Tax constraints on indexed options.

• Author: Schizer, David M.
• Position: Symposium on Norms and Corporate Law

Indexed stock option grants reward executives for outperforming a benchmark, such as the market as a whole or competitors in the same industry.(1) These options offer superior incentives by limiting the influence of factors beyond an executive's control, such as general market and industry conditions.(2) Yet indexed options are almost never used.(3) Professor Saul Levmore seeks to explain this puzzle with norms.(4) This comment on his article argues that tax plays a larger role in this puzzle than he acknowledges, although tax is not a complete explanation.(5) Accounting and Professor Levmore's norms-based account are then briefly considered.

1. TAX CONSTRAINTS ON INDEXED OPTIONS

   1. Section 162(m) and "Phony" Performance Pay

      The main tax advantage of traditional options over indexed ones derives from [sections] 162(m) of the Internal Revenue Code. A product of populist concerns about soaring executive pay, this rule disallows a publicly traded firm's deduction for compensation exceeding one million dollars. Yet the rule exempts performance-based pay.(6) The goal of this exception is either to encourage such pay or, a cynic might say, to render the measure toothless. Both traditional and indexed options qualify as performance-based, and so the deduction for either type of option is not limited.(7)

      Traditional options have a tax advantage, though, if the parties do not want the executive to bear too much firm-specific risk. The parties will prefer pay that imposes less of this risk, but is still deductible. Traditional options thread this needle. They include a bet on the market as a whole. This value is not really performance-based, but is treated as such for tax purposes.(8) For example, the option might give an executive the right to buy stock for the current price of $100. If the stock appreciates to $110, the executive earns ten dollars--even if the rest of the market doubles, so that a ten percent return is not impressive. With a traditional option, even poor performers profit in a bull market. In contrast, an indexed option does not offer this windfall; executives are rewarded only for outperforming the benchmark (for example, competitors or the market as a whole). Thus, indexed options are more "performance-based" than traditional options, but both are deductible. Therefore, traditional options are a tax-efficient way to limit an executive's firm-specific risk.(9)

      1. Nonperformance Pay in Disguise: Three Pay Packages

      As an illustration of this point, three alternative pay packages are considered for an executive whose market value is $10 million per year. To preserve its tax deduction, the firm cannot offer more than $1 million in cash.(10) Thus, the remaining $9 million--or ninety percent of the pay package--must be offered through options, which could be indexed or traditional.(11)

      An appeal of traditional options is that a $9 million traditional grant conveys far less firm-specific risk than $9 million of indexed options--indeed, about half as much, since traditional options also include a valuable market bet.(12) Of course, some firm-specific risk is needed to produce useful incentives. But if too much is imposed, undiversified executives could demand an unduly high premium.(13) Moreover, as Professor Levmore emphasizes, too much firm-specific risk could induce the executive to take foolish gambles.(14)

      If the point is to reduce firm-specific risk, traditional options are not the only way. Instead, the firm could offer a smaller grant of indexed options (for example, $4.5 million) and more cash (for example, $5.5 million).(15) Yet because of [sections] 162(m), the firm could not deduct $4.5 million of cash, and thus would owe almost $1.6 million of extra tax.(16)

      While traditional options preserve the firm's deduction, they impose two offsetting costs. First, the executive must bear general market risk.(17) Second, these options provide less effective incentives in a falling market, a factor that may prove increasingly important in coming years. To compensate the executive for these costs, the firm must share the tax savings. For instance, the executive's option grant can be increased from $9 million to $10 million. In some cases, a relatively modest premium will suffice. Market risk in the options is acceptable if the executive would have invested in the market anyway.(18) Likewise, the risk of being undercompensated in a falling market is less daunting if executives expect to be made whole ex post, for instance, through repricing of existing grants or larger future grants. The three pay packages are compared in the following table:

      Table 1: Comparison of Three Pay Packages Pay Package Firm-Specific Risk Nondeductible Portion $1 million cash Intense 0 $9 million indexed concentration option $1 million cash Less intense 0 $9 million traditional option $5.5 million cash Less intense (like $4.5 million cash $4.5 million indexed $9 million option traditional option) 2. Section 162(m) Cannot Be the Whole Story

      Thus, [sections] 162(m) inadvertently favors traditional options over indexed ones--a distortion that justifies repeal of this measure. Even so, [sections] 162(m) is only a partial explanation. Indexed options were rare even before this rule was enacted in 1993. In some cases, the tax benefit to the firm should be less than the nontax cost to the executive (for example, extra market risk in a bear market). Moreover, the rule should have less influence for firms that are subject to a low tax rate.(19) In addition, [sections] 162(m) cannot explain why less-senior executives (who are not subject to the rule) receive traditional instead of indexed grants. Finally, other compensation is not entirely performance-based, but still qualifies as such under [sections] 162(m). For instance, cash bonuses could be based on lax "performance" standards (for example, sales of at least eighty percent of last year's volume). A problem with this alternative, though, is that the tax rule requires a meaningful chance of failing the performance standard.(20) Yet such risk is precisely what the parties may be trying to avoid.(21)

   2. Indexing Incentive Stock Options

      A second tax constraint is that so-called incentive stock options ("ISOs") arguably cannot be indexed. ISOs offer capital gain treatment to the executive, albeit at the cost of no deduction for the employer.(22) For the option to qualify as an ISO, the "option price" must not be "less than the fair market value of the stock at the time such option is granted."(23) This language can plausibly be read as permitting indexed options as long as, on the grant date, the index is at least as valuable as the stock price.(24) However, meeting this test on the grant date arguably is not sufficient under the regulations: The "option price"--which is defined as the price actually paid on the option(25)--"may be determined in any manner so long as the minimum price possible under the terms of the option cannot be less than the fair market value of the stock at the date of grant."(26) An indexed option cannot satisfy this condition because the exercise price could fall below this minimum value at some point during the life of the option (for example, as the index falls).(27)

      Even so, the significance of this tax constraint on indexed ISOs should not be overemphasized. The statutory language arguably permits ISOs to be indexed, and there is no policy reason to disfavor indexation. As a result, the Treasury should be willing to change the regulation. Yet to my knowledge, no one is lobbying for this reform. Stakes are low, in any event, because ISOs are relatively uncommon. The tax savings to the executive (which is generally the difference between the maximum tax bracket of 39.6% and the long term capital gains rate of 20%) is usually less than the tax cost to the employer (a 35% tax).(28) As a result, these options are tax-advantaged only for firms that do not pay corporate tax (for example, because...