Taking Stock of the Book Min Tax

Three weeks ago, I asked the question–just what is the Inflation Reduction Act’s corporate alternative minimum tax?

We know what it’s supposed to do, to crack down on the billion-dollar tax cheats, the huge companies allegedly shirking their responsibilities and paying $0 in taxes. But that’s rhetoric. In practice, what will this strange new income definition, riddled with exceptions to appease various lawmakers, actually do?

Because this is an international tax newsletter, I focused on how it will tax foreign income. That’s a key aspect. The biggest answer, though, is probably that the tax will hit companies which use a significant amount of stock-based compensation.

Stock options are likely one of the top reasons why companies report giant profits to shareholders but much less in taxable income to the Internal Revenue Service, along with accelerated depreciation and the research & experimentation credit. And the latter two were given special protection from the tax.

We’ll have to see when the numbers come in, but it’s probably not wrong to call the CAMT a stock options tax, that does a few other things.

Why stock-based compensation creates a book/tax disparity–that is, a divergence between the profit according to financial “books” and according to the tax code–is complicated, sometimes befuddling even the experts. I’ve tried to wrap my head around it in the past, but it often escapes me as well. Now that it’s a key part of a new tax regime, it’s time to re-examine this issue.

Part of the confusion is that stock-based compensation creates both a timing difference and a permanent difference for book/tax liability. This timing difference runs in the opposite direction that most of the other timing differences do, as financial accounting requires recognition of the cost before it creates a deduction for tax purposes. (Usually, it’s the tax benefit that comes faster.) Under Generally Accepted Accounting Principles, a company will record the cost in its financial statements when the stock option is granted–usually, when a new employee is hired. But the company can only claim a deduction for this when the employee exercises the option, which could be many years later.

The timing issue is mostly a distraction, though, as the large corporations subject to this tax are likely granting and executing stock options in roughly equal proportions. The real difference has to do with how the value of those stock options is calculated. When the stock option is granted, the company must estimate its future book value. But the company will be eligible for a deduction based on the actual value of the stock when it is claimed–and as these companies often see their stock prices skyrocket, that value can be much higher than the initial estimate.

In both cases, the method makes sense for its purpose. Investors want to know up-front the potential labor costs of a company, whether they’re in cash or new stocks. And the deduction itself is tied to measurable economic events–the actual issuance of stock and what it is worth.

Nevertheless, this disparity has long been a target for critics of the corporate income tax system. The late Sen. John McCain (R-Ariz.), along with former Sen. Carl Levin (D-Mich.), pushed for legislation to eliminate the disparity. The Institute on Taxation and Economic Policy, which has long tracked and criticized companies with low effective tax rates compared to financial profits, more recently called for further legislation to deal with the issue in a December 2019 report.

However, the stock option deduction has its defenders, and not just from the right-leaning pro-business crowd. Donald Marron of the Tax Policy Center, a joint project of the Brookings Institutions and the Urban Institute, argued that the current system creates parity between stock-based compensation and regular cash salaries–what the tax system ought to strive for, to prevent arbitrary distortions or incentives. And it’s not like Uncle Sam is totally missing out. The employees who claim the stock options will pay income tax on those earnings, at the higher individual rate.

“America’s tax system has many flaws,” Marron wrote. “The basic way we tax employee stock and options is not one of them. Current practice creates a level playing field between cash compensation for employees and most forms of stock and option compensation.”

Victor Fleischer, a former Democratic tax staffer and scourge of the carried interest loophole, wrote a paper on the issue with Boston University Professor David Walker in 2009. They ultimately found that “conforming employee and employer tax treatment with GAAP raises concerns about liquidity, fairness, and manipulation.”

The root cause of the disparity is the lack of an actual cash expense for the company. (Sometimes there can be a cash expense for stock options, but that’s not the issue here.) The cost is the diluted value of the shares, as new stock is issued. Existing shareholders essentially pay a chunk of these employees’ salaries themselves.

Which is funny, because most of the time the corporate income tax system pretends like the shareholders don’t exist. Corporations are the taxable units, the shareholders float above the system as owners. Stock-based compensation is a rare exception, and we can see it creates a glitch in the system.

Just what is a corporation, anyways? In his bestseller “Sapiens,” Yuval Noah Harari noted that complex, organized societies require “imagined realities,” useful fictions, to function. And a corporation is one of those–this immaterial entity that is somehow separate and distinct from its workers, owners, equipment, building, land, and even its money. (The last being another imaginary item.)

“Modern business-people and lawyers are, in fact, powerful sorcerers,” Harari wrote. “The principal difference between them and tribal shamans is that modern lawyers tell far stranger tales.”

In the case of the corporate income tax, the tax system is meant to identify this entity composed of workers, owners and assets, then sever it from those and measure the success or failure of this abstract entity. It actually does sound a bit like magic.

This is a dynamic that seems to create many of the most problematic issues in the tax system. It’s why, before 2017, companies could defer offshore earnings indefinitely. It’s why interest is deductible and equity isn’t, creating a perverse incentive for debt. It’s ostensibly the reason behind the Section 199A deduction, what Edward Kleinbard called “Congress’ worst tax idea ever.” (Sen. Ron Johnson insisted on the deduction to maintain parity between corporations and self-owned businesses. But that parity only exists if you disregard the shareholders, and the dividend and capital gains taxes they pay.)

Not only is the corporation theoretical, but corporate income seems increasingly disconnected from reality.

The spendthrift, “fake-it-till-you-make-it” Silicon Valley culture famously prizes investment and growth over profits. It’s likely an exaggeration–WeWorks learned that Wall Street’s patience with losses isn’t infinite–but it’s undeniably part of how many of the biggest U.S. companies got that way.

The HBO comedy show “Silicon Valley” satirized this mentality, with a billionaire investor forbidding his company from ever showing revenue.

“It’s not how much you earn, it’s about what you’re worth,” the investor says. “And who’s worth the most? Companies that lose money.”

This can create a dynamic where a company keeps growing, its stock keeps going up, its executives get paid, its shareholders see windfalls–everyone seems to be doing great, except for the “corporation” and its balance sheet. And the IRS.

Many tax academics have questioned whether the corporation is really the ideal basis for taxation. Nothing I’m saying here is very new. I think if I were to conduct a poll, most tax experts would concede that, if they were designing a new tax system from the ground up, they wouldn’t include a corporate income tax.

But what to do with it now? There have been moves toward corporate integration in the past, but that wouldn't address all of these issues. Proposals such as replacing the corporate income tax with a shareholder tax are likely politically unfeasible, at least for now, and run into their own host of administrative and conceptual problems.

It may well be that a corporate income tax, despite its basic flaws, is the most practical and politically palpable way to tax rents. The price is constant tinkering with overlapping new regimes--and dealing with the unintended consequences.

DISCLAIMER: These views are the author's own, and do not reflect those of his current employer or any of its clients. Alex Parker is not an attorney or accountant, and none of this should be construed as tax advice.

NOTE: I'll be on vacation next week, so the newsletter will not return until the week of Sept. 12.

NEWS OF THE WEEK

It’s truly the dog days of summer, tax-wise, with little in the way of news for my roundup. (Maybe folks are too busy pouring over the OECD Pillar One comments.) But if you need more beach reading, you can check out this report from the International Monetary Fund on taxing “windfall” profits of fossil fuel companies, and an Organization for Economic Cooperation and Development report on the aging world population and its effect on government revenues. Enjoy!

PUBLIC DOMAIN SUPERHERO OF THE WEEK

Thirteen, created by Bernie Klein & Dick Wood for Daredevil Comics in 1941. Thirteen is the alter-ego of Harold Higgins, a reporter with devastating life-long bad luck around the number 13. (He lost his life savings on March 13, 1940, for instance, and his fiancé died in an auto accident on Sept. 13 of the same year.) But that luck changed after he decided to embrace the digits and fight crime undercover, along with his 13-year-old sidekick Jinx. (As Deadpool and Domino learned, good luck is indeed a superpower.)