Investigators Find $43 Billion Tax Gap for Stock Options

There is a multibillion-dollar gap between what public companies book as expenses for their executives' stock options and what they report to the IRS under two different sets of rules, according to Senate investigators and a key senator who is seeking to change the reporting system.

The discrepancy, with far greater deductions for stock options being reported to the Internal Revenue Service, is costing the Treasury billions of dollars, Sen. Carl Levin, D-Mich., said Monday. He is proposing that the gap be closed in legislation requiring uniform regulations.

An investigation by a Senate Homeland Security and Governmental Affairs subcommittee, whose results were being made public Tuesday, found a $43 billion "gap" for stock options between corporate IRS tax returns and expenses reported in financial statements for December 2004 to June 2005.

That means U.S. public companies legally avoided billions of dollars in taxes for that period by claiming $43 billion more in tax deductions for options awards than the compensation amount for options recorded on their books, said Levin, the subcommittee's chairman.

The panel was holding a hearing on the issue Tuesday with officials from the IRS and the Securities and Exchange Commission testifying, as well as directors of KB Home, Occidental Petroleum Corp. and Safeway Inc.

"The differences are huge," Levin said in a conference call with reporters. Companies usually favor a much larger tax deduction for stock option grants under IRS rules and report a small fraction of those amounts to shareholders in financial statements, he said.

That is an anomaly, Levin said, making stock options _ which are a big chunk of executives' pay _ the only type of compensation with two different reporting regimes.

While not breaking the law, the companies benefited from an "outdated and overly generous stock-option tax rule," he said.

The SEC and federal prosecutors have been investigating more than 100 companies, many of them in California's Silicon Valley, over suspect timing of stock option awards to executives. Options give the recipient the right to buy the stock at a set price in a specified period of time.

Backdating options make the rewards even more lucrative by retroactively setting the exercise price to a low point in the stock's value. Usually, a stock option's exercise price coincides with the market value at the time of a grant to give the recipient an incentive to drive the price higher.

If companies backdate options without properly disclosing and accounting for the move, it can cause profits to be overstated and taxes to be underpaid.

In addition, the IRS has been examining stock option awards to executives at some companies for possible tax-law violations.