Executive stock options under Senate review.

• Author: Lipschultz, Brent

Over the past several years, executive stock options have drawn the attention of legislators in Washington. This is not surprising, considering that close to 50% of executive pay is attributable to stock option exercises, according to Forbes magazine (see DeCarlo, "Big Paychecks," Forbes (May 2007), available at www. forbes.com/leadership/2007/05/03/ceoexecutive-compensation-lead- 07ceocx_sd_0503ceocompensationintro.html). The most recent scandals associated with option backdating, the 2005 adoption by the Financial Accounting Standards Board (FASB) of Financial Accounting Standard No. 123(R), and the adoption of final regulations under Sec. 409A have presented human resource, compensation, and benefits professionals with complicated rules and reporting requirements.

This item summarizes recent concerns cited in U.S. Senate subcommittee hearings and recent changes affecting stock options and outlines considerations that corporate executives should evaluate in determining when to exercise stock options.

Aligning tax and accounting reporting

On June 5, 2007, a U.S. Senate subcommittee cited concerns pertaining to the inconsistencies of current accounting and tax rules related to stock options and gave examples of options reporting for financial statement and Federal tax purposes by multinational corporations. In 2005, the FASB issued accounting rules requiring companies to record a financial statement expense equal to a stock option's fair market value (FMV) at the date of grant. These rules provide for various valuation mechanisms to compute a stock option's FMV in the year of grant and allow compensation expense to be recognized over the option vesting period, as well as allowing a deduction for option grants that never vest.

When considering the FASB rules for stock option accounting, the perceived problem cited by the Senate subcommittee is that, for tax purposes, companies are allowed a tax deduction equal to the difference between the stock's FMV on the exercise date and the stock's cost, which is often higher than the book expense. The U.S. Senate recently stated that this additional tax expense has "shortchanged" the U.S. Treasury. Based on an IRS determination, this book-to-tax disparity amounted to $43 billion in fiscal year 2004 and represented 3,200 companies, 250 of which accounted for the difference (see "Statement of Senator Carl Levin (D-Mich) before Permanent Subcommittee on Investigations on Executive Stock Options: Should the IRS and Stockholders Be Given Different Information?" (June 5,2007), available at http://hsgac.senate.gov/_files/OPEN INGCARLLEVINJune52007.pdf). As a component of its comments, the Senate introduced data from nine multinational companies that showed no stock option expense on the financial statements prior to the FASB change. All nine companies presented evidence that, if the new FASB rules had been adopted, the book expense would have been lower than the tax deductions in all cases.

If options remain unexercised, there will be a book expense without any tax deduction. Finally, the issue of when a corporation can...