Skip to comments.A primer on stock options, why the tax code is much of the problem, and what Rush missed yesterday
Posted on 07/17/2002 8:46:06 AM PDT by 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...
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.
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?
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?