Tax as Gatekeeper: Why Company Stock is Not Worth the Money

Abstract

Tax as Gatekeeper: Why Company Stock is Not Worth the Money addresses a topic that has captured the attention of most Americans, in addition to politicians and academics: will those of us participating in the current tax subsidized retirement system be able to retire? Increasingly retirement is being postponed because savings are inadequate for retirement. Employees today are seeing the results of popular retirement plans based on saving and investing current compensation in order to allow for future retirement. The success of our current tax subsidized retirement policy is, therefore, important to all of us, whether working or about to retire. Recent corporate scandals and the general stock market decline have focused our attention on the large number of tax qualified retirement plans whose assets consist chiefly of company stock, that is the corporate stock of the very corporation by which these individuals are employed. Enron's spectacular and catastrophic decline vividly illustrates the danger of these investments since many individuals lost not only current employment but all their retirement assets when their company stock became worthless; unfortunately Enron is not an isolated example. Individual ignorance of basic principles of investing is usually cited as the problem: after all, these employees invested in the company for which they worked believing in its success. Calls for legislative regulation to prevent further Enron-type debacles have however garnered very little support. The reason for this is that most individuals value autonomy, especially when making decisions that involve employment and retirement; current and deferred consumption; saving and investing. Employers also prefer these popular and less heavily regulated retirement plans (including 401(k) plans), plans that allow them to shift to their employees the risk for accumulating adequate retirement assets. Given the popularity of 401(k) plans and preference for individual autonomy, is there a solution to the problem posed by company stock's riskiness? Some have even argued that company stock's inherent riskiness is justified by its potential greater return. This Article argues that company stock is not worth the money and individual ignorance of basic principles of prudent investing has been incorrectly identified as the problem. In fact, individuals who invest in company stock are acting predictably according to behavioral economics (whether because of simplifying heuristics or excessive extrapolation). This article identifies the real problem: tax incentives that encourage employers to contribute non-transferable company stock to these plans thereby providing endorsement for company stock. Current tax rules allow corporations tax benefits far in excess of that realized by individual employees whose adequate savings at retirement is putatively the goal of this very expensive tax subsidy. By applying these current rules to companies whose assets are heavily concentrated in company stock and using readily available stock information, this article graphically shows that company stock is not worth the money: only corporations gain the full value of the current fair market deduction. Employees bear all the risk of loss and enjoy no potential for gain during the period of restriction, often their entire careers. In short, corporations use extremely favorable tax rules applicable to these plans to shift the risk for retirement to employees whose autonomy is effectively comprised by corporations' contribution of legally non-transferable stock. In addition, these rules allow corporations to engage in tax arbitrage, gaining a current tax advantage based on the stocks' (possibly temporary?) high price while making this same stock appreciation unavailable to employees. While Congress debates whether to impose more unnecessary regulation or encourage ineffective investor education, amending the tax rules to reinforce retirement policy would provide an efficient mechanism and a solution more in keeping with desire for individual autonomy. Eliminating inefficient and expensive perverse tax incentives would bring other advantages. Most troubling in this debate is the failure of those proposing solutions to identify the role of tax rules. These rules encourage employer plan design resulting in significant concentrations of company stock that employees interpret as government endorsement by tax subsidy of the very investment identified as a problem. Blaming the victim, policy makers are unable to arrive at a solution because they have incorrectly identified the problem. This article proposes that we begin by recognizing tax rules as a matter of first-order importance to the entire tax induced, employer-provided retirement system. We can then amend the tax provisions producing not only incoherent retirement but incoherent tax policy. In this way, tax can be used as an efficient gatekeeper to promote good retirement policy while allowing individual autonomy.