© TAX ANALYSTS. Reprinted with permission.
Only occasionally noticed in the debate over the valuation of stock options has been a parallel debate over whether Social Security and unemployment taxes should be collected on them. Last year, the IRS announced it would collect those taxes by ending a 30-year-old administrative policy that had placed a moratorium on their payment. When that decision generated an avalanche of negative comments, the IRS announced (Notice 2002-47, 2002-28 IRB 97) it would delay implementation of what it now believes to be a requirement in current law to collect the taxes. Subsequently, the Senate Finance Committee cleared a pension reform bill (S. 1971), which is expected to be taken up in September, containing a provision that would permanently extend the IRS moratorium on imposing employment taxes on the exercise of statutory stock options.
There is certainly a case to be made for not subjecting stock options to Social Security and unemployment tax. In particular, pensions and some other forms of deferred compensation receive similar treatment. For another, collecting taxes would make the administration of these options more complex. However, one has to be careful in making analogies to other tax law provisions affecting deferred compensation and employee benefits, as they are full of contradictions. When the taxation of employee benefits is considered as a whole, Congress could find itself in the funny position of offering special employment tax treatment to employees who have stock options while denying it to the same degree to those who buy company stock through a section 401(k) plan. Moreover, if there is an employment tax preference for stock options but not for other compensation through stock or stock rights, companies may tend to use stock options in lieu of alternative compensation packages that might be more in the best long-run interests of the companies and the nation itself.
Congress provides preferences in employment taxes for a variety of forms of deferred compensation. Defined benefit pension plans and some other forms of employer-provided defined contribution retirement plans, for instance, are excluded altogether from Social Security tax both on contribution and distribution. One reason for the Social Security preference is that private pension and retirement income can serve as a substitute for government money in providing income in old age.
When it comes to stock option plans, the retirement case is somewhat weak since they are easily cashed in before retirement. However, much stock option income is earned by those well above the cap applying to the OASDI portion of the Social Security tax. Only the hospital insurance (or HI) portion of the Social Security tax has no cap on the amount of earnings subject to tax. For administrative simplicity, one might simply decide that it is better to forgo this tax and, if one wants higher tax rates on those with higher incomes, simply to assess them directly through the income tax. Finally, one might argue that the Social Security tax is meant to be a tax on labor income, and some of the returns from stock options really represent a return on capital.
The problem with these arguments is that the law and administrative practice do not apply them consistently. The rank-and-file employee contributing to a 401(k) plan must pay Social Security taxes on that compensation even when it is invested in his or her company's stock, just as are stock options.
Also paying these taxes are self-employed individuals who take Keogh deductions on their tax returns. (For them, all contributions are taxed.) Taxing these rank-and-file and self-employed people on their deferred compensation, even when it is investment in their own companies' stock, hardly seems fair if those receiving stock options are to be allowed to forego employment taxes altogether.
In light on the Enron debacle, Congress has moved to help employees diversify their 401(k) plans away from ownership in employer stock. But now in the stock option case, they are moving back again in the other direction by attempting to encourage the issuance of stock options, which effectively invest only in employer stock in preference to employee contributions to those 401(k) plans as well as those 403(b) plans that are diversified.
Don't misunderstand me. Despite Enron, a good case still can be made for encouraging employees to accept some of their earnings in the form of investment in their own companies' stock. But that does not mean that stock options should be preferred on an employment tax basis to 401(k) plans, whether invested in their own companies' stock or not.
Suppose there were no discrimination against 401(k) plans or against rank-and-file employees, and at stake was only the issue of how to tax higher-level managers and executives. Having a significant stake in their own companies might be a way to encourage them to act in the best interests of shareholders. That is the basic theory behind stock options. But it has never been clear that if this ownership is desirable, the superior method of achieving it is through stock options. These options contain a variety of risks because of their uncertain valuation to the firm, the executive, and the shareholder whose ownership of the firm is diluted.
Perhaps it would be better simply to offer executives company stock directly. Perhaps executives should be paid in cash, but expected to invest a share in their old companies' stock. If it were possible to enforce, maybe the stock offered to top executives should be kept by the company as a potential bonus based on future company or stock performance and not made available as collateral for loans. Maybe a special class of stock held by executives could be sold only if prior notification is given weeks in advance. Or perhaps there is some other mix of stock, calls, or other financial instruments that might better encourage executives to act in the best interests of the firm for the long-run.
I am not trying to settle here on some ideal alternative instrument or mix of instruments, nor do I deny that some might require legislation before they could be offered. My point is that now is the time when we need to be taking a good, hard look at alternatives to stock options. Many or most of these alternatives would likely be subject to employment taxes; given its current stance, IRS is not likely to grant them a 30-year moratorium on employment taxes without statutory approval. If Congress jumps the gun by permanently removing employment taxes only on stock options, it makes it much more difficult for employers to explore alternatives, as they would initially be subject to higher employment taxes and more complex to administer.
In sum, Congress might want to extend the IRS moratorium for awhile until it figures out what is in the public's best long-term interest. In the interim, it should decide what overall policy it wants to provide for compensation invested in own company stock or even in a diversified portfolio of stock and whether by employer or employee. Whatever it decides, there seems to be little reason to favor stock options over 401(k) and similar investments more likely to be owned by rank-and-file employees. It also should be careful not to derail the development of alternative forms of paying executives in own-company stock that might lead them to care more about the long-term value of their companies.