IRS

Deduction

Tax Impact

Ordinary Income

Capital Gains

Total Taxation

Net Taxation

Investor Model

$0

$0.00

$0

$14

$2.80

$2.80

Employee Model

$10

($3.50)

$10

$4

$4.80

$1.30

The company does not receive a deduction with warrants, and the warrant holder does not recognize any income.  Upon exercise of the warrant (share purchase), the capital gains holding period begins.  Upon sale of the share after completing the holding period for capital gains, their tax bill would be $2.80 per share (i.e., $14 gain x 20%).  In contrast, under the current IRS employee model, the employer realizes a $10 tax deduction for compensation expense (the gain at exercise), the employee recognizes the same amount as ordinary income.  Upon a later sale the employee qualifies for capital gains on the additional $4 gain. Thus the Treasury nets only $1.30 per share in revenue in the employee model compared to the investor model, where the IRS realizes $2.80 per share in revenue.

As we noted in an earlier blog entry treating corporate executives as shareholder/ investors for tax purposes would be beneficial to the Treasury by increasing revenue and simplifying taxation.  More importantly, it would align tax policy with social and economic objectives of encouraging long-term stock ownership as a deterrent to excessive risk taking and of making corporate and individual taxation more transparent.

Paul McConnell is a Managing Director of Board Advisory, LLC

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The Risks of Accelerating Executive Bonus Payments for Tax Benefit

Posted by Jeff McCutcheon on October 19, 2012  /   Posted in Compensation Committees

accelerateWith continuing uncertainty regarding the nation’s finances fueled by current 2012 election banter, executives are faced with the temptation to accelerate executive bonus payments to be paid in 2012 to avoid increasing income tax liabilities.  If Congress does not act, the typical executive could save in excess of 5%[1] of the amount of the bonus payments.  In reviewing these requests, board members are advised to consider the old adage, “There is no such thing as a free lunch.”

Companies have accelerated compensation payments to executives in the past to avoid tax rate changes.  Most notably, in late 1993 a significant minority of companies accelerated executive bonus awards that otherwise would have been paid in 1994, to avoid the uncapping of the 1.45% Medicare tax.  Unfortunately, tax increases under presidents George H.W. Bush and Bill Clinton did not provide the same opportunity for tax planning.

With the risk of Bush-era tax cuts expiring, board members could be asked to consider acceleration of incentive payments for their organizations.  Should your board be asked to weigh in on this issue, we suggest you consider the following.

  • While the request is typically for the benefit of senior executives, the benefit of accelerating income may go well beyond the executive ranks.  Nearly all full-time wage earners could face a tax increase of at least 3%.  Given the public concern over exceptional treatment of executives, particularly the CEO, we suggest boards discuss whether a limited action only benefiting senior management is appropriate, or whether an all-or-none approach may be warranted.
  • While the executive may save 5% in taxes, the acceleration has an economic cost to shareholders.  It is objectively fair to assess the economic cost of the accelerated payment at the company’s cost of incremental debt.  While some companies are currently experiencing very low borrowing costs, for others, the 2 ½ month advance payment will likely have an economic cost to shareholders of 2-3% or more.  While this economic cost is not an expense reported on the summary compensation table it is a cost incurred by the company and should be part of an informed discussion.
  • There are consequences of accelerating payment in terms of making individual or organization performance assessments and in terms of protecting the company in the event of and termination of employment prior to the end of the performance period.  Board members should consider whether contractual protections are warranted to clawback or adjust any award made in error or made prior to a having a full appreciation of company and individual performance over the entire performance period.  Further, an advance payment that is contingent upon later results could conceivably constitute a loan specifically prohibited by Sarbanes-Oxley[2].
  • There may be risks to the company’s public image and brand.  Given the level of public scrutiny currently provided executive compensation, it is not inconceivable that the act of taking exceptional action to avoid taxation for executives may draw the company and the board into a public debate they cannot win.  Keep in mind that the rationale for the acceleration would likely require some narrative in the Compensation Disclosure and Analysis section of the proxy statement.
  • Lastly, there could be tax consequence with accelerated payment.  Most companies’ 162(m)-qualified plans require compensation committee certification of results and prohibit “positive discretion.  Any acceleration could potentially jeopardize the company’s tax deduction for the award.

Clearly, we do not consider the acceleration of payments to be a “slam dunk” decision.  While it may be appropriate and non-controversial under many circumstances, such a decision can only be made by a board when benefitting from a full appreciation of each organization’s unique facts and underlying economics.

 

–          Jeff McCutcheon

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[1] i.e., Reversion of the top tax bracket from 35% back to 39.6%, plus the impact of reinstatement of the phase out of itemized deductions.

[2] Section 402 of Sarbanes-Oxley prohibits companies from making loans or arranging credit for named executive officers.  Public companies should seek legal advice prior to accelerating payments to executive officers.

Aligning Tax Policy with Sound Executive Compensation Practices

Posted by Paul McConnell on May 26, 2009  /   Posted in Compensation Committees

If we want executives to act and be rewarded like investors, we should tax them like investors.

As the chorus of public outrage over executive compensation rises to a new crescendo, it is understandable why the populist approach to “solve” executive pay is through regulatory pay limits. However, executive compensation experts and investor representatives alike agree that rather than limiting pay, the best thinking on the subject is focused on creating plans where executive wealth is tied to that of long-term investors – where they are unable to profit (or limit losses) from short-term changes in company performance or company stock price. There is much agreement that this linkage is best accomplished through executive equity arrangements with provisions such as “hold-till-retirement” requirements. However, in implementing these provisions boards of directors are now finding that federal tax policy is not aligned with what is arguably in the best interest of the public, not to mention shareholders.

We believe that minor changes to the tax code could facilitate these ownership provisions, thus providing greater alignment of executive pay with public interests. Further, these changes will also increase federal revenues by increasing the effective tax on executive pay without the adverse economic effect of broad rate increases. Simply put, we recommend that the tax code cease treating certain long-term executive equity incentives as annual “compensation”, and instead treat it like an investment.

Current Tax Law Rewards an Early Exit

The table below shows the current taxation of various popular executive equity compensation vehicles:

Vehicle Form of Income Timing
Restricted Stock or Performance Shares Full value is Compensation Vesting
Nonqualified Stock Option (NQSO) Gain is Compensation Exercise
Incentive Stock Option (ISO) Gain is Capital Gains Sale of shares

Any compensation value from an executive equity grant is also deductible to the employer (subject to the limits and performance rules of section 162(m)) and is subject to Medicare taxes (1.45% rate) from both the executive and the employer.

The net effect of this approach is that today’s executives have a powerful incentive to exercise stock options during favorable market cycles, then liquidate their positions to provide cash flow to execute the exercise, including withholding taxes. Since there is no further tax liability and typically little obligation beyond perhaps modest stock holding requirements, a rational executive/investor would clearly sell their ownership position and interests to diversify their overall portfolio. The existing tax treatment does not encourage long-term executive ownership nor penalize sale of stock during the executive’s career.

Alternative Tax Approach Creates Value from Holding to Retirement

An alternative approach is to treat executive equity awards as a sale of company stock on the date of grant, similar to any other investor purchasing shares for cash. Where there is a discount element (e.g., restricted stock or performance shares), the discount at grant would be treated as compensation to the executive and deductible to the company (subject to 162(m)). However, the tax on this compensation would not be due until it was both vested and sold. Thus a company could create a very favorable tax situation for its executives (and an incentive benefiting investors and the public alike) by requiring that they hold the stock until after they leave the company. Like other investors, any post-grant gain (or loss) would be taxed as a capital gain at the time of sale. Similarly, any dividends paid would be taxed at the 15% rate (under current law).

Vehicle Form of Income Timing
Restricted Stock or Performance Shares Value at grant is Compensation, any post-grant change is Capital Gain (Loss) Sale of Shares
Stock Options [1] Gain is Capital Gains Sale of shares

These proposed tax rules create a strong incentive for executives and Boards to design equity plans utilizing hold–till-retirement provisions. For example, without a hold-till-retirement provision a performance share grant would trigger immediate taxation for the full value at vesting. The executive would typically then sell shares to satisfy the withholding tax. With the benefit of a hold-till-retirement provision, the executive would not be liable for any tax until the shares were sold – at some point after retirement. This will result in more net shares remaining in the hands of executives, presumably providing a more significant incentive for delivering long-term results for investors and the public at large.

Curiously, although the executive would receive favorable tax treatment, the tax revenue gains to the government would be significant. Currently, the executive’s ordinary income tax and the corporate deduction largely offset each other. As a result, the executive’s basis in the stock is stepped up to the price at the date of vesting (for full value shares) or exercise (in the case of an option). Thus the net tax received by the federal government is limited to the capital gains tax calculated on any stock appreciation subsequent to vesting/exercise – and there is little incentive for executives to hold shares after vesting/exercise.

Under the proposed approach, the executive’s capital gains would be measured from the grant date price – as is the case with an investor purchase – with no offsetting tax deduction by the corporation. While this results in a lower tax rate for the executive, the effective taxation is increased by eliminating the employer’s tax deduction. Furthermore, the combination of hold-till-retirement covenants and supporting tax policy better aligns the executive performance incentive with the interests of investors and the public over time, rather than allowing an executive group to be rewarded for short term results. With a broad definition of equity incentive plans (i.e., including non-public company equity and equity-like vehicles), this approach can successfully apply regardless of company size or ownership structure (e.g., small businesses, joint ventures, subsidiaries, private equity and start-ups).

We believe this is an easily achievable first step toward aligning federal tax policy with public policy interests regarding executive compensation and corporation accountability. If we want executives to act and be rewarded like investors, we should tax them like investors.

– Paul McConnell

Paul McConnell works with a number of Board Advisory clients within the banking and related financial services arena on executive pay alignment, performance measurement, and executive performance issues. You can view Mr. McConnell’s bio here. If you have any question or comments on this article, or want to speak with Paul about any executive rewards, performance, or succession issue, he can be reached at pmcconnell@board-advisory.com, or at (407)876-7249.

[1] The tax code changes proposed in this article could be achieved by simply modifying existing ISO provisions in IRC sections 421 through 424, to reflect contemporary executive pay programs and hold-till-retirement obligations.

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© 2009 Board Advisory.
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