Tesla fights to avoid the steep cost of scrapping Elon Musk’s pay package

Tesla has vowed to press on with its fight to restore Elon Musk’s historic pay package, and failure could have a high cost: the potential for more than $100bn in tax and accounting charges for the company and its chief executive.

Delaware judge Kathaleen McCormick recently denied the electric vehicle maker’s second attempt to give Musk the largest package of stock options in history — worth $56bn at the time of the original ruling and more than $129bn at the current share price. She found that shareholders’ overwhelming vote to reapprove the grant did not override her previous rejection of the 2018 deal as unfair and awarded by a board in thrall to its CEO.

Her stance has left the board with a dilemma: pursue a lengthy and uncertain appeal with Delaware’s Supreme Court or award its chief executive with a new options package.

If issued with similar terms, a new package could trigger a $50bn-plus corporate accounting charge and separately impose a punitive tax rate of up to 57 per cent on Musk’s shares, triggering a massive tax bill.

In April, Tesla warned shareholders that reissuing a new set of stock options entitling Musk to buy the same 304mn shares would result in a compensation-related accounting charge of more than $25bn, since the company’s valuation was substantially higher than in 2018. That compares with a $2.3bn charge for the original 2018 award.

Those calculations were based on a share price of $175 on April 1, when Tesla’s market capitalisation was $558bn. The stock has since more than doubled to $425 giving Tesla a valuation of $1.3tn — much of that due to investor enthusiasm for Musk’s newfound relationship with president-elect Donald Trump — implying the accounting charge could multiply by a similar amount.

Less known are the potential tax implications for Musk, whose net worth recently soared past $400bn — the first person to reach that level of wealth.

If Tesla prevails in its appeal, which must be filed within 30 days of the December 2 ruling, Musk would pay the standard federal rate of 37 per cent tax for stock compensation when he exercises his 2018 options, which he is under no obligation to do until 2028.

If the Delaware Supreme Court declines to overturn the original ruling and the board opts to issue a new plan on similar terms, the options would be awarded already “in the money”, since the financial targets have already been achieved. 

“It is very simple. If you grant options that are ‘in the money’, which they clearly are now, all kinds of bad things happen,” Schuyler Moore, a tax partner at Los Angeles law firm Greenberg Glusker, told the Financial Times. “That is why they are trying so hard to ratify the original deal. If they re-award it now, there will be hell to pay on taxes.”

When devised in 2018, the stock options were contingent on ambitious targets — such as increasing revenue 15 times and valuation 12-fold — which Musk had achieved by 2023.

At the time the package was awarded, the options were “out of the money” and not exercisable, thereby qualifying for exceptions in a part of the tax code known as 409A, which governs deferred compensation.

The rule was introduced in 2005 after Enron executives rushed to cash out vested stock they had received as part of their compensation plans before the company went bankrupt.

McCormick’s decision to rescind Musk’s plan in January cancelled his options, which from a tax perspective no longer exist.

Moore said attempting to award a new deal with the same terms now could breach section 409A, which “triggers the immediate taxation of the full value of deferred compensation on the date it is vested, well before the deferred compensation would be taxable under normal rules”.

“To add insult to injury, section 409A would impose an additional 20 per cent tax on the value,” Moore wrote in an article in the influential journal Tax Notes Federal. “The damage is done on the date of grant.”

That means Musk would be immediately liable for 57 per cent income tax on the difference between the strike price and the current value of the stock, whether he chooses to exercise the options or not. At Wednesday’s closing price of $425 and a strike price of $23.34 set in 2018, the difference would be $122bn, which means an almost $70bn tax bill.

“The tax issue here is straightforward. If you give him the same non-409A-compliant package now, you face acceleration of the income tax at the point of receipt rather than when he exercises, with the penalty rate on top,” said Bradford Cohen, a tax partner at Jeffer Mangels Butler & Mitchell. “It could be a very expensive, unfortunate mistake.”

Even for Musk, the world’s richest man, that would be eye-watering. In early 2022, the billionaire posted on X that he “paid the most taxes ever in history for an individual last year” in reply to a message saying he owed the US Internal Revenue Service $11bn in 2021.

“The only sure way that Musk could avoid these issues is to . . . successfully appeal [the decision], since it should then be viewed as a nullity,” said Moore. “A lot will be riding on those attempts.”

Despite Musk opting not to exercise his package when entitled to last year, “having the options is powerful and valuable”, said Moore, because they act as a deterrent to potential acquirers or activists. Musk can also borrow against their implied value, as long as he does not grant a lien on the options.

The board has another route to help Musk avoid the extra 20 per cent in tax, but it is still costly. Directors could award him 304mn Tesla shares worth $129bn at the current price, which would be subject to the standard rate of 37 per cent, about $48bn.

When quizzed on the issue by McCormick during a hearing in August, a lawyer for Tesla also raised the prospect that a likely higher personal tax rate could result in Musk receiving an even larger package to offset the cost of his taxes.

“Ultimately, as we know how economics work, then you’d have to likely pay him more. If he has a number he wants and he’s getting taxed, those get passed on [to shareholders],” said Rudolf Koch of Richards, Layton & Finger.

Moreover, if Musk were to flood the market by selling that much stock at once to cover the tax, it would risk causing the share price to fall.

The company would still have to shoulder the accounting charge. And if pay negotiations start over, Musk may not agree to a five-year lock-up period after exercising during which he cannot sell, a feature of his 2018 package.

Musk has previously raised the prospect of withdrawing from the electric-car maker, and the board had argued that the compensation plan was a key way of retaining the mercurial billionaire’s commitment.

In January, he posted on X that he was “uncomfortable growing Tesla to be a leader in AI and robotics without having ~25% voting control” and “unless that is the case, I would prefer to build products outside of Tesla”.

Tesla did not immediately respond to a request for comment.