Employee Stock Options: Tax Treatment and Tax Issues
Prepared for Members and Committees of Congress
The practice of granting a company’s employees options to purchase the company’s stock has
become widespread among American businesses. Employee stock options have been praised as
innovative compensation plans that help align the interests of the employees with those of the
shareholders. They have also been condemned as schemes to enrich insiders and avoid company
The tax code recognizes two general types of employee options, “qualified” and nonqualified.
Qualified (or “statutory”) options include “incentive stock options,” which are limited to
$100,000 a year for any one employee, and “employee stock purchase plans,” which are limited
to $25,000 a year for any employee. Employee stock purchase plans must be offered to all full-
time employees with at least two years of service; incentive stock options may be confined to
officers and highly paid employees. Qualified options are not taxed to the employee when granted
or exercised (under the regular tax); tax is imposed only when the stock is sold. If the stock is
held one year from purchase and two years from the granting of the option, the gain is taxed as
long-term capital gain. The employer is not allowed a deduction for these options. However, if the
stock is not held the required time, the employee is taxed at ordinary income tax rates and the
employer is allowed a deduction. The value of incentive stock options is included in minimum
taxable income for the alternative minimum tax in the year of exercise; consequently, some
taxpayers are liable for taxes on “phantom” gains from the exercise of incentive stock options. In th
the 110 Congress, identical bills H.R. 3861 and S. 2389 have been introduced to provide an
abatement of any taxes still owed on “phantom” gains.
Nonqualified options may be granted in unlimited amounts; these are the options making the
news as creating large fortunes for officers and employees. They are taxed when exercised and all
restrictions on selling the stock have expired, based on the difference between the price paid for
the stock and its market value at exercise. The company is allowed a deduction for the same
amount in the year the employee includes it in income. They are subject to employment taxes
also. Although taxes are postponed on nonqualified options until they are exercised, the deduction
allowed the company is also postponed, so there is generally little if any tax advantage to these
On December 16, 2004, the Financial Accounting Standards Board issued new rules requiring
companies to subtract the expense of options from their earnings. The Securities and Exchange
Commission (SEC) applied these new rules to financial statements for large publicly traded
companies beginning with their next fiscal year after June 15, 2005 (or December 15, 2005, for
small companies). Currently, the SEC is investigating allegations that some companies backdated
some of their stock options.
This report will be updated as issues develop and any new legislation is introduced.
Backgr ound ..................................................................................................................................... 1
Defini ti on ..................................................................................................................... ............. 1
Advantages and Disadvantages of Stock Options.....................................................................2
Types of Employee Stock Options............................................................................................3
Qualified Stock Options..................................................................................................................3
Incentive Stock Options............................................................................................................4
Employee Stock Purchase Plans...............................................................................................4
Current Tax Treatment..............................................................................................................4
Alternative Minimum Tax.........................................................................................................5
Nonqualified Stock Options............................................................................................................7
Are Nonqualified Options Tax Favored?..................................................................................8
The Issue of Tax Versus Book Income......................................................................................9
Executive Compensation Limits.............................................................................................10
FASB Rule for Expensing Stock Options......................................................................................10
Backdating Stock Options.............................................................................................................12
Author Contact Information..........................................................................................................15
The practice of granting a company’s employees, officers, and directors options to purchase the 1
company’s stock has become widespread among American businesses. According to Information
Technology Associates, 15 to 20% of public companies offer stock options to employees as a part
of their compensation package, and over 10 million employees receive them. During the
technology company boom of the 1990s, they were especially important to start-up companies 2
allowing them to avoid paying large cash salaries to attract talent.
Employee stock options have been extolled as innovative compensation plans benefitting 3
companies, stockholders, and employees. They have been condemned as schemes to enrich 4
insiders at the expense of ordinary stockholders and as tax avoidance devices.
This report explains the tax treatment of various types of employee stock options recognized by
the Internal Revenue Code, examines some of the issues that have arisen because of the real and
perceived tax benefits accorded employee stock options, discusses the Financial Accounting
Standards Board’s (FASB) rule for expensing employee stock options, and describes the
controversy over the backdating of stock options.
Employee stock options are contracts giving employees (including officers), and sometimes
directors and other service providers, the right to buy the company’s common stock at a specified
exercise price after a specified vesting period. The exercise price is typically the market price of
the stock when the option is granted (although it can be more or less, as discussed later under
“Types of employee stock options”), the vesting period is usually two to four years, and the
option is usually exercisable for a certain period, often five or 10 years. The value of the option
when granted lies in the prospect that the market price of the company’s stock will increase by the
time the option is exercised. (If the price falls, the option will simply not be exercised; the
contract does not obligate the employee to buy the stock.) Employee stock options typically
cannot be transferred and so have no market value.
To illustrate, suppose that Ceecorp, Inc., is a publicly held corporation whose stock is selling for
$10 a share on January 1, 2004. As a part of her compensation plan, Ceecorp’s chief financial
officer (CFO) was granted options on that date to buy 1,000 shares of stock for $10 a share any
time over the next 10 years, subject to certain conditions. One condition was that she had to work
for the company until she exercised her options. Another was that her right to the options vested
over a period of four years, one-quarter each year. This meant that on January 1, 2005, she
received an unrestricted right to buy 250 shares of stock for $10 a share, and so on each year
until, on January 1, 2008, all of the options were fully vested and she could buy 1,000 shares if
1 The original author of this report was Jack H. Taylor, consultant in business taxation.
2 John Doerr and Rick White, “Straight Talk About Stock Options,” The Washington Post, March 12, 2002, p. A21.
4 Warren Buffett, “Stock Options and Common Sense,” The Washington Post, April 9, 2002, p. A 19; Martin A.
Sullivan, “Stock Options Take $50 Billion Bite Out of Corporate Taxes,” Tax Notes, March 18, 2002, p. 1,396.
Suppose that Ceecorp’s stock had risen to $30 a share on January 1, 2005, when the CFO became
vested with the right to buy 250 shares, with no further restrictions on her ownership of the stock.
She could pay the company $2,500 for the 250 shares, which were at that point worth $7,500,
with an immediate gain of $5,000 (ignoring taxes for the moment) in either cash if she sold the
stock or property if she held on to it. She could similarly exercise the other options as they
became vested or wait for later stock price changes. The options would continue to be worth extra
compensation for her as long as Ceecorp’s stock was selling for more than $10 a share.
When she exercised her options, the company had to be prepared to sell her the stock at the
below-market exercise price. So on January 1, 2005, if she chose to buy 250 shares of Ceecorp
stock, the company had to either buy 250 shares of its own stock for $7,500 or issue 250 shares of
new or treasury stock that it could have sold for $7,500. When it sold these shares to the CFO for
$2,500, the economic reality was the same as if it had paid her $5,000 in cash: she received
additional compensation of $5,000 and Ceecorp was out $5,000 that it would have still had if she
had not exercised her options.
Paying for the services of employees or directors by the use of stock options has several
advantages for the companies. Start-up companies often use the method because it does not
involve the immediate cash outlays that paying salaries involves; in effect, a stock option is a
promise of a future payment, contingent on increases in the value of the company’s stock. It also
makes the employees’ pay dependent on the performance of the company’s stock, giving them
extra incentive to try to improve the company’s (or at least the stock’s) performance. Ownership
of company stock is thought by many to assure that the company’s employees, officers, and
directors share the interests of the company’s stockholders. Before June 15, 2005, accounting
rules did not require stock options to be deducted from income in the companies’ financial
statements; consequently, net profits reported to shareholders were larger than they would have
been if the same amounts were paid in cash.
Critics of the stock options, however, argue that the practice gives officers and directors a strong
incentive to inflate stock prices and that there is no real evidence that it does improve
performance. (Many of the leading users of stock options were among the companies suffering
substantial stock losses in recent years.)
Receiving pay in the form of stock options can be advantageous to employees as well. Stock
options can be worth far more than companies could afford to pay in direct compensation,
particularly successful start-up companies. Some types of stock options receive favorable income
tax treatment. Receiving pay in the form of stock options serves as a form of forced savings, since
the money cannot be spent until the restrictions expire.
Of course, it is a risky form of pay, since the company’s stock may go down instead of up. Some
employees may not want to make the outlay required to buy the stock, especially if the stock is
subject to restrictions and cannot be sold immediately. And some simply may not want to invest
their pay in their employer’s stock.
There are a number of variations on the general idea of an employee stock option. Some
variations are due to the tax rules that govern them, and some are because of the intended use of
the options by the companies granting them. This report focuses on the tax treatment of the
options and the issues arising from the tax treatment; but one of the issues is whether the tax code
has kept up with the proliferation of ways options can be designed.
The Internal Revenue (IR) Code recognizes two fundamental types of options. One is called
“statutory” or “qualified” options because they are accorded favorable tax treatment if they meet
the Code’s strict qualifications (IR Code Section 421-424). Generally, the value of these options
is not taxed to the employee nor deducted by the employer. The second is “nonqualified” options,
which have no special tax criteria to meet, but are taxed to the employee as wage income when
their value can be unambiguously established (which IRS says is when they are no longer at risk
of forfeiture and can be freely transferred). They are deductible by the employer when the
employee includes them in income (IR Code Section 83).
Some options have special features designed to do more than just compensate employees. Some,
such as the employee stock purchase plans discussed below, are granted at less than the market
price of the stock, to make it easier for recipients (particularly lower level employees) to buy
stock. Nonqualified options are often used to reward management, and some are only exercisable
if certain goals are met. “Premium” options are granted at a price higher than the current price of
the stock; “performance-vested” options are not exercisable until a specific stock price is reached.
“Indexed” options are repriced based on broad stock indices, to differentiate between the 5
company’s performance and the market’s performance. There are other variations.
Options are not the only way to use a company’s stock to compensate employees. Direct grants of
stock are always possible, and can be hedged with restrictions similar to those governing the
exercise of options. “Stock appreciation rights” and “phantom stock” plans pay employees the 6
cash equivalent of the increases in the company’s stock without their actually owning any.
These various plans have different tax consequences for companies and employees.
Two types of stock options qualify for the special tax treatment provided in IR Code Section 421:
incentive stock options and employee stock purchase plans. Both types require that the recipient
be an employee of the company (or its parent or subsidiary) from the time the option is granted
until at least three months before the option is exercised. The option may cover stock in the
company or its parent or subsidiary. Such options may not be transferrable except by bequest.
5 Shane A. Johnson and Yisong S. Tian, “The Value and Incentive Effects of Nontraditional Executive Stock Option
Plans,” Journal of Financial Economics, vol. 57 (2000), pp. 3-34.
6 See Joint Committee on Taxation, Present Law and Background Relating to Executive Compensation (JCX-29-02),
April 2002, p. 26.
Incentive stock options (IR Code Section 422) must be granted in accordance with a written plan
approved by the shareholders. The plan must designate the number of shares to be subject to the
options and specify the classes of employees eligible to participate in the plan. The option price
must be no less than the market value of the stock at the time of the grant, and it must require
exercise within 10 years from the time it was granted. The market value of the stock for any
incentive stock options exercisable in any year is limited to $100,000 for any individual. This is
the limit on the amount that receives favorable tax treatment, not on the amount that may be
granted; options for stock exceeding $100,000 in market value are treated as nonqualifying
options. There are additional restrictions for options granted to persons owning more than 10% of
the outstanding stock.
An employee stock purchase plan (IR Code Section 423) must also be a written plan approved by
the shareholders, but this type of plan must generally cover all full-time employees with at least
two years of service (or all except highly compensated employees). It must exclude any employee
who owns (or would own after exercising the options) 5% or more of the company’s stock. The
option price must be at least 85% of the fair market value of the stock either when the option is
granted or when it is exercised, whichever is less. The options must be exercised within a limited
time (no more than five years). The plan must not allow any employee to accrue rights to
purchase more than $25,000 in stock in any year.
Both types of qualified stock options receive some tax benefit under current law. The employee
recognizes no income (for regular tax purposes) when the options are granted or when they are
exercised. Taxes (under the regular tax) are not imposed until the stock purchased by the
employee is sold. If the stock is sold after it has been held for at least two years from the date the
option was granted and one year from the date it was exercised, the difference between the
market price of the stock when the option was exercised and the price for which it was sold is
taxed at long-term capital gains rates. If the option price was less than 100% of the fair market
value of the stock when it was granted, the difference between the exercise price and the market
price (the discount) is taxed as ordinary income (when the stock is sold).
Companies generally receive no deduction for qualified stock options, so the tax advantage
accrues to the employee, not the employer. Companies that would not be taxable anyway, such as
start-up companies not yet profitable, would care little if at all about the tax deduction and would
be expected to use this method of compensation. Many companies that are taxable grant qualified
stock options, however, so these options must have some advantage that outweighs the tax cost.
In some cases, the companies no doubt find that rewarding their employees with qualified stock
options is worth the cost; in other cases, perhaps, the officers and employees who receive the
options exercise special influence over the companies’ compensation policies.
If the stock is not held for the required two years from the granting of the option and one year
from its exercise, special rules apply. The employee is taxed at ordinary income tax rates instead
of capital gains rates on the difference between the price paid for the stock and its market value
either when the option was exercised or when the stock was sold, whichever is less. The company
is then allowed a deduction just as if the employee’s taxable gain were ordinary compensation
paid in the year the stock is sold.
To illustrate the tax treatment of incentive stock options, suppose that the Ceecorp’s grants to the
CFO described previously were under an incentive option plan approved by the shareholders. The
CFO could postpone taxation of her $5,000 gain by holding the stock until at least January 1,
2006 (one year after she bought it and two years after the options were granted). Assuming the
stock was still worth $30 a share, she could realize her gain at that point and be taxed at the lower
capital gains rate instead of her regular tax rate.
Imposing the alternative minimum tax on qualified stock options reduces their tax advantage; for
persons paying the AMT, the tax treatment is similar to the regular tax treatment of nonqualified 7
options. Although the minimum tax exemptions limit the minimum tax to relatively high-income
taxpayers, it does impose some burden on the otherwise tax-favored option plans.
The minimum tax can make the receipt of qualified stock options an extremely complex problem.
It is imposed in the year the options are exercised (and the stock is transferred without
restrictions) at the AMT rates of 26 or 28%, and the basis of the stock then becomes, for AMT
purposes, the market price of the stock. When the stock is sold, it will have two bases, one for the
AMT and one for the regular tax. Double taxation will not result, because an alternative minimum
tax credit will be available (if the employee is not again subject to the minimum tax) or an
adjustment of minimum taxable income will be made (if he owes minimum tax again that year).
Since taxpayers often will not know if they are subject to the minimum tax until the tax year is
over, tax planning can be very difficult.
Under certain circumstances, it is possible for an individual to owe the AMT on the value of
incentive stock options at the time that these options are exercised. But in the same year, a
subsequent decline in the value of the stock after exercise would cause the individual to owe
income taxes under the AMT on “phantom” gains. There was a credit for prior year minimum
taxes in excess of regular taxes that accrues when the taxpayer returns to the regular tax system, 8
but this credit was not refundable.
On December 20, 2006, this “unfair” situation was solved for most taxpayers by passage of the
Tax Relief Act and Health Care Act of 2006 (P.L. 109-432), which made the credit for prior years’
minimum tax liability refundable. According to Sections 402 and 403 of this act,
an individual’s minimum tax credit allowable for any taxable year beginning before January
1, 2013, is not less than the “AMT refundable credit amount”. The “AMT refundable credit
amount” is the greater of (1) the lesser of $5,000 or the long-term unused minimum tax
credit, or (2) 20 percent of the long-term unused minimum tax credit. The long-term unused
minimum tax credit for any taxable year means the portion of the minimum tax credit rd
attributable to the adjusted net minimum tax for taxable years before the 3 taxable year
7 For a description of the alternative minimum tax, see CRS Report RL30149, The Alternative Minimum Tax for
Individuals, by Steven Maguire.
8 For an analysis of this issue, see CRS Report RS20874, Taxes and Incentive Stock Options, by Jane G. Gravelle.
immediately preceding the taxable year (assuming the credits are used on a first-in, first-out 9
The Tax Increase Prevention Act of 2007 (P.L. 110-166) provided a one-year extension of AMT
relief for non-refundable personal credits to offset AMT liability for tax year 2007 and increased
the individual AMT exemption amount for taxable years beginning in 2007 to $66,250, in the
case of married individuals filing a joint return and surviving spouses, and $44,350 in the case of
other unmarried individuals.
Some taxpayers are still liable for taxes on “phantom” gains from the exercise on incentive stock th
options. Consequently, legislation has been introduced in the 110 Congress to provide an
abatement of any taxes still owed on “phantom” gains. H.R. 3861 and S. 2389 are identical bills
Amend the Internal Revenue Code to: (1) increase the alternative minimum tax (AMT)
refundable credit amount for individuals who have long-term unused minimum tax credits
from prior taxable years; and (2) abate any underpayment of tax attributable to the 10
application of special AMT rules for the treatment of incentive stock options.
Continuing the tax advantages that qualified stock options receive is not often raised as an issue
in their tax treatment. It is often argued that giving favorable tax treatment to a limited amount of
compensation in the form of options helps spread the use of options to rank-and-file workers.
(Nonqualified options, which are not tax favored, are more likely to go to officers and highly paid
employees.) Employee stock ownership plans are explicitly promoted as a means for workers to
become owners of their companies. In addition, the cost to the government is at least partially
offset by the lack of a tax deduction at the company level. There may be a corporate governance
issue in why publicly held companies are willing to incur an unnecessary tax cost for the benefit
of officers and employees. (The company could offer nonqualified stock options, which are
deductible; in fact, many companies do offer both incentive and nonqualified options to the same
Before 1995, qualified stock options were not considered wages for Federal Insurance
Contribution Act (FICA) and Federal Unemployment Tax Act (FUTA) purposes. The Internal
Revenue Service (IRS) issued a ruling in 1971 to this effect (Revenue Ruling 71-52). However, 11
the Tax Court later ruled that they were wages for calculating the research tax credit, and IRS
acquiesced in that decision in 1997. Subsequently, IRS said that it would be required to impose
employment taxes on the options also, and it made several attempts to impose the taxes in 12
9 Joint Committee on Taxation, Technical Explanation of H.R. 6408, the “Tax Relief and Health Care Act of 2006,” as
Introduced in the House on December 7, 2006, Dec. 7, 2006, pp. 83-84.
10 The summary of S. 2389 as introduced in the Senate.
11 Sun Microsystems, Inc., v. Commissioner, T. C. Memo. 1995-69.
12 Sheryl Stratton, “Hearing on Stock Option Regs Should Be Livelier Than Most,” Tax Notes, May 13, 2002, p. 968.
In November 2001, IRS announced a proposed regulation that would subject the value of
qualified stock options (the difference between the exercise price and the market price) to FICA
and FUTA taxes in the year the options are exercised. This new rule would have been effective
January 1, 2003, and until that time IRS would not attempt to collect any taxes on the options. No
change in income tax treatment was proposed, and income tax withholding would not have been 13
The proposed regulation received a negative reaction in the public comments that IRS requested.
Companies argued that the additional tax cost and the paperwork burden of a new accounting
requirement would discourage the granting of options and make them less attractive to
employees. The critics argued that Congress explicitly excluded the value of an exercised
qualified stock option from income, and that something cannot be “wages” if it is not also 14
On June 25, 2002, the Treasury Department and the IRS announced an indefinite extension of
their administrative moratorium on qualified stock options. Pam Olson, acting Assistant Secretary
for Tax Policy, stated that
Given the significant administrative changes that would be required of employers to
implement the proposed withholding, it is clear that a delay in the effective date is necessary
to provide employers with adequate time to make the required changes. In addition, Treasury
and IRS need additional time to consider the many comments we received on the proposed
regulations and to decide on an appropriate course of action. Consequently, employers will
not be required to implement the changes for at least two years after the regulations have 15
been issued in final form.
On October 22, 2004, P.L. 108-357 (American Jobs Creation Act) was signed by the President,
and this law included a provision (Title 11, Subtitle F), which excluded qualified stock options
from FICA and FUTA taxes.
Employee options that do not qualify for tax-favored treatment are by far the most important (at
least by value). Because there are no statutory limits on the amount of these options that can be
offered, these are the options used to compensate corporate officers and highly paid employees.
Unlike qualified options, these options can be offered to anyone “providing services” to the
company, not just employees. Therefore, they can also be given to those who serve on the
company’s board of directors (or even to independent contractors). When news reports and policy
analysts mention options, without other qualifications, they normally mean nonqualified options.
13 Proposed Regulation REG-142686-01, Internal Revenue Bulletin 2001-49, p. 561.
14 See Stratton, op. cit.
15 U.S. Department of the Treasury, “Treasury and IRS Extend FICA and FUTA Tax Moratorium for Statutory Stock
Options,” press release, June 25, 2002, p. 1.
Nonqualified options fall under the general rules governing the transfer of property other than
money in return for services (IR Code Section 83). Basically, the rule is that the recipient receives
income equal to the fair market value of the property (less any amount paid for it) when he
receives an unrestricted right to the property and its fair market value can be reasonably
ascertained. Stock options without a “readily ascertainable market value” are specifically
excepted by Section 83(e)(3). (Qualified stock options are also excluded.)
In the case of nonqualified options, IRS has ruled that options that are not tradeable (as is almost
always true of these options) have no “readily ascertainable market value.” Therefore, their fair
market value cannot be established until they are exercised and any restrictions on the disposition
of the stock have been lifted. At that time, the value of the options is equal to the difference 16
between the exercise price and the stock’s current market price. (There is a provision in Section
83 (b) allowing the recipient of the options to elect to include their value in income in the year
they are exercised, valuing them as if the stock were not restricted. However, no future deduction
is allowed if the stock is later forfeited.)
Nonqualified stock options exercised by employees are subject to FICA and FUTA taxes and
income tax withholding, just as cash wages are.
The company granting the options is allowed to deduct from income the same value of the
options that the recipient includes in income, in the same year it is taxable to the recipient
If the options granted by Ceecorp to its CFO in our previous example were nonqualified options,
there would be three notable differences from the qualified options assumed before. One is that
she would have been immediately taxable on the difference between what she paid for the stock
and what it was worth in the year she acquired it, so she would have owed income and FICA
taxes on $5,000 in 2005. The second was that Ceecorp could deduct the $5,000 as employee
compensation on its own tax return (and would also owe FICA and FUTA taxes on it). And
probably most important in the real world (although not in our example), there would have been
no limit on the value of the options granted, so a highly compensated officer like a chief financial
officer could receive potentially large amounts of additional compensation.
Nonqualified options are not taxed to the recipient when they are granted or when they become
vested, so receiving compensation in this form postpones the payment of taxes from when they
would have been due on an equivalent amount of cash wages. However, the reason for not taxing
them is the uncertainty of their actual value; the tax rules follow the practical path of postponing
tax until their value is realized, as is the case with capital gains. In addition, the company’s
deduction of the compensation is also postponed, being allowed only in the same year that the
recipient reports the income realized. Since most of these options go to highly compensated
individuals, whose marginal tax rates would often be higher than the company’s, the government
16 IR Reg. 1.83-7.
probably suffers little if any revenue loss. So it could be argued that the government should be
indifferent to the issue.
The treatment of stock options under the generally accepted accounting rules that govern the way
companies report to stockholders, creditors, and regulators is quite different from the tax
accounting rules. Originally, the accounting rules were of very limited scope. Because employee
options were normally priced equal to the market price of the company’s stock when they were
granted, they were said to have no value. The fact that they were intended to have value and
therefore serve as compensation was not taken into account. As they became more popular,
however, the accounting standards were modified to require some recognition of their effect on a
company’s income. Rule FAS 123 required companies to estimate the value of the options when
they are granted (using an option pricing model) and show that amount, called the “fair value,” as
a cost over the years until the options are vested. In their published financial statements, the
companies could either treat the estimated value of the options as a cost in calculating net 17
income, or they could use the traditional valuing of the options (i.e., zero) in calculating net
income and show the effect of deducting the estimated value in a footnote. Most companies chose
to use the footnote method, but in the early 2000s many large corporations shifted to the
deduction method. These corporations included Boeing, Coca-Cola, General Electric, General 18
Motors, and Winn-Dixie. Financial corporations adopting the deduction method include Allstate
Insurance, American Express, Bank of America, J.P. Morgan Chase, Merrill Lynch, Citigroup, 19
Wachovia, and Prudential Financial.
In the very simple example used so far, Ceecorp and its CFO, the traditional valuation of the
options when granted would be: the stock is selling for $10 a share, the options allow the CFO to
buy it at $10 a share, so the options’ value is zero. Ceecorp, like almost all public corporations,
would probably calculate its net profit on its financial statement using this valuation. Under FAS
123, however, it would also use an estimating model to determine a market value. The model
would estimate the likelihood that the stock would go up in value over the life of the option and
take other variables into account and establish what the option might be worth on the open market
when granted (if it could be marketed). So, Ceecorp might estimate that the “fair value” of the
options when granted was $16 each, for a total value of $16,000, and report in a footnote to its
financial statement an additional compensation cost of $4,000 each year for the four years over
which the options vested. It would not account for the actual cost of the options when exercised 20
on its income statement.
Several bills were introduced in Congress over the years to restrict the tax deduction for options
because of the differences with the accounting treatment. The bills attempted to change the
companies’ accounting practices, to make the cost of stock options more apparent to stockholders
and investors; but the device chosen in the bills is to restrict the tax deduction allowed to the
17 This method is commonly referred to as “expensing.”
18 Steve Burkholder, “FASB to Change Reporting of Shifts to Expensing of Employee Stock Options,” Daily Tax
Report, No. 153, Aug. 8, 2002, p. GG1.
19 “Members to Expense Stock Options, Financial Services Forum Announces,” Daily Tax Report, No. 157, Aug. 14,
2002, p. G1.
20 It would account for the difference in its balance sheet. For a more complete discussion of the accounting issues, see
CRS Report RS21392, Stock Options: The Accounting Issue and Its Consequences, by Bob Lyke and Gary Shorter.
amount “treated as an expense” on the companies’ books of account. Without further changes in
either the accounting rules or the tax law, however, this approach did not in fact conform the tax
and book treatment. The book expense was based on the estimated value of the options when
granted and is charged off over the vesting period of the options. The tax deduction, in contrast,
was allowed only when the options are exercised, and would, under this approach, be limited to
the smaller of the estimated or actual values. In addition, the amount deducted by the company
would no longer necessarily equal the amount taxed to the individual.
The tax deduction for compensation paid to the chief executive officer and certain other highly
paid officers of a publicly held corporation is limited under IR Code Section 162(m) to
$1,000,000 annually, with a number of exceptions. The most important exception is incentive
compensation; with shareholder approval, compensation rewarding officers for performance is
not subject to a deduction limit. Since stock options have value only if the stock performs well,
compensation in the form of stock options is not subject to the executive compensation limits if
they are granted in accordance with a plan approved by the shareholders and meet the other
requirements of Section 162(m).
On March 31, 2004, the Financial Accounting Standards Board (FASB) issued a new exposure
draft that would treat all forms of share-based payments to employees, including employee stock
options, the same as other forms of compensation by recognizing the related cost in the income 21
statement. The expense of the award generally would be measured at fair value at the grant date.
On July 1, 2004, the Council of Institutional Investors (a group of 140 pension funds), voiced its
concern about reports that FASB was considering delaying implementation of the planned 22
standard on stock option compensation. On July 14, 2004, the National Association of
Manufacturers, the Business Roundtable, and the U.S. Chamber of Commerce issued a joint news
release stating that FASB should engage in field testing of multiple stock option valuation models 23
and delay finalizing any standard until such testing has occurred. Alan Greenspan, Chairman of
the Board of the Federal Reserve, endorsed FASB requiring the expensing of stock options. He
stated: “Not expensing stock options may make individual firms look more profitable than they 24
On December 16, 2004, the FASB issued new rules requiring companies to subtract the expense 25
of options from their earnings. These new rules would dramatically reduce the earnings of many
21 Alison Bennett, “Baker Criticizes Stock Options Proposal; Announces Subcommittee Hearing in April,” Daily Tax
Report, no. 62, Apr. 1, 2004, p, GG-2.
22 Sarah Teslik, Executive Director of Council of Institutional Investors, “Letter to Director of Financial Accounting
Standards Board,” July 1, 2004.
23 Kurt Ritterpusch, “Options Bill Jurisdictional Issues Remain But Blunt Hopes to See Bill on Floor Soon,” Daily Tax
Report, no. 135, July 15, 2004, p. G-4.
24 Alan Greenspan, Chairman of the Board of Governors of the Federal Reserve System, “Letter Responding to
Senators Levin, McCain on Stock Options Accounting,” Oct. 1, 2004.
25 Financial Accounting Standards Board, “FASB Issues Final Statement on Accounting for Share-Based Payment,”
FASB News Release, Dec. 16, 2004.
companies that currently show this expense in footnotes.26 Initially these new rules would apply
to financial statements beginning after June 15, 2005, for large publicly traded companies (or
December 15, 2005 for small businesses) or the third quarter of 2005 for those large companies 27
on a fiscal calendar year. But, effective April 21, 2005, the Securities and Exchange
Commission (SEC) postponed the stock option expensing standard until the beginning of
companies’ next fiscal year. Thus, companies with fiscal years on a calendar year basis will not
have to comply with the expensing standard until the first quarter of 2006. The SEC gave three
justifications for this postponement: reducing compliance costs, relieving companies from having
to change their accounting systems in the middle of the fiscal year, and allowing auditors to 28
conduct more consistent review procedures. On March 29, 2005, the SEC stated that public
companies may choose from a number of valuation methods to estimate the fair market value of 29
their stock options.
In response to the FASB requirement that the cost of stock options be included as an expense on
financial statements, a survey found that some companies were reducing the amount of their stock 30
option benefits or eliminating their stock option plans. Another study found that 439 companies
had pushed up vesting dates on their stock options to beat the December 31, 2005, deadline;
consequently, these companies eliminated more than $4 billion in expenses, which would 31
otherwise have shown up on income statements starting in 2006.
The Securities and Exchange Commission continued to refine appropriate methodologies for the 32
valuation of stock options. On December 5, 2005, Alison Spivey, associate chief accountant
with the SEC’s Office of Chief Accountant, issued a warning regarding volatility assumptions for 33
valuing stock options. Some large U.S. companies reduced the cost of their stock options by 34
making subjective changes in their methods used in valuing their stock options. In estimating
the value of their stock options, companies have to make assumptions about numerous factors
including volatility or the magnitude and speed of share-price swings over the life of their 35
options. The cost of an option rises as its volatility increases. One study found that the volatility
assumptions for 50 large companies with sales in excess of $20 billion declined by an average of 36
13% from 2003 to 2005. On October 17, 2007, the SEC approved the Zions Bancorporation’s
auction process to value employee stock options. The SEC stated,
26 “FASB to Require Expensing of Options Starting Next Year,” The Wall Street Journal, vol. 224, no. 119, Dec. 17,
2004, p. C3.
28 Securities and Exchange Commission, “Amendment to Rule 4-01(a) of Regulation S-X Regarding the Compliance
Date for Statement of Financial Accounting Standards No. 123 (Revised 2004), Share-Based Payment,” 70 Federal
Register 20717, Apr. 21, 2005.
29 17 C.F.R. PART 211.
30 Andrew Blackman, “Firms Reconsider Stock Discounts for Employees,” The Wall Street Journal, vol. 246, no. 46,
Sept. 6, 2005, p. D2.
31 Ben White, “Pushing Fast-Forward on Options,” The Washington Post, Dec. 19, 2005, p. D1.
32 Steven Marcy, “SEC Continues to Refine Determination of Valuation, Volatility Assumption in Plans,” Daily Tax
Report, Dec. 14, 2005, p. G9.
34 Richard Waters, “Options Rule Used to Lift Earnings,” Financial Times, Apr. 24, 2006, p. 18.
35 Steven D. Jones, “Option Expensing Leaves Room for Tallying the Volatility Factor,” The Wall Street Journal, May
2, 2006, p. C3.
Your Submissions represent significant progress towards the identification of a suitable
market-based approach to valuing employee share-based payment awards. We remain
committed to supporting the development of a variety of competing market-based objective
measurement of the fair value of employee stock options, of which yours is an example. Of
course, future auctions using the approach outlined in your Submissions must be evaluated
by a company and its external auditors based upon the particular facts and circumstances to
ensure that the result produces a reasonable estimate of fair value in accordance with 37
Professor Erik Lie, currently on the faculty of the University of Iowa, formulated the hypothesis
that some companies backdated (retroactively selected), without disclosure, dates for granting 38
options to times when prices of their stock were low. He found that some companies exhibited a 39
pattern of behavior of backdating stock options without disclosure. Dr. Lie wrote an article titled
“On the Timing of CED Stock Options Awards,” which included an empirical analysis supporting 40
his backdating hypothesis and sent a copy of this article to the SEC in 2004. In May 2005, his 41
article was published in a journal called Management Science.
Dr. Lie indicates that “the board of directors of a company generally assigns the administration of 42
the [stock option] grants of the stock option plan to the compensation committee.” Executives,
however, may be able to influence the decisions of the committee because executives often
propose parameters of stock option grants, executives often have close personal friendship with
some committee members, and executives may influence the timing of compensation committee 43
meetings. Using a sample of almost 6,000 stock option grants to chief executive officers (CEOs)
between 1981 and 1992, he conducted several statistical analyses and concluded “that the 44
abnormal stock returns are negative before the award dates and positive afterward.” These
findings were consistent with his hypothesis of backdating of stock options without disclosure.
The publication of Dr. Lie’s article led to SEC investigations of the timing of the granting of stock
options by certain companies.
Dr. Lie’s article did not mention any company by name, but his hypothesis of backdating of stock
options without disclosure was tested for five corporations by authors Charles Forelle and James 45
Bandler in an article in The Wall Street Journal on March 18, 2006. These authors examined the
timing of stock option grants for five corporations. In each case, stock options were granted on
37 Conrad Hewitt, Chief Accountant, SEC, Letter to James G. Livingston, Vice President of Zions Bancorporation, Oct.
38 For a comprehensive analysis of the issue of backdating of stock options, see CRS Report RL33926, Stock Options:
The Backdating Issue, by James M. Bickley and Gary Shorter.
39 Steve Stecklow, “Options Study Becomes Required Reading,” The Wall Street Journal, May 30, 2006, p. B1.
41 Erik Lie, “On the Timing of CEO Stock Option Awards,” Management Science, vol. 51, no. 5, May 2005, pp. 802-
42 Ibid., p. 803.
44 Ibid., p. 810.
45 Charles Forelle and James Bandler, “The Perfect Payday; Some CEOs Reap Millions by Landing Stock Options
When They Are Most Valuable; Luck—or Something Else?,” Wall Street Journal, March 18, 2006, p. A1.
dates when prices were extremely low. The authors concluded that the odds of these dates 46
“happening by chance was extraordinarily remote.” For example, one corporation CEO received
six stock-option grants from 1995 to 2002, which occurred at dates when the stock price was 47
unusually low. The author found that the probability of these dates being selected by chance was 48
around one in 300 billion.
Backdating of stock options without disclosure has serious implications:
Companies have a right to give executives lavish compensation if they choose to, but they
can’t mislead shareholders about it. Granting an option at a price below the current market
value, while not illegal in itself, could result in false disclosure. That’s because companies
grant their options under a shareholder-approved “option plan” on file with the SEC. The
plans typically say options will carry the stock price on the day the company awards them or
the day before. If it turns out they carry some other price, the company could be in violation
of its options plan, and potentially vulnerable to an allegation of securities fraud.
It could even face accounting issues. Options priced below the stock’s fair market value
when they’re awarded bring the recipient an instant paper gain. Under accounting rules,
that’s equivalent to extra pay and thus is a cost to the company. A company that failed to
include such a cost in its books may have overstated its profits, and might need to restate past 49
In addition, backdating without disclosure can have important negative tax implications for both
the company and the recipient of the stock options:
Backdating options can force companies to restate tax positions, which can result in an
obligation to lose tax deductions and pay back taxes, penalties and interest. For tax purposes,
corporations can generally deduct executive compensation. However, IRC Section 162(m)
limits this deduction for public companies to $1 million per year per executive for
compensation paid to the top five most highly compensated executive officers for proxy
reporting purposes. If options are in the money when granted . . . then the compensation
realized by the grantee upon exercise will count towards the $1 million IRS deduction cap.
Thus the discounted options are ineligible as performance-based compensation under Section
162(m). Furthermore, discounted options would be treated as “non-qualified defined
compensation” under Section 409A, resulting in taxation (and excise taxes) at the time of
vesting, rather than exercise. Finally, for incentive stock options to qualify for favorable tax
treatment, they must be granted at 100% of the underlying stock fair market value on the date 50
On May 22, 2006, Charles Forelle and James Bankler wrote a second article in The Wall Street 51
Journal concerning backdating of stock options without disclosure. The authors identify five
50 Orrick, “Stock Options Grant Timing: Is Your Company at Risk?”, June 14, 2006, pp. 3-4. Available at
51 Charles Forelle and James Bandler, “Matter of Timing: Five More Companies Show Questionable Options Pattern—
Chip Industry’s KLA-Tencor Among Firms with Grants before Stock-Price Jumps—A 20 Million-to-One Shot,” May
22, 2006, p. A1.
more companies “with highly improbable patterns of options grants....”52 The authors state that 53
the SEC is investigating at least 20 companies for manipulation of options timing.
Some companies that opposed the FASB proposal to require expensing of stock options are now
under investigation by federal authorities for allegedly backdating the dates of the granting of 54
stock options without disclosure. “This turn of events,” according to Randall A. Heron and Erik
Lie, “casts the companies’ arguments against expensing stock options in a different light and 55
offers what some accounting-industry observers say is a vindication for FASB.”
In their article in the Journal of Financial Economics titled “Does Backdating Explain the Stock
Price Patten Around Executive Stock Option Grants?,” Professor Randall A. Heron and Professor
Erik Lie examine the frequency of backdating of stock options since August 29, 2002, when the
Sarbanes-Oxley Act (P.L. 107-204) mandated that the SEC change the reporting regulations for 56
stock option grants. Before the change, executives receiving stock options had up to 45 days 57
after the end of the company’s fiscal year to report them to the SEC. After August 29, 2002,
recipients of stock options must report them to the SEC within two business days of receiving the 58
grant. One day after receiving this information, the SEC makes it public, and now firms with
corporate websites are required to post this information on the day after they disclose it to the 59
SEC. The authors state that
if backdating produced the abnormal return patterns around executive option grants, we
hypothesis that the new reporting requirements should substantially dampen the abnormal 60
return patterns that previously had been intensifying over time.
Heron and Lie utilized a large sample of stock option grants to CEOs between August 29, 2002,
and November 30, 2004, and compared this sample with a large sample from January 1, 2000, to 61
August 28, 2002. The authors conclude that
Overall, we find evidence suggesting that backdating is the major source of the abnormal
stock return patterns around executive stock option grants. Our evidence further suggests that
the new reporting requirements have greatly curbed backdating, but have not eliminated it.
To eliminate backdating, it appears that the requirements need to be tightened further, such
that grants have to be reported on the grant day or, at the latest, on the day thereafter. In 62
addition, the SEC naturally has to enforce the requirements.
54 David Reilly, “FASB Appears in a New Light on Stock Options,” The Wall Street Journal, Aug. 14, 2006, p. C1.
56 Randall A. Heron and Erik Lie, “Does Backdating Explain the Stock Price Pattern Around Executive Stock Option
Grants?,” Journal of Financial Economics, vol. 83, no. 2, pp. 2-3. This article is available at http://www.biz.uiowa.edu/
57 Ibid., p. 3.
60 Ibid., p. 3.
61 Ibid., pp. 29-30.
62 Ibid., p. 30.
Thus, the authors found that while the undisclosed backdating of stock options still occurs, it was
far more prevalent before new reporting regulations were applicable on August 29, 2002.
On July 26, 2006, the SEC voted to adopt changes to the rules requiring disclosure of executive 63
and director compensation and related matters. These new rules include disclosure regarding 64
The Securities and Exchange Commission, various state prosecutorial, and Department of Justice
(DOJ) probes into backdating abuses are ongoing. In addition, many firms have mounted their
own internal probes into possible abuses. About 200 companies have been under federal 65
investigation and/or have restated earnings. By November 2007, the SEC’s investigation
caseload had fallen from a peak of 160 to about 80, and the SEC had brought civil enforcement
actions against seven companies and 26 former executives associated with 15 firms. And
according to reports from the DOJ, there were at least 10 criminal filings against defendants for
James M. Bickley
Specialist in Public Finance
63 U.S. Securities and Exchange Commission, “SEC Votes to Adopt Changes to Disclosure Requirements Concerning
Executive Compensation and Related Matters.” Press release #2006-123, July 26, 2006, 8 p. Available at
64 Ibid., p. 4.
65 For a list and status of 140 of these companies (last updated Sept. 4, 2007), see the Wall Street Journal online site at
http://online.wsj.com/public/resources/documents/info-optionsscore06-full.html, visited May 7, 2008.