A Bad Idea for Taxing Stock Options

by Kevin D. Williamson

A particularly foolish idea put forward in the Senate Republicans’ tax plan is the proposal to tax stock options and similar compensation instruments at the time they vest rather than at the time they are exercised. Silicon Valley, where start-up firms rely heavily on equity compensation rather than salary, is howling, and rightly so.

A stock option is exactly what the name implies: an option to buy a certain number of shares of company stock at a certain price. Using equity as a form of compensation aligns the interests of employees, executives, and shareholders—everybody wants to see the value of the company go up, and everybody has real skin in the game. This is a particularly attractive instrument for start-up companies, which may not have a great deal of cash for big salaries but which instead give enterprising professionals who are willing to take a risk on the opportunity to make real wealth by taking a big piece of the company in lieu of a big check every two weeks.

There are a couple of different ways to award stock options. (The Senate bill would apply the same treatment to RSUs—restricted stock units—a similar kind of contract.) You can award the options at a lower price than the current price of the stock: If you give the employee the option to pay $90 a share for 1,000 shares of stock currently priced at $100 a share, then you have given that employee $10,000, notionally. But the opposite approach is more common: You give employees the option to purchase shares at a higher price than the current share price, on the theory that they will work hard to make the company successful and send that share price higher. In a previous life, stock options were a part of my compensation, and I can tell you from unhappy experience that the actual share price does not always climb above the option price. Not every company succeeds—and, with corporate life expectancies already declining and high-value workers changing jobs more often, the typical five- or ten-year stock-option plan may be impractical, anyway.

Taxing options at the time they are vested, rather than at the time they are exercised and the actual income (if any) is realized, creates two possibilities. If the share price is lower than the option price, then the vested option has no taxable value, at least at the time it is vested. If on the other hand the option price exceeds the share price at the time of vesting, then the employee will owe taxes on income he has not realized yet—and may not realize in the future, either. Share prices go up and down. You don’t get a check when those options vest. There’s no money you can spend, save, invest, give to charity, or use to put your kids through college. There’s just a contract that is worth a notional sum of money right at the moment.

If you sign an employment contract at a salary of $100,000 a year, you don’t pay taxes on that $100,000 when you sign the contract. You pay it when you get the money. Stock options should be treated the same way.

(In fact, there’s a pretty good argument for treating all income the same way and taxing it at the same rate when it actually lands in somebody’s bank account; that would mean abolishing the corporate tax but taxing corporate profits as ordinary income when they are distributed through dividends or realized via capital gains.)

What’s happening in the technology sector is enormously important to the U.S. economy—try backing Apple, Google, Facebook, Microsoft, Amazon, and a few others out of the GDP and employment figures and see what the U.S. economy looks like. There isn’t really a good revenue case for taxing options on vesting rather than taxing them when realized. The Senate estimates that the measure would produce an extra $13.4 billion in revenue over ten years, but that’s either moving forward revenue that eventually would be collected by taxing the options when the options are exercised or, worse, by taxing people on gains that aren’t actually realized—most startups fail, after all, but they may fail after employees’ shares are vested.

(Again, alas: personal experience.)

The House version offers a substantial improvement over the Senate version. Not only would it forgo taxing options on vesting, it would allow employees to defer paying taxes on exercised options until those options are liquid. That’s an issue for certain firms with shares that are not widely traded, creating a situation in which an employee owns shares that he cannot actually sell to realize his gain.

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