Economix Blog: More on How Stock Options Are Valued

Several readers wrote with additional questions about the tax treatment of stock options. Given the complexity of the issue, it’s not surprising that there might be confusion. So here is a more detailed explanation, using the example cited in the article, involving Sirius XM radio:

Mel Karmazin, the chief executive of Sirius XM Radio, was granted options to buy 120 million shares at 43 cents each. If he could have exercised them at the grant date, at that price, the shares would have been worth $51 million. He would have paid that amount and had no profit.

But options cannot be exercised until they are vested and some are never exercised at all  —  sometimes people leave the company before the options vest or the stock price drops and doesn’t recover before the options expire. So companies use various models (like Black-Scholes) to estimate the fair market value of the options that they report as an expense on their financial statements.

In this case, Sirius XM calculated a fair market value of $35 million and took that as an expense on its financial books. But on its tax return, the company is not entitled to deduct anything for options until they are actually exercised. And when the company does deduct the cost of those exercised options, the amount of the deduction is the appreciation in the value of the stock.

If the 120 million options were to be exercised at the current stock price of about $1.80 a share, they would generate $216 million in stock. Mr. Karmazin would realize a gain of $165 million (the $216 million value of the stock minus the $51 million he would spend to exercise the options) which would be taxed as ordinary income, presumably at the top rate of 35 percent. Sirius XM would be eligible to take “a mirror deduction” of $165 million. At the top corporate rate of 35 percent, that would provide Sirius XM a $57 million reduction in taxes.

The fact that the individual who exercises the option is taxed on income equal to the “mirror deduction” taken by the company also led some readers to write that the policy is revenue neutral and therefore not a tax break at all. But the bipartisan Joint Committee on Taxation has estimated that limiting companies’ deduction to the amount they declare as an expense would increase federal revenue by $25 billion over the next decade.

Article source: http://feeds.nytimes.com/click.phdo?i=7afb739864bb1907e97e13d8213e21ee