The stock market’s rebound from the financial crisis three years ago has created a potential windfall for hundreds of executives who were granted unusually large packages of stock options shortly after the market collapsed.
Now, the corporations that gave those generous awards are beginning to benefit, too, in the form of tax savings.
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. And it is one of the many obscure provisions buried in the tax code that together enable most U.S. companies to pay far less than the top corporate tax rate of 35 percent — in some cases, virtually nothing even in very profitable years.
In Washington, where executive pay and taxes are highly charged issues, some critics in Congress have long sought to eliminate this tax benefit, saying it is bad policy to let companies claim such large deductions for stock options without having to make any cash outlay. Moreover, they say, the policy essentially forces taxpayers to subsidize executive pay, which has soared in recent decades. Those drawbacks have been magnified, they say, now that executives — and companies — are reaping inordinate benefits by taking advantage of once depressed stock prices.
A stock option entitles its owner to buy a share of company stock at a set price over a specified period. The corporate tax savings stems from the fact that executives typically cash in stock options at a much higher price than the initial value that companies report to shareholders when they are granted.
But companies are then allowed a tax deduction for that higher price.
For example, in the dark days of June 2009, Mel Karmazin, chief executive of SiriusXM Radio, was granted options to buy the company stock at 43 cents a share. At today’s price of about $1.80 a share, the value of those options has risen to $165 million from the $35 million reported by the company as a compensation expense when they were issued.
If he exercises and sells at that price, Karmazin would, of course, owe taxes on the $165 million as ordinary income. The company, meanwhile, would be entitled to deduct the $165 million as additional compensation on its tax return as if it had paid that amount in cash. That could reduce its federal tax bill by an estimated $57 million, at the top corporate tax rate.
SiriusXM did not respond to repeated requests for comment.
Dozens of major corporations doled out unusually large grants of stock options in late 2008 and 2009 — including Ford, General Electric, Goldman Sachs, Google and Starbucks — and soon may be eligible for corresponding tax breaks.
Executive compensation experts say that barring another market collapse, the payouts to executives — and tax benefits for the companies — will run well into the billions of dollars in the coming years. Indeed, of the billions of shares worth of options issued after the crisis, only about 11 million have thus far been exercised, according to data compiled by InsiderScore, a consulting firm that compiles regulatory filings on insider stock sales.
"These options gave executives a highly leveraged bet that stock prices would rebound from their 2008 and 2009 lows, and are now rewarding them for rising tides rather than performance," said Robert J. Jackson Jr., an associate professor of law at Columbia University who worked as an adviser to the office that oversaw compensation of executives at companies that received federal bailout money. "The tax code does nothing to ensure that these rewards go only to executives who have created sustainable long-term value."
For some companies, awarding stock options can seem like a tempting bargain, since there is no cash outlay and the tax benefits can exceed the original cost.
Under standard accounting rules, companies calculate the fair market value of the options on the date they are granted and report that value as an expense, disclosed in regulatory filings. But the Internal Revenue Service allows companies to claim a tax deduction for any increase in value when those options are exercised, usually years later at a much higher price. The tax savings are listed in regulatory filings as "excess tax benefits from stock-based compensation."
For most companies, the primary advantage of using options is that it allows them to award large bonuses without actually depleting their cash, said Alan J. Straus, a New York tax lawyer and accountant.
"But the tax treatment is a nice bonus," he said. "It’s the only form of compensation where a company can get a deduction without having to come up with cash."
Some corporate watchdog groups, and a few members of Congress, call the corporate tax deduction an expensive loophole.
Many tax lawyers and accountants counter that the tax deduction is justifiable because the options represent a real cost to the company. And because the executives who exercise their options are taxed at high individual rates, the companies say that a change would result in an unfair form of double taxation.
Yet even those who support the existing tax policy say it was opportunistic for executives to avail themselves of big increases in stock options — which are supposed to be a performance-based reward — when a marketwide collapse meant that most companies’ stock price seemed destined to go up.
The increases in the value of options granted during the financial crisis would not just cost the Treasury. Shareholder advocates and corporate governance experts say they come at the expense of other investors, too, whose stake in the company is diluted.
Well before the market downturn, hundreds of U.S. corporations reduced their tax bills by billions of dollars a year through their shrewd use of stock options. A decade ago, companies like Cisco and Microsoft were widely criticized because their stock options created such big deductions that, in some years, they paid no federal taxes at all. When shareholders and regulators complained about the excessive use of stock options, Microsoft temporarily stopped issuing them in 2003.
From 2005 to 2008, Apple reported that the options exercised by its employees cut its federal income tax bill by more than $1.6 billion. Stock options reduced Goldman Sachs’ federal income tax bill by $1.8 billion during that period, and Hewlett-Packard’s by nearly $850 million, according to filings by the companies.
Companies say the tax treatment is justified because they are deducting the cost of paying an employee, just as they would if they paid a salary in cash.
Sen. Carl Levin, D-Mich., has tried for nearly a decade to eliminate the tax break, which affects the most commonly granted stock options. He has introduced a bill that would limit a company’s tax deduction for options to the same amount declared on its financial books. His proposal would also count options toward the maximum of $1 million that companies can deduct for an executive’s pay each year (outside of performance-based bonuses).
The bipartisan Joint Committee on Taxation has estimated that if the senator’s proposal were enacted, it would add $25 billion to the Treasury over the next decade.
Stock options became a popular reward for top executives in the 1990s after Congress imposed the $1 million cap. They lost a little of their appeal after accounting changes in 2005 forced companies to start counting the value of the options as an expense. Scandals over the backdating of options also made some companies wary. Restricted stock and other forms of equity sometimes replaced options.
Once the stock market dropped in the fall of 2008, however, there was a spike in the number of options granted by companies. According to regulatory filings compiled by Equilar, an executive compensation consulting firm, the number of options issued by companies in the Standard & Poor’s 500 jumped to 2.4 billion in 2009 from 2.1 billion in 2007, although they had been on the decline since 2003.
Goldman Sachs granted 36 million stock options in December 2008, 10 times more than the previous year.
General Electric, which granted 18 million options in 2007 and 25 million in 2008, granted 159 million in 2009 and 105 million in 2010.
Some companies say that their options awards in 2008 and 2009 were decided before it was clear the stock market would recover. Others say that because share prices had plunged, they had to issue more options to reach the target compensation for their top executives.
General Electric acknowledged that it issued far more options after the market collapse because they offered a cheaper way to pay executives than restricted stock and other forms of compensation. A GE spokesman, Andrew Williams, said that tax considerations did not play a role in that decision.
To be sure, some executives whose option values have skyrocketed can point to notable accomplishments. Howard Schultz, chief executive of Starbucks, was granted options valued at $12 million in November 2008 that are today worth more than $100 million. In the years since, Starbucks has laid off thousands of employees, closed hundreds of stores and retooled its business plan. The strategy reversed the company’s slide in earnings. Shares of Starbucks, which traded in the $30s during much of 2008 and fell below $8 after the near collapse, closed Thursday at $46.45.
But other companies whose executives have already cashed in some options issued during the crisis have not performed particularly well compared with their peers. The oil drilling company Halliburton is one.
And some financial services companies that have seen the value of the options they issued after the market collapse rise significantly — including Goldman Sachs and Capital One Financial — were able to weather the crisis, in some part, because of the billions in federal bailout money they received.
"The reason the CEOs and corporate boards gave all those options during the crisis is because they expected the market to recover — and because the economy is cyclical, everyone knew it would recover," said Sydney Finkelstein, a professor of management at Dartmouth’s Tuck School of Business. "And the whole game is played with other people’s money — the market’s money and the taxpayers’ money."