One of the ways that employees can be compensated for their work, in addition to wages, salaries and benefits, is by granting shares of the company. The tax treatment of stock-based compensation has gained attention for contributing to the gap between corporate taxable income and accounting income reported in financial statements, which President Biden has proposed targeting with a new minimum tax. It also adds to concerns about executive compensation and income inequality.
Critics of equity compensation, however, overlook how it helps align incentives between employees and employers and the underlying rationale for how it is imposed.
There are several types of equity 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 give an employee the right, but not the obligation, to buy company stock at a specified price over a period of time, often five or 10 years. The price specified is usually higher than the market price of a company’s stock at the time the options are granted, meaning that an employee only benefits if the stock price rises during his or her life. mandate.
For example, a company with a current stock price of $ 10 may offer employees the option of buying the stock at $ 20. Employees would benefit from this arrangement once the fair market value of the stock exceeds $ 20, as they could buy it at a discount and sell it at a profit. An employee would be liable for capital gains tax when exercising the option and selling the purchased shares.
If the specified option 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 also sold. For example, if a company offers an option to buy the stock at $ 9 when the current stock price is $ 10, the difference of $ 1 would be taxed as ordinary income when the stock was sold.
RSUs are a promise by an employer to provide stock or money to an employee in the future, which is not accessible until acquired by the employee (acquisition means ownership and is often gradually introduced over time). Once vested, the market value of RSUs is considered taxable income, and a portion of the shares is withheld by an employer to cover tax on an employee’s ordinary income.
While stock-based compensation is often associated with business leaders, many other workers often benefit. One estimate reveals 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 profits since the 1980s.
Stock-based compensation is a useful tool for companies to align employee incentives with company performance as measured by the stock price. There is some evidence that stock-based compensation attracts and retains employees who have greater confidence in management decisions, which could help companies build more cohesive teams.
Stock-based compensation also has tax implications for employers. Under financial accounting rules, employers typically deduct the fair market value of stock-based compensation when it is granted to calculate accounting income (which is reported in a company’s financial reports to shareholders) . However, to calculate taxable income, stock-based compensation is not deducted until employees vest (or stock options are exercised), potentially creating a difference between the amount. deducted for accounting and tax purposes.
For example, take an employer who awards $ 10,000 PSUs to an employee in January, which are deductible from book income at the original value of $ 10,000. If the PSUs 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 accounting income of $ 5,000.
|Accounting income of the employer||Employer’s taxable income|
|January: PSUs granted at fair market value of $ 10,000||$ 10,000 deduction||Not deducted until acquired|
|December: RSUs become fully available to employees and increased to $ 15,000 in fair market value||Already deducted when granting||Deduction of $ 15,000|
|Jet lag||Difference of $ 5,000 between accounting income and taxable income|
Source: author’s calculations.
“Qualified” stock options meeting certain requirements are not deductible by the employer and are treated as capital gains income for the employee, as they are not counted as tax compensation. .
Because of these timing differences, stock-based compensation is one of the many ways that a company’s accounting income and taxable income can diverge.
President Joe Biden has proposed a minimum tax of 15 percent on the accounting income of certain companies to reduce these tax gaps. The Tax Foundation estimates that the proposed minimum book tax would raise around $ 110 billion over 10 years when combined with Biden’s other corporate tax proposals. Much of this income would come from the penalization of stock-based compensation, which can account for around 30 percent of accounting tax differences.
The time difference between accounting and tax deductions does not always lead to larger deductions when calculating taxable income. If the value of a company’s shares declines between the time an RSU is awarded and the time it is acquired, taxable income may exceed accounting income. For example, if the value of $ 10,000 of RSU fell to $ 7,500 during the year, the business would have a larger accounting income deduction ($ 10,000) than the taxable income deduction ($ 7,500 ).
Some critics of stock-based compensation wonder why there are differences in accounting and tax treatment. One of the reasons is to ensure that the tax deduction granted by employers matches the taxable income that employees receive. In the example above, the $ 15,000 deduction for the business would be matched with $ 15,000 of taxable income for the individual.
This is equivalent treatment for other forms of remuneration, such as salary income, where what is deductible for the employer is taxable for the employee. The federal government also benefits in terms of revenues, because while employees pay taxes at the top 37% regular tax rate, companies deduct the compensation from their tax return at the 21% corporate tax rate. .
Stock-based compensation is a useful tool to help align incentives between employees and their employers, not a loophole. Increasing taxes on stock-based compensation through an income tax on the books will disadvantage this form of compensation and make the tax system more complex without offering benefits to workers.
Was this page useful for you?
The Tax Foundation works hard to provide insightful analysis of tax policy. Our work depends on the support of members of the public like you. Would you consider contributing to our work?
Contribute to the Tax Foundation
Let us know how we can better serve you!
We are working hard to make our analysis as useful as possible. Would you consider telling us more about how we can do better?
Give us your feedback