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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...


TOPICS: Announcements; Business/Economy; Editorial; Front Page News; Your Opinion/Questions
KEYWORDS: options
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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.

1 posted on 07/17/2002 8:46:06 AM PDT by ken5050
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To: JohnHuang2; rohry
FYI
2 posted on 07/17/2002 8:46:32 AM PDT by ken5050
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To: LindaSOG
Ping!!
3 posted on 07/17/2002 8:47:08 AM PDT by ken5050
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To: Lazamataz; technochick99
FYI
4 posted on 07/17/2002 8:48:13 AM PDT by ken5050
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To: ken5050
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.
5 posted on 07/17/2002 8:57:07 AM PDT by Marc Poor
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To: ken5050
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?
6 posted on 07/17/2002 8:57:24 AM PDT by knowtherules
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To: Marc Poor
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....
7 posted on 07/17/2002 9:01:22 AM PDT by ken5050
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Index ping for later reading
8 posted on 07/17/2002 9:02:27 AM PDT by FreedomPoster
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To: sinkspur; bvw; Tauzero; robnoel; kezekiel; ChadGore; Harley - Mississippi; Dukie; Matchett-PI; ...
Interesting opinion on stock options over here...
9 posted on 07/17/2002 9:04:51 AM PDT by rohry
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To: ken5050
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.
10 posted on 07/17/2002 9:05:27 AM PDT by 3AngelaD
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To: ken5050
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?
11 posted on 07/17/2002 9:10:57 AM PDT by The Vast Right Wing
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To: ken5050
*Applause* Thank you for the post.
12 posted on 07/17/2002 9:13:52 AM PDT by ChadGore
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To: ken5050
I await the stock options have no value and it's a free lunch on the stock market crowd.
13 posted on 07/17/2002 9:31:12 AM PDT by razorback-bert
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To: ken5050
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.


14 posted on 07/17/2002 9:51:05 AM PDT by Pylot
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To: ken5050; AF_Blue
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!
15 posted on 07/17/2002 9:51:12 AM PDT by TruthNtegrity
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To: 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.
16 posted on 07/17/2002 9:53:55 AM PDT by Marc Poor
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To: ken5050
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?

17 posted on 07/17/2002 9:59:13 AM PDT by Southack
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To: ken5050; christine11; LoneGreenEyeshade
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.
18 posted on 07/17/2002 10:00:18 AM PDT by Starwind
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To: ken5050
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?

19 posted on 07/17/2002 10:05:52 AM PDT by Southack
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To: The Vast Right Wing
In that case, why not also have a corporation treat an unused credit line as an expense?  Options amount to much the same thing.
20 posted on 07/17/2002 10:09:24 AM PDT by Frumious Bandersnatch
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To: 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?

Because at time of issue, the issuer doesn't know the value of the option until it is exercised. That value could increase, in which case the issuer get's a writeoff, or the value could decrease, in which case they don't.

21 posted on 07/17/2002 10:12:53 AM PDT by Starwind
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To: Starwind
Thanks for your comments, and the reference. I didn't say anythign about withholdoing for ISO's....only for the NQSOs..and sadly the problems it causes....Re the AMT, are your saying that you feel that one does or doesn't owe the AMT. The IRS is itself confused, or conflicted, may be a better term, but CPA's I've spoken to seem to feel that the issue of the "credit" for the AMT, which can be taken when you ultimately sell the stock, means thatthe AMT tax is due the year the ISO is exercised, because, I mean, how can you earn a credit if you haven't already paid the tax?

Again, I hope I didn't provide wrong info. I believe what I wrote is correct, as is understood. Also, individuals in this case nearly always go to tax professionals for guidance, and most aren't willing to sign off on theadvice to exclude it from the AMT.....

22 posted on 07/17/2002 10:14:20 AM PDT by ken5050
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To: ken5050
Super excellent!

All of the complicated, complex wheeling and dealing could be avoided if this country would institute a Consumer Tax -- which I've always supported to most everyone's astonishment.

23 posted on 07/17/2002 10:14:33 AM PDT by Jackie
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To: RJayneJ; JohnHuang2; Dog Gone
#19 is for you, too.
24 posted on 07/17/2002 10:15:38 AM PDT by Southack
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To: Frumious Bandersnatch
I don't know if I buy that. I mean a person with a credit line of $2000 (but no balance) is in better shape than someone who is expecting a property tax bill for around $2,000 in the mail (but doesn't know the exact amount).
25 posted on 07/17/2002 10:16:35 AM PDT by Marc Poor
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To: knowtherules
You hit it on the head. Only a fool or one who is listening to bad or no advice exercises and holds. The dangers are too real....

A boatload of Silicon Valley and dot-com people were granted options with a strike price in the teens, or lower. They exercised the options in the eighty dollar plus range but held on to the stock. When it came time to pay uncle the price had dropped to the forty dollar level, or lower...but the tax due was set on the eighty dollar price. Many out there lost everything in order to satisfy the IRS. They should have flipped in totum or at least enough to pay the tax. This happened well before any current issues.

26 posted on 07/17/2002 10:21:00 AM PDT by wtc911
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To: ken5050; rohry; bvw; Tauzero; robnoel; kezekiel; ChadGore; Harley - Mississippi; Dukie; ...
Thanks for the post.

If you have been listening to Rush today you will know that he has referred us to "The Dodd Report" at http://www.publiccampaign.org which shows that Dodd was the leading voice for all that Wall Street wanted during the 90's.

Under the heading of, "Who's on the leash?" Rush says we'll find that he sponsored the legislation that limited the liability of accounting agencies like Arthur Anderson, for any wrongdoing they're found to be guilty of.

Rush is wondering if this info will make it to the *mainstream* news media. Riiiiiiiiight!


27 posted on 07/17/2002 10:21:48 AM PDT by Matchett-PI
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To: ken5050
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....

It's no more difficult than predicting the future. Yes, one can "price" an option but the "price" is based on an assumption about the future value of the stock.

One thing no one has mentioned is what happens if the expensed stock option expires without exercise --- because the stock has gone south. Does the corporation then reverse the expense and eliminate the liability? In other words does the corporation show a higher profit and increased net worth because the stock has decreased in value? Is that what we want to happen?

In my experience people who propose radical reforms frequently do not think matters through.

28 posted on 07/17/2002 10:24:17 AM PDT by aculeus
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To: Marc Poor
The property tax is an actual liability.  The credit line and options are both potential liabilities.  Neither becomes an actual liability until exercised.  It is not inevitable (though probable in both cases) that either will ever actually be exercised.
29 posted on 07/17/2002 10:26:23 AM PDT by Frumious Bandersnatch
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To: knowtherules
Exactly my point..the IRC forces you to sell, and repurchase rather than hold for the long term. And of course, there are those stupid rules on "wash sales" as an added complication
30 posted on 07/17/2002 10:26:52 AM PDT by ken5050
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To: Southack
You are right about the expensing practices. They were but a small part of the sleight of hand that WC pulled to make the stock more attractive than it was.

One of the tricks pulled by another company was to count project cost over runs as revenue. If, for example, an international power plant construction job was bid and accepted at $100m but the actual cost to completion was $160m then the over run was $60m. This company would record the additional $60m as revenue. The problem was that in almost every case the amount actually collected was far less because the buyer would not agree to the full over run after accepting a bid at the original cost.

The company was Haliburton, while Cheney was at the wheel.

31 posted on 07/17/2002 10:28:27 AM PDT by wtc911
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To: ken5050
Re the AMT, are your saying that you feel that one does or doesn't owe the AMT. The IRS is itself confused, or conflicted, may be a better term, but CPA's I've spoken to seem to feel that the issue of the "credit" for the AMT, which can be taken when you ultimately sell the stock, means thatthe AMT tax is due the year the ISO is exercised, because, I mean, how can you earn a credit if you haven't already paid the tax?

I believe the AMT is not owed on an exercised ISO.

When I showed section 83g to my accountants, their jaws bounced off the floor. All CPA's are licensed by the IRS. The IRS literally holds their careers in the IRS's hands. Only the most agressive will buck the IRS.

The CPA community tends to circle the wagons around their own as well, and they follow the opinion of whomever is the 'leading CPA'. Well if that leader hasn't done their homework, or won't publicly take an adverse stance, that sets the thinking in all the follower CPA's as well.

Then you also get the problem, if you ultimately convince them, that they've been mis-trained by the IRS and mislead by their peers, they're in a the awkward position of filing an ISO exercise a new way, inviting the scrutiny of the IRS and risking their license, and further risking being sued for malpractice by previous clients who paid the AMT on ISO's.

So they don't change, and don't rock the boat.

Show section 83g to your accountant and they'll either confess ignorance ('well gee that's tax law stuff and I rely on my trusty IRS example sheet'), or rely on the reputations of others ('you must be wrong because so and so wouldn't make a mistake and knows more about it than you'), or they'll scratch their heads.

32 posted on 07/17/2002 10:32:09 AM PDT by Starwind
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To: wtc911
Actually, one could also advance the thesis, as I do, that the whole stock market bubble was exacerbated by the failure to lower the capital gains tax....look, forget the question of options...The average small investor went out, and bought INTC, of CSCO, or AMZN...or heck, pick one....the stock went from $10 to $110 ( I'm using an example to make the math easier)...now, you know the stock is overpriced, you'd like to sell, but if you do, you'll owe 28% to the feds on your capital gains, plus whatever the state tax bill is....say the average total bill, in places like NY and Cal, is 35%..so, you figure that you've got a 35% downside protection....in other words, if you sold at 110 to protect you profits, you'd give 35% to the government, so why sell...LOts of folks held on for that very reason...to their regret
33 posted on 07/17/2002 10:34:37 AM PDT by ken5050
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To: Starwind
Thanks for the comments. I'm going to email them to several CPA's. If the seismograph registers many jaws dropping in the NY area, you'll know yoiu're correct.. I'll keep you advised...
34 posted on 07/17/2002 10:38:02 AM PDT by ken5050
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To: ken5050
Yep, but some of us lived by the "pigs get fat, hogs get slaughtered" creed and took our profits without kicking ourselves when it went higher. Not everytime, but enough to upgrade the domicile and pay off a semester or two.
35 posted on 07/17/2002 10:38:04 AM PDT by wtc911
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To: ken5050
What everybody has missed in this whole options debate is that when options are excercised, they are distributed from the equity (retained earnings) of the company. Equity is the collection of afer-tax earnings over the history of the company. You would have to violate all accounting principles to move options into the expense category, rather than as a capital item.

Personally, I prefer full disclosure of the dollar value of all options excercised, or some variant thereof, as a means of giving the shareholders full information without requiring even more accounting shenanigans to fix something that is perfectly correct in its application.

36 posted on 07/17/2002 10:41:29 AM PDT by Fractal Trader
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To: ken5050
I think you forgot to mention that on what you call NQSOs the purchaser increases his basis on the stock after he pays the tax on the spread between the option price and the market price. So when the time comes to sell, the tax bite should be much smaller as a result of the higher basis and the lower capital gains tax rate.
37 posted on 07/17/2002 10:42:09 AM PDT by mdwakeup
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To: ken5050
Re-thought your post. The problem was not that the small investor knew that the stock was over-priced but did not want to sell and pay 35%....the problem in 1998-mid-2000 was that the average investor did NOT know that. Few little guys even looked at P/E ratios and those who did fell short of the education required to really understand the data and it's importance. It was greed, mis-education and a desire to be part of the pack that drove the little guy.
38 posted on 07/17/2002 10:42:34 AM PDT by wtc911
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To: Starwind
All; I misquoted the IRC section is it 83(e)(1) below which excludes sec 83 from section 421 (ISO) transactions: See IRC 83

Sec. 83. Property transferred in connection with performance of services

TITLE 26, Subtitle A, CHAPTER 1, Subchapter B, PART II, Sec. 83

Next Previous Contents Sections Search Help

STATUTE

(a)
General rule
If, in connection with the performance of services, property is transferred to any person other than the person for whom such services are performed, the excess of -
(1)
the fair market value of such property (determined without regard to any restriction other than a restriction which by its terms will never lapse) at the first time the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier, over
(2)
the amount (if any) paid for such property, shall be included in the gross income of the person who performed such services in the first taxable year in which the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever is applicable. The preceding sentence shall not apply if such person sells or otherwise disposes of such property in an arm's length transaction before his rights in such property become transferable or not subject to a substantial risk of forfeiture.
(b)
Election to include in gross income in year of transfer
(1)
In general
Any person who performs services in connection with which property is transferred to any person may elect to include in his gross income for the taxable year in which such property is transferred, the excess of -
(A)
the fair market value of such property at the time of transfer (determined without regard to any restriction other than a restriction which by its terms will never lapse), over
(B)
the amount (if any) paid for such property. If such election is made, subsection (a) shall not apply with respect to the transfer of such property, and if such property is subsequently forfeited, no deduction shall be allowed in respect of such forfeiture.
(2)
Election
An election under paragraph (1) with respect to any transfer of property shall be made in such manner as the Secretary prescribes and shall be made not later than 30 days after the date of such transfer. Such election may not be revoked except with the consent of the Secretary.
(c)
Special rules
For purposes of this section -
(1)
Substantial risk of forfeiture
The rights of a person in property are subject to a substantial risk of forfeiture if such person's rights to full enjoyment of such property are conditioned upon the future performance of substantial services by any individual.
(2)
Transferability of property
The rights of a person in property are transferable only if the rights in such property of any transferee are not subject to a substantial risk of forfeiture.
(3)
Sales which may give rise to suit under section 16(b) of the
Securities Exchange Act of 1934
So long as the sale of property at a profit could subject a person to suit under section 16(b) of the Securities Exchange Act of 1934, such person's rights in such property are -
(A)
subject to a substantial risk of forfeiture, and
(B)
not transferable.
(d)
Certain restrictions which will never lapse
(1)
Valuation
In the case of property subject to a restriction which by its terms will never lapse, and which allows the transferee to sell such property only at a price determined under a formula, the price so determined shall be deemed to be the fair market value of the property unless established to the contrary by the Secretary, and the burden of proof shall be on the Secretary with respect to such value.
(2)
Cancellation
If, in the case of property subject to a restriction which by its terms will never lapse, the restriction is canceled, then, unless the taxpayer establishes -
(A)
that such cancellation was not compensatory, and
(B)
that the person, if any, who would be allowed a deduction if the cancellation were treated as compensatory, will treat the transaction as not compensatory, as evidenced in such manner as the Secretary shall prescribe by regulations, the excess of the fair market value of the property (computed without regard to the restrictions) at the time of cancellation over the sum of -
(C)
the fair market value of such property (computed by taking the restriction into account) immediately before the cancellation, and
(D)
the amount, if any, paid for the cancellation, shall be treated as compensation for the taxable year in which such cancellation occurs.
(e)
Applicability of section
This section shall not apply to -
(1)
a transaction to which section 421 applies,
(2)
a transfer to or from a trust described in section 401(a) or a transfer under an annuity plan which meets the requirements of section 404(a)(2),
(3)
the transfer of an option without a readily ascertainable fair market value,
(4)
the transfer of property pursuant to the exercise of an option with a readily ascertainable fair market value at the date of grant, or
(5)
group-term life insurance to which section 79 applies.
(f)
Holding period
In determining the period for which the taxpayer has held property to which subsection (a) applies, there shall be included only the period beginning at the first time his rights in such property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier.
(g)
Certain exchanges
If property to which subsection (a) applies is exchanged for property subject to restrictions and conditions substantially similar to those to which the property given in such exchange was subject, and if section 354, 355, 356, or 1036 (or so much of section 1031 as relates to section 1036) applied to such exchange, or if such exchange was pursuant to the exercise of a conversion privilege -
(1)
such exchange shall be disregarded for purposes of subsection (a), and
(2)
the property received shall be treated as property to which subsection (a) applies.
(h)
Deduction by employer
In the case of a transfer of property to which this section applies or a cancellation of a restriction described in subsection (d), there shall be allowed as a deduction under section 162, to the person for whom were performed the services in connection with which such property was transferred, an amount equal to the amount included under subsection (a), (b), or (d)(2) in the gross income of the person who performed such services. Such deduction shall be allowed for the taxable year of such person in which or with which ends the taxable year in which such amount is included in the gross income of the person who performed such services.

39 posted on 07/17/2002 10:45:27 AM PDT by Starwind
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To: mdwakeup
You're correct, of course, but if 95% of NQSOs are flipped the same day, your point's moot.....
40 posted on 07/17/2002 10:49:10 AM PDT by ken5050
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To: ken5050; christine11; LoneGreenEyeshade
I've been citing the wrong paragraph. It is Sec 83, subsection (e) paragraph (1) that excludes 83 from ISO (sec 421) transactions.
41 posted on 07/17/2002 10:49:12 AM PDT by Starwind
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To: Starwind
That's most definitely a thread killer.....LOL
42 posted on 07/17/2002 10:50:22 AM PDT by ken5050
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To: ken5050
:-) sorry 'bout that. Mabye it'll be an asset saver someday for someone who reads this, and takes action.
43 posted on 07/17/2002 10:53:40 AM PDT by Starwind
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To: wtc911
I had a lot of clients who hated the idea of paying a "s**tload" of taxes just to protect the "downside" ..Sounds like you, and Ihappily took profits and got out...I remember writing here 3 years ago that the whole thing was gonna implode.. I was excoriated..I've been mostly in cash since late 99, got out when the Dow was about 9000, but 99.9% of those here wrote that I was an idiot..
44 posted on 07/17/2002 10:54:19 AM PDT by ken5050
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To: ken5050
I cannot tell you how many people I used to know who were employees of tech companies and who had MILLIONS of dollars worth of stock options, but didn't want to sell becuase of the exposure to taxes. As a result, people who could have paid their houses off and possibly even retired are instead holding onto worthless options and watching their mortgate payment eat up their entire combined unemployment checks. Seriously. But hey, at least they didn't have to pay all those taxes on the gains!

I talked to them, I cajoled them, I begged and pleaded with them to sell and take some profits. None of them did.

45 posted on 07/17/2002 11:02:24 AM PDT by Billy_bob_bob
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To: ken5050
We sold out around August 2000. So, we didn't call it quite as well as you did, but we did pretty darn good overall.
46 posted on 07/17/2002 11:03:36 AM PDT by Billy_bob_bob
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To: ken5050
Most excellent post.
47 posted on 07/17/2002 11:09:33 AM PDT by Tauzero
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To: Southack
As far as I can see, you and I are on total agreement on this entire issue.

Those who are in favor of expensing stock options can't possibly understand what they're talking about, or they wouldn't be calling for it. I would rather see company stock options be prohibited entirely than to let them be expensed.

48 posted on 07/17/2002 11:16:57 AM PDT by Dog Gone
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To: ken5050
It is interesting how options are set up to benefit the top executives more than they benefit everybody else.

Why doesn't the salary cap apply to sports and entertainment people? </RHETORICAL>

49 posted on 07/17/2002 11:28:15 AM PDT by DrDavid
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To: The Vast Right Wing
Stock options are not a liability. Liabilities are obligations to transfer goods or services in the future based on past transactions or events. An obligation to issue stock is not a liability.
50 posted on 07/17/2002 11:43:25 AM PDT by TheCPA
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