Are stock options granted to a corporation's officers and directors added back to earned surplus for Texas franchise tax, and in what year?

Plain-English summary

This letter answers a question about how the pre-2008 Texas franchise tax treated stock options given to a corporation's officers and directors.

• The add-back rule. For a corporation that is not exempt from it, Tax Code Sec. 171.110(a)(1) required officer and director compensation to be added back to the corporation's earned surplus to the extent that compensation was excluded in determining the corporation's federal taxable income. (Earned surplus was one of the two bases of the old franchise tax.)
• What counts as "compensation." Franchise Tax Rule 3.558(b)(3) defined it as the amount reportable to the officer or director as includable in that person's federal taxable income, without regard to any federal monetary limits, and it counts wherever it is reported on federal forms - a Form W-2, a Form 1099-MISC, or Schedule K-1 of Form 1065.
• Stock options are in. Stock options that meet that test are subject to the add-back. If the corporation takes a federal income tax deduction attributable to the stock options, the amount deducted is added back to earned surplus as officer/director compensation.
• Which year. The add-back is made for the tax reporting period in which the corporation took the federal deduction - the accounting period on which the corporation's earned surplus was based (see Sec. 171.1532 and Sec. 171.0011). It is not tied to when the options were granted or exercised as such, but to when the federal deduction was taken.
• Further authority. The Comptroller pointed to Comptroller's Decision No. 36,607, which addresses this issue in detail, and enclosed a copy of Rule 3.558.

Currency note: This letter describes the pre-2008 franchise tax. The 2007 legislation (House Bills 3 and 3928) replaced the taxable-capital/earned-surplus tax with the current margin tax effective January 1, 2008, and the margin tax does not use this officer/director add-back. Treat the letter as historical.

What this means for you

Corporations that granted stock options to officers or directors (pre-2008 reports)

If your corporation deducted stock-option costs on its federal return and that amount was reportable to an officer or director on a W-2, 1099-MISC, or K-1, the pre-2008 franchise tax required you to add it back to earned surplus in the year you took the federal deduction. The federal dollar limits on what an individual must include did not shrink the add-back.

Accountants and tax professionals reviewing old franchise-tax reports

For any open pre-2008 franchise-tax period, test officer/director stock-option compensation against Rule 3.558(b)(3): if it was reportable to the individual as federally includable income and the corporation deducted it, it belongs in the earned-surplus add-back for the deduction year.

Common questions

Q: Were stock options treated as officer/director compensation for the old franchise tax?
A: Yes, if they met Rule 3.558(b)(3) - i.e., they were reportable to the officer or director as includable in that person's federal taxable income.

Q: In which year was the add-back made - when options were granted or exercised?
A: In the tax reporting period in which the corporation took the corresponding deduction on its federal income tax return (the period on which earned surplus was based).

Q: Did federal dollar limits reduce the amount added back?
A: No. Rule 3.558(b)(3) measured the amount "without regard to any monetary limitations imposed for federal income tax purposes."

Citations and references

Statutes and rules:

• Texas Tax Code Sec. 171.110(a)(1) - officer and director compensation added back to earned surplus to the extent excluded from federal taxable income
• Franchise Tax Rule 3.558(b)(3), 34 Tex. Admin. Code - definition of "compensation" for the add-back
• Texas Tax Code Sec. 171.1532 and Sec. 171.0011 - the accounting period on which earned surplus is based

Comptroller decision:

• Comptroller's Decision No. 36,607 - addresses the officer/director compensation add-back in detail

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/200206192L

Original ruling text

June 17, 2002

From: Jerry Bobbitt

To:

Dear Mr. Toews:

Your question concerning stock options has been referred to my attention. The
response below is directed at corporations that are not exempt from the
compensation add-back.

Tax Code Sec. 171.110(a)(1) requires that any officer and director compensation
be added to a corporation's earned surplus to the extent the compensation is
excluded in determining the corporation's federal taxable income.

Franchise Tax Rule 3.558(b)(3) defines "compensation" for purposes of the
statutory add-back. This rule provides that "compensation" is:

The amount reportable to an officer or director for the tax reporting period as
includable in the officer/director's federal taxable income without regard to
any monetary limitations imposed for federal income tax purposes.

The rule further provides that compensation is included wherever reportable on
federal tax reporting forms including a Form W-2 Wage and Tax Statement, a Form
1099-MISC, or Schedule K-1 of Form 1065. Stock options that meet the above
criteria would be subject to the add-back.

If a corporation does take a deduction on its federal income tax return that is
attributed to stock options, then the amount deducted will be added back to the
corporation's earned surplus as officer and director compensation.

You also asked that if the stock options are considered compensation, is the
amount considered compensation when granted or exercised. Based on the
above-referenced Tax Code provision and rule, the add-back would be made for
the tax reporting period in which the corporation took the deduction on its
federal income tax return. For franchise tax reporting purposes, this period
would correspond to the accounting period in which the corporation's earned
surplus was based. Please see Tax Code Sections 171.1532 and 171.0011.

Comptroller's Decision No. 36,607 addressed this issue and discusses it in
detail. I have attached a copy of this decision along with a copy of Franchise
Tax Rule 3.558.

If you have any questions, my internet address is
, or you may call 463-4496.

Sincerely,

Jerry Bobbitt
Tax Policy Division