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Monday, July 7, 2008

Walker & Fleischer: Book/Tax Conformity and Equity Compensation

David I. Walker (Boston University) & Victor Fleischer (Illinois) have posted Book/Tax Conformity and Equity Compensation on SSRN.  Here is the abtsract:

Should we require companies to report the same amount of income to the IRS as they report to their shareholders? The idea behind "book/tax conformity" is that managers' desire to increase reported earnings would act as a check on their desire to minimize taxable income, and vice versa. Some scholars have proposed a comprehensive approach, adopting financial income as the basis for corporate taxation. Legislators, meanwhile, have offered a targeted approach that singles out equity compensation, which has historically been a significant source of the "gap" between book income and taxable income.

This Article argues that book/tax conformity carries unexplored costs that reduce its attractiveness, at least in the context of equity compensation (and quite possibly in other areas as well). Conforming the employer's tax treatment of stock and options with the accounting rules creates a paradox for employee-level taxation. Either employee taxation is also conformed to book, which raises liquidity, fairness, and other concerns, or we must diverge from section 83(h), which limits the employer's deduction to the amount included by the employee as income. Severing this link between the employer's deduction and the employee's inclusion would eliminate an important check on tax gamesmanship that is analogous to the check that book/tax conformity proponents seek to create. Conforming tax deductions for options with book, in other words, may simply trade one form of gamesmanship for another.

More broadly, book/tax conformity must be evaluated in light of (1) the cost of other gamesmanship that may result from conformity, (2) the availability of other means of combating manipulation, (3) potential distortions in compensation design, and (4) effects on the decision to be a private or public company. We conclude that equity compensation should be excluded from comprehensive book/tax conformity regimes, and one-off proposals to conform employer taxation of stock and options with book are probably misguided. On the other hand, we suggest that if targeted conformity of equity compensation is desired, revising the accounting rules for options to match those of stock appreciation rights, which would yield conformity at the tax end of the spectrum, possibly could improve upon the status quo.

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