Tuesday, April 02, 2002

Bad Option-Alan Reynolds has an interesting piece on option taxation policy and some patently bad reporting on the subject. Plans have been floated for years to try to tax stock options when issued instead of when they are exercised; Carl Levin (D-Mich.) and John McCain (DR-Ariz.) are providing the current version. There are a number of reasons (other than the fact that Levin and McCain are sponsoring it) to oppose this measure. One reason is that options on non-publicly-traded companies are hard to price. Most option-pricing models, such as the standard Black-Scholes model, use five basic variables
(1)-Current Stock Price (2)-Exercise (or striking) Price- what you’ll pay for the option (3)- A risk-free interest rate—the Three-month Treasury bill rate’s a good proxy (4)-Time to maturity (5) Volatility
For company’s that aren’t on a stock exchange, as many startups are, it’s hard to get a solid stock price. Secondarily, the volatility figure is often calculated using other publicly traded options (or earlier prices on that option) on the company, taking the option price and the other four inputs and coming up with an implied volatility for the option. Without either the stock or the option being publicly traded, it’s hard to get a good clean look at the stock price. The second, and more important, reason is that it will make it harder for startups to get good help. If we do get a valuation system in place, then the current IRS-sanctioned value of the option will be added to the employee’s taxable income and subtracted from the company’s net income. Since the startup is likely bleeding red ink, the added loss will be carried over until the day that the company starts making money. However, the employee will pay taxes on the option today. Say an employee who’s be worth $75,000 gets $50,000 salary and $25,000 in options. Assuming a 30% tax hit, the $50,000 salary becomes $42,500 with the $7500 he’ll have to pay taxes on the options. The IRS doesn’t lose much money from giving the startup company a deduction but can tax the heck out of the individual getting it. If the options pan out, he’ll make more, and Uncle Sam will be there with his hand out for his share of the profits. f the company goes bust, as a lot of dot-commers did, then the option-holder will be able to claim a capital loss. The IRS throws a monkey wrench in this, making you take the deduction in $3000/year increments unless you have other capital gains to apply it to. The IRS would be quick to take it away as income and slow to take the tax revenue hit as losses, both on the corporate and individual end. This would thus be a case where liberals and big corporations could join forces to screw the small businessman. The reduced cash income to employees will hurt small corporate start-up more than existing big business, which have the income to bounce the booked expense off of. Big companies also wouldn’t mind if this law slows their pesky upstarts down. We saw some of this in the Clintoncare debate, as your big unionized companies (who already supply health insurance) didn’t mind making the non-unionized little guys pay for it to. Also, start-ups tend to be less unionized, so are a better target for liberal lawmakers. There is a good populist measure to this bill, as liberals and McCainiacs will use it to try and make hay on Enron. However, this would hamper small businesses, which creates most of the jobs in this country, by making it harder to get quality staff. The problem with shooting down this bill is that it takes a sophisticated argument to do so. Let’s get started.

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