Wednesday, August 27, 2008

Average American taxpayers subsidizing fat cats

MSN Money describes how American tax law essentially has average taxpayers subsidizing CEOs, mainly through favorable tax treatment of stock options. These tend to be issued in large chunks to CEOs, allegedly to incentivize them to improve the business (although in fact they're not the best way to do that).

By far the biggest tax break on CEO pay comes from a stock-option rules. Companies get huge tax breaks for lavishing giant stock-option awards on execs.

Here's how this works. When a company issues options, it writes off an expense right away based on their estimated value. When options are cashed in, companies deduct the profits earned by the execs.

There's never a cash outlay from the company, but exercising options creates more stock, which dilutes earnings and dividends, lowering the value of existing stock.

The real cost is borne by shareholders, but the tax savings go to the company. And executives benefit because the rule makes it easier for companies to dole out rich options packages. (This rule applies to options earned by the rank and file as well, but those grants are much smaller.)

The numbers are huge. Applying the standard 35% tax rate to the $543 million that Ellison realized from options this year, the company could save $190 million by declaring most of his profits as a write-off, estimates Albert Meyer, a money manager at Bastiat Capital and an outspoken critic of excessive use of stock options.

By the same math, IAC would have saved $64 million on the $183 million that Diller realized in 2007 by cashing in options. And Countrywide would have saved more than $42 million on the $121.5 million that Mozilo got last year by cashing in options.

The Institute for Policy Studies estimates companies save about $10 billion a year in taxes from this rule. But the amount may be much higher. In response to queries from Levin last year, the Internal Revenue Service estimated the difference between what companies booked as an expense on options in 2005 and how much employees profited was $61 billion. Assuming a 35% tax rate for companies, the tax break would have been worth $21.3 billion.

In addition, as outrageous as it sounds, companies can deduct from their income (when figuring taxes) any amount of executive pay. And while the average worker is limited to a $15,500 contribution to their 401(k) and/or a $5,000 contribution to an IRA (smaller companies may not have 401ks), executives can essentially accumulate unlimited deferred compensation.

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