A primer on stock options, why the tax code is much of the problem, and what Rush missed yesterday

[ken5050]

Much has been written, and babbled, about executive stock options as the root cause of much of the recent financial shenanigans. Yet what is more remarkable is what isn't being said about them. Most congresscritters, tripping over themselves to get to a microphone, know not of what they speak. Even Larry Kudlow, on Rush's show yesterday, got several things wrong. And surprisingly, it may well be that the income tax code ( no real surprise here,) is a major cause of much of this financial manipulation. So, if you'd like to learn a little more, read on...

[ken5050]

First, let me state up front that in no way am I condoning any of the financial abuses, frauds, or other accounting schemes that have come to light. Also, in the last decade, executive compensatio has gotten way out of whack. The top people are enriching themselves, with the blessing of aquiescent boards. The perps should go away for a long time. And I believe emphatically, that companies should be required to expense options grants when issued. Nevertheless, there is much in the income tax code that almost portends the behavior we have seen.

First, there are two types of stock options: Incentive Stock options (ISOs) and Non Qualified Stock Options (NQSOs) The difference between the two is mainly due to the tax treatment they enjoy.

NQSO are primarily issued to the lower paid workers in a company. Let's consider an employee who receives an option grant of 100 shares of XYZ at a price of $10, good for 3 years. That means that at anytime in the next three years, he can buy the stock at $10, and if it's selling for more, he has a nice profit. Sounds good, so far, right? But, sadly, the devil is in the details. Let's assume our employee takes the $1000 out of savings to exercise the NQSO and keeps the stock. The company is required, under current tax law, to treat the grain on the stock, the $2000, as ordinary income, EVEN THOUGH THE STOCK ISN'T SOLD, and further, it has to withhold tax from the employee on that income, in his current pay period. Let's assume that our employee earns $40,000/year, or $800/week. Let's say that after FICA, withholding, and other deductions, his tax home is $500/week. The company is required to withhold 20% of the gain, or $400, plus any applicable state and local income taxes, from the paycheck, so our employee may now get a take home check of $100...PLUS, he's out the $1000 that he paid to buy the stock. That's a $1500 bite out of his wallet. Many can't afford that. This is a real incentive to hold the stock, right? Something like 95% of NQSOs are flipped same day, becaue employees can't afford to lay out the cash for the stock AND give up the requisite taz withholding.

So, why is this? Well, the corporations get income tax deductions when the employees exercise the options, which can save them a lot of money on corporate income taxes. Microsoft has saved billions in corporate taxes this way, but to some extent on the back of its employees. So, where is Tommy Daschle and the other Dems, the so-called champions of the working people, on this issue? Rather silent, eh, and curiously so. Why should average Americans have to pay taxes on something they didn't yet sell? Why the deafening silenced from Congress?

Now let's take up ISOs. These are generally issued to the top executives, usually in grants in the 1000's, or even tens of 1000's, or even higher multiples.

ISOs differ from NQSO in the tax treatment they receive, in that if the executive exercises the option, i.e. buys the stock, but doesn't sell the stock for at least ONE YEAR from the date he exercised the option, then the ENTIRE gain on the stock above the grant price is subject to a long term capital gains treatment, at a max rate of 28%, which is far better than then current max rate on ordinary income of nearly 40%. And there's an added bonus to this feature. It encourages top execs to hold onto the stock. It wouldn't look good on Wall Street if the top people in XYZ were selling, right?

Ah, but there's another kicker that rears it's ugly head in the form of the Alternative Minimum Tax, that obscene part of the tax code that thoroughly confounds and entraps millions of Americans each year. Now, with ISOs, when you exercise them, and buy in the stock, even if you don't sell, the imputed gain that year is used to determine your AMT, and you have to come up with a big chunk of money. Yes, you do get a tax credit when you finally sell the stock at a later date, but hey, you can't "eat" credits, or deposit them into your checking account to cover your IRS bill.

Author's note: I'm not a CPA, though I have a good working knowledge of these issues, and invite any who are reading this to chime in. I've tried to simplify the example, and the question of the AMT, and hopefully, I've succeeded.

OK, now here's our key exec at XYZ who has options on 10,000 shares of XYZ at $10/share, ( it's now at $30)and he wants to exercise the options and hold the stock, because he believes its a good long term investment, and he doesn't think that execs should be selling.

OK, first, he needs to come up with $100,000 to buy the stock (10,000 x $10) and then when he does his tax bill for the year, on the $200,000 gain, maybe another $60,000 in income taxes.So some execs will margin the stock to pay for the exercise price and the income taxes....that's what Ebbers did, and when the price when down, he was screwed. Many more will sell enough of the stock to cover the exercise cost and the taxes due, but that can be 40-50% of the proceeds in some cases. Many, not wanting to run the risk, especially since they hold so many other options grants, sell as soon as possible, pay the taxes, and buy big houses, yachts, and jets with the money. That may turn out to be the smartest choice.

Again, I'm in no way condoning fraud, or other financial manipulation. But options evolved as a means to align the long term interests of executives, and indeed, all employees, with the stockholders, by actually making them stockholders. However, Congress, with its unique ability to screw things up via the IRC, may be responsible for much of the carnage before us.

Yet you haven't seen anyone, anywhere, anyhow, talking about this. Must be an election year.

[ken5050]

FYI

[ken5050]

Ping!!

[ken5050]

FYI

[Marc Poor]

Terrific synopsis! Should corporations be required to expense options as they are issued? There must be a way to compute the expected current value of these options, and then carry that as a liability on the balance sheet.

[knowtherules]

Why would anyone exercise and hold an option. Especially considering they are granted as a form of direct compensation or bonus? It seems that all your potential tax liabilities and margin headaches go away when you flip an option. If you want to repurchase shares of your company's stock, do it with the proceeds of the option flip. No?

[ken5050]

The value of the option can be estimated, then it should be deducted in the current year as an expense..which reduced earnings....Look, companies estimate the useful life of building and airplanes when they take depreciation, so figuring the value of an option isn't that hard....

[FreedomPoster]

Index ping for later reading

[rohry]

Interesting opinion on stock options over here...

[3AngelaD]

Bravo, Ken. May I add to your elegant essay the fact that Congress, back in the early '90s, included a provision in the tax law that prohibits corporations from claiming any amount of executive salaries in excess of $1 million a year (apiece) as a business expense on their corporate taxes. The purpose of this was to discourage "obscene" salaries of some corporate executives. But the unintended consequence of this was to cause corporations to begin compensating their key employees with generous helpings of stock options in order to keep those executives happy. The way these are structured has the tendency to encourage executives to live for today, making decisions that provided short-term benefits such as an increase in stock value, but that weren't necessary good for the long-term health of the corporation.Result: what we have today.

[The Vast Right Wing]

When corporations issue stock options they are a liability, just like issuing a bond or stock, why shouldn't they be marked to market and treated like any other financial instrument for tax and accounting reasons?

[ChadGore]

*Applause* Thank you for the post.

[razorback-bert]

I await the stock options have no value and it's a free lunch on the stock market crowd.

[Pylot]

Your example using Microsoft is particularly apt because it was Steve Balmer, who, as a member of the NASDAQ board of directors, got this treatment of NQSO's blessed for NASDAQ companies.

The upshot is this. Microsoft pays under the market wages. Prints money in the form of options (which when exercised dilute the stock of shareholders who paid cash for the stock!) then Microsoft actually gets to claim the gain as a payroll expense!

Microsoft made more money on this scam in the past five years than they did in selling product.

The beauty of the scam is, that when the value of the stock collapses, the options become worthless, get re issued to retain the enticement of the underpaid employees and the process can begin all over again.

[TruthNtegrity]

Ken, Bravo for this post. I've been yelling at my TV every time some CongressCritter finds a microphone to speak into but they never seem to hear me! LOL.

AF_Blue - this is a really good explanation and everyone has been talking like they understood this, and they don't have a clue!

[Marc Poor]

We are probably on the same page with this. If the expected value of the liability for a given company was, say $3 million last quarter, and is $3.5 million this quarter, then a expense of $.5 million would be charged this quarter. (right?). If the stock price dropped, and the options became worthless, then there would be a credit to earnings for the quarter. At least, that how it seems to me.

[Southack]

You're missing the point. Expensing options (prior to when they are exercised and before we know their final value) makes accounting MORE complicated and LESS transparent.

In contrast, with the accounting scandals swirling around us, we should be making accounting LESS complicated and MORE transparent.

Let's just pretend that a bunch of Worldcom-style corporations abuse this option-expensing trick. In that scenario, they will claim that their options are an enormous expense... just prior to tax time. Those expenses get immediately written off their taxes, but the companies haven't actually been out any physical money for issuing for those options, so the crooks have on hand a HUGE pile of cash that is now unaccounted for on their companies' books (i.e. the difference between their "guess" at the final options value and what it actually cost to physically print a stock option on paper).

They take that money, which is now legally hidden because a bunch of nimrods changed the accounting rules to force companies to have this scenario, and they send it to their personal accounts. It won't be until the options are actually exercised that any of this will be revisited, and by that time they'll have sufficiently buried all of the transactions that they'll be able to get away with even more theft.

In short, it isn't smart or clever to permit crooks to make their accounting procedures more complicated.

The new fad about "expensing options" will make accounting procedures more complicated, however. There will be guesses as to the final value of the options and there will be new, additional revisions to accounting books because of that sort of change.

And no one has even pointed out any benefit to "expensing options".

Who gains from this big push to expense options, and why are they bringing it up now?

[Starwind]

You might look at Sec 83, para g of the Internal Rev Code.

Sec 83 is the section under which the value of the AMT is computed, and paragraph g excludes section 83 from any transaction that conforms with Section 421 (ISO's), and 4 other transactions as well.

There is no withholding for ISO's when exercised either.

If you follow thru the various IRS tax guidelines and handbooks. Not once does the IRS say you'll owe taxes on an exercised ISO, they only say you 'may' and refer you to Section 83, but then if you read all of it, you'll find para g which excludes itself (sec 83) from ISO transactions.

In short, it is arguable that the AMT does not apply to ISO's and thus ISO's are treated as long term gain (or loss) only in the year they are sold. There is disagreement within the IRS about this. Officially, they deny the meaning of section 83g, unofficially they scratch their heads and tell to you to file accordingly.

Otherwise, you summarized it correctly, sadly.

[Southack]

By the way, Microsoft and every other American company already DOES expense their options.

Yes, you heard it here first. All American companies ALREADY expense their options.

But they "expense" them when the options are exercised so that the accountants know the PRECISE value of the option.

All of this talk about "expensing" options is really talk about counting options as expenses (read: tax deductions) prior to knowing what the final value of the option will be worth. Sure, we could GUESS that a stock option will be worth $5 when its owner exercises it one day, but how accurate is that guess going to be on average? Everytime that guess is wrong, we'll have to make ADDITIONAL, new revisions to our already over-complicated accounting books. Why would anyone want to add those extra layers of obfuscation into our existing accounting fiasco?

In other words, it's a lot of nonsense that would add a lot of guesswork onto our corporate books.

And what would it get us?

We'd still have had Enron/Worldcom/Global Crossing frauds regardless of when options were expensed, so why do we hear such a sudden outcry to expense options (prior to knowing what they'll finally be worth)?

Who gains from that?

[Frumious Bandersnatch]

In that case, why not also have a corporation treat an unused credit line as an expense?  Options amount to much the same thing.