Proposed Minimum Tax on Book Income Would Hit Stock-Based Compensation

Federal Tax

One way employees can be compensated for their work, in addition to wages, salaries, and benefits, is through awards of company stock. The tax treatment of stock-based compensation has received attention for contributing to the gap between corporate taxable income and book income reported on financial statements, which President Biden has proposed targeting with a new minimum tax. It also adds to concerns over executive pay and income inequality.

Critics of stock compensation, however, neglect how it helps align incentives between employees and employers and the underlying rationale for how it is taxed.

There are several types of stock compensation. Two common types are stock options, which were more popular in the 1990s and early 2000s, and restricted stock units (RSUs), which have recently become more popular.

Stock options provide an employee the right, but not the obligation, to purchase company stock at a specified price over a certain time period, often five or 10 years. The specified price is typically higher than the market price of a company’s stock at the time the options are granted, which means that an employee only benefits if the share price rises over their tenure.

For example, a company with a current stock price of $10 may offer an option for employees to purchase the stock at $20. Employees would profit from that arrangement once the fair market value of the stock exceeds $20 because they could buy it at a discount and sell it for a profit. An employee would owe capital gains tax when they exercise the option and sell the purchased stock.

If the option specified price is less than the fair market value of the stock when it was granted, that difference is taxed as ordinary income when the stock is sold too. For example, if a company offers an option to purchase the stock at $9 when the current stock price is $10, the $1 difference would be taxed as ordinary income when the stock was sold.

RSUs are a promise from an employer to provide stock or cash to an employee in the future, which are not accessible until they vest with the employee (vesting meaning ownership and is often phased in over time). Once vested, the market value of RSUs is considered taxable income, and a portion of the shares are withheld by an employer to cover an employee’s ordinary income tax.

While stock-based compensation is often associated with corporate executives, many other workers often benefit from it. One estimate finds that 78 percent of stock-based compensation goes to employees below the executive suite. In fact, the growing use of stock-based compensation may explain much of the gap between wage growth and labor’s share of corporate earnings since the 1980s.

Stock-based compensation is a useful tool for firms to align employee incentives with the firm’s performance as measured by the stock price. Some evidence indicates that stock-based compensation attracts and retains employees who have greater confidence in management decisions, which could help firms build more cohesive teams.

Stock-based compensation also has tax implications for employers. Under financial accounting rules, employers generally deduct the fair market value of stock-based compensation when it is granted to calculate book income (what is reported on a firm’s financial reports to shareholders). However, to calculate taxable income, stock-based compensation is not deducted until employees are vested (or stock options are exercised), potentially creating a difference between the amount deducted for book and tax purposes.

For example, take an employer who grants $10,000 worth of RSUs to an employee in January, which is deductible from book income at the original $10,000 value. If the RSUs vest in December at a fair market value of $15,000, the employer deducts this fair market value when calculating taxable income. This creates a gap between taxable income and book income of $5,000.

Illustrating Timing Differences for Stock-Based Compensation
  Employer Book Income Employer Taxable Income
January: RSU granted at $10,000 fair market value $10,000 deduction Not deducted until vested
December: RSU becomes fully available to employee and has increased to $15,000 fair market value Already deducted when granted $15,000 deduction
Timing difference $5,000 gap between book income and taxable income

Source: Author calculations.

“Qualified” stock options satisfying certain requirements are not deductible by the employer and are treated as capital gains income for the employee, as they are not counted as compensation for tax purposes.

Due to these timing differences, stock-based compensation is one of several ways in which a firm’s book income and taxable income can diverge.

President Joe Biden has proposed a 15 percent minimum tax on the book income of certain corporations aimed at narrowing these book-tax gaps. Tax Foundation estimates that the proposed minimum book tax would raise about $110 billion over 10 years when combined with Biden’s other corporate tax proposals. Much of this revenue would come from penalizing stock-based compensation, which may make up about 30 percent of book-tax differences.

The timing difference between book and tax deductions does not always lead to larger deductions when calculating taxable income. If the value of a firm’s stock goes down between when an RSU is granted and when it vests, taxable income may exceed book income. For example, if the $10,000 worth of RSU fell in value to $7,500 over the year, the firm would have a larger book income deduction ($10,000) than taxable income deduction ($7,500).

Some critics of stock-based compensation question why differences in the accounting and tax treatment exist. One reason is to ensure that the tax deduction employers take matches the taxable income employees receive. In the above example, the $15,000 deduction for the firm would be matched with $15,000 of income taxable to the individual.

This is equivalent treatment for other forms of compensation, like wage income, where what is deductible for the employer is taxable for the employee. The federal government also benefits in terms of revenue, because while employees pay tax at a top ordinary income tax rate of 37 percent, corporations deduct the compensation from their tax return at the corporate tax rate of 21 percent.

Stock-based compensation is a useful tool to help align incentives between employees and their employers, not a loophole. Raising taxes on stock-based compensation through a book income tax will disadvantage this form of compensation and produce more complexity in the tax system without providing benefits to workers.

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