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...

[Starwind]

I've been citing the wrong paragraph. It is Sec 83, subsection (e) paragraph (1) that excludes 83 from ISO (sec 421) transactions.

[ken5050]

That's most definitely a thread killer.....LOL

[Starwind]

:-) sorry 'bout that. Mabye it'll be an asset saver someday for someone who reads this, and takes action.

[ken5050]

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..

[Billy_bob_bob]

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.

[Billy_bob_bob]

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.

[Tauzero]

Most excellent post.

[Dog Gone]

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.

[DrDavid]

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>

[TheCPA]

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.

[The Vast Right Wing]

O.K., well it is a contractual obligation that may induce a cash outflow in the future. Call it what you want, they should be marked to market like any other financial instrument.

[TheCPA]

Expenses on the financial statements are not necessarily the same as tax deductions. Financial statements are governed by generally accepted accounting principles, which are primarily determined by the Financial Accounting Standards Board. Deductions on the tax return must be authorized by the Internal Revenue Code.

[TheCPA]

CPAs are licensed by the state boards of accountancy, not by the IRS. However, CPAs may practice before the IRS unless the IRS revokes their right to practice before it.

[TheCPA]

We use double entry accounting. For example, if a company issued stock in payment of a typical business expense, the company would debit the expense account and credit common stock and paid in capital in excess of par. The expense would flow through to retained earnings and decrease total stockholders' equity, but the increase in the common stock and paid in capital accounts would offset it. The expense would be relected on the income statement, but the effect on the balance sheet is to move amounts from retained earnings to the other equity accounts with abolutely no effect on total stockholders' equity.

[mdwakeup]

If that large a percentage is flipped, that would make a pretty strong argument that they should be treated simply as compensation. So I'm not sure what's the problem.

[rohry]

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...

There is a theory that changes in the Japanese capital gains tax caused their stock market (and real estate market) to crash, also.

[Southack]

"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."

Tell me about it.

I had multiple people come to me asking for advice about how to handle their options, and I told them all to sell at least enough stock to cover their taxes. Not one of them did, that I can remember. So now they can all write off their losses on their future tax bills, over a great deal of time, but they are all out that initial hefty tax bill that for some reason "everyone" decided to pay rather than sell any of their precious stock (some in dot com firms that never earned a penny of profit). Most of that stock costs less than good wallpaper now. But that initial tax bill was real for them.

With that said, how would those dot com firms have been "saved" if they had been forced to make these accounting changes such that they had to guess at what those stock options would be worth when they were finally exercised?

The answer is that NONE of them would have been saved. This entire "expense options" craze offers NO BENEFIT to any honest firm (while opening wide the bank vault to crooks).

[SauronOfMordor]

Why would anyone exercise and hold an option. Especially considering they are granted as a form of direct compensation or bonus?

Mostly, they don't. You can see insider trade activity for (for example) IBM on yahoo. If you scroll down, you'll notice that when a person does an "option exercise", it's usually coupled with a sale the same day

[RJayneJ]

Thanks for the heads up! };^D)

[Cool Guy]

Thanks, good job.