What is a tax loophole? According to a recent front page story in the New York Times, a loophole is simply an area of the tax code, which if changed, would increase government revenue. But isn’t a loophole more? Berkeley Law Tax Professor Mark Gergen thinks so.
The Times story attacked the way corporations are taxed on the stock options they issue as compensation to employees. It was part of the “But Nobody Pays That” series, which explored “efforts by businesses to lower their taxes and the debate over how to improve the tax system.” Generally, under Section 83(a) of the I.R.C., stock options are taxed when the employee exercises the option by purchasing stock. Once exercised, the employee pays taxes on the difference between the exercise price and the market price as if it were regular income. At the same time, pursuant to Section 83(h) of the I.R.C., the company then deducts as an expense the amount claimed as income by the employee, lowering its income tax liability. According to the article, this deduction loophole has allowed the likes of Google, Goldman Sachs and Apple to drastically reduce their tax liability. The article was not the first place this has been pointed out either. In July 2011, Senator Carl Levin (D-MI) attempted to end this deduction by introducing the “Ending Excessive Corporate Deductions for Stock Options Act.”
Commentators to the online story (and a follow up story written by the same author) were quick to point out that employees are already paying taxes on the income gained from the stock option. Thus, forcing companies to pay taxes on the options would not fix a loophole, but rather result in a form of double taxation that does not exist in any other area of employee compensation. New York University Law Professor, Daniel Shaviro, also attacked the article in his blog arguing that because many of these options go to earners facing the top income tax rate (35%), which is equal to the corporate income tax rate, shifting the tax burden to companies would not alter revenue.
Professor Gergen argues that not only is this tax scheme not a loophole, its designed to collect the most revenue while minimizing wasteful transactions and fraud. For instance, he says, if the companies were forced to pay the increased tax rate on stock options, they would simply sell stock and then pay the employee in cash, two transactions for which the company would pay no taxes under current law. Thus, if the government decided either to tax both the employee and employer or simply shifted the burden to the employer, the government would still only collect taxes on the income from the employee. Moreover, changing the law would defeat one of the purposes of stock options. Because executives would be paid more in cash and less in stock, they would not have the same incentive to increase profits and not defraud the company. In essence, Professor Gergen argues that while there are plenty of tax issues with respect to executive compensation with which the Times could have criticized, the treatment of stock options is not one of them.