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]

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.

[ken5050]

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.....

[Jackie]

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.

[Southack]

#19 is for you, too.

[Marc Poor]

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).

[wtc911]

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.

[Matchett-PI]

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!

[aculeus]

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.

[Frumious Bandersnatch]

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.

[ken5050]

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

[wtc911]

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.

[Starwind]

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.

[ken5050]

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

[ken5050]

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...

[wtc911]

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.

[Fractal Trader]

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.

[mdwakeup]

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.

[wtc911]

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.

[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

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.

[ken5050]

You're correct, of course, but if 95% of NQSOs are flipped the same day, your point's moot.....