Last week, U.S. Senators Levin and McCain proposed legislation that, if enacted, would change the amount and timing of corporate tax deductions for stock option compensation. The short title of the bill is telling: “Ending Excessive Corporate Deductions for Stock Options Act.”  

Currently, both the timing and the amount of the book expense and the tax deduction related to options are disconnected. For book purposes, a corporation generally recognizes the expense, which equals the fair value of the options, on the date of grant. For tax purposes, a corporation takes the deduction when the grantee exercises the option and recognizes taxable income. The tax deduction equals the excess of the fair market value of the underlying stock over the option exercise price. Corporations may recognize a tax deduction only for exercises of nonqualified stock options and for disqualifying dispositions of incentive stock options.  

The proposed legislation seeks to connect the book expense and the tax deduction. Such change is intended to reduce the amount of the deduction, but also results in an acceleration of the deduction. The bill grandfathers options granted before the date the bill is enacted, so long as such options were vested before June 15, 2005 (or December 15, 2005, for certain corporations). For all other outstanding options, the bill permits a deduction for the year in which the bill becomes law.  

The proposed legislation would also reduce the potential compensation deduction to publicly traded companies by including stock option compensation as compensation subject to the $1 million deduction limit under Internal Revenue Code Section 162(m).  

While its is unclear whether this particular legislation will be enacted, this bill is another indication that Congress is taking a hard look at executive compensation practices. This legislation assumes an unfairness because of the disconnect between corporate accounting and corporate taxation; if enacted, however, it will create a new disconnect. Currently, the corporate deduction is the same in amount and timing as the option grantee’s recognition of taxable income. In other words, as one taxpayer reports taxable income, another taxpayer receives a corresponding deduction. This would no longer be the case if the proposed legislation becomes law.  

To see the full text of the legislation, click here.