Dot.com or Dot.bomb? the Unpleasant Tax Surprise of Stock Options in a Volatile Market

By Rhoades-Catanach, Shelley C. | Issues in Accounting Education, November 2003 | Go to article overview

Dot.com or Dot.bomb? the Unpleasant Tax Surprise of Stock Options in a Volatile Market


Rhoades-Catanach, Shelley C., Issues in Accounting Education


ABSTRACT: This case explores the tax treatment of employee stock options as well as associated tax- and financial-planning issues. The number of employee stock option plans and related option grants has increased dramatically in the last decade. Today, senior management and rank-and-file workers alike often own substantial numbers of options and shares of employer stock acquired through the exercise of options. While these holdings can be valuable forms of compensation, exercising options also can be costly and risky. Early in 2000, following the stock market boom and its substantial decline later that same year, many employees who exercised options while the equity markets were at record highs were left with large tax bills. In some cases, the taxes owed exceeded the value of the optioned stock at year-end. This case details the tax and financial impact of option exercise on one employee that chose to retain optioned stock during the stock market crash of 2000. The educational objectives of the case include: (1) becoming familiar with the tax and financial aspects of compensatory stock options, (2) identifying the risks and rewards of option grant and exercise, (3) quantifying the cash inflows and outflows associated with stock options and their tax consequences, and (4) planning to maximize the after-tax value of stock option compensation. The case also discusses the tax treatment of options from the employer's perspective and the policy issues associated with tax deductions for option exercise.

INTRODUCTION

Corporate employers often seek ways to link employee compensation to firm performance. Compensation granted in the form of employer stock or options to acquire stock provide a popular alternative. A stock option is the right to purchase a specified number of shares of stock for a stated price (option or strike price) for a stated period of time. Typically, the strike price is equal to or less than the market price of the stock at date of grant. As a result, the option has no ascertainable value to the employee on the date it is granted. However, the option does entitle the employee to future appreciation in the value of the optioned shares over the option period. Thus, the compensation awarded the employee via the option is purely prospective and a function of the stock's market price over time.

A decade ago, stock options were typically granted only to senior executives of the largest publicly traded corporations. However, in the 1990s, their use grew dramatically. One study indicates that currently as many as 10 million employees hold stock options, a 10-fold increase from 1991. (1) In many companies today, middle management and even rank-and-file employees are eligible to participate in option programs.

Stock options are often viewed as a "no-lose" proposition for both employee and employer. Employees are allowed to purchase employer stock at favorable prices, linking their compensation to stock performance, and employers can award compensation without draining cash resources. In addition, certain types of options can generate a tax deduction for the company without reducing book earnings. Although shareholder ownership is diluted by option exercise, employee stock ownership is believed by many to increase employee effort and eventually stock price. However, many of these option program benefits are realized only if share prices increase. In a volatile or declining market, options may never be exercisable, or employees who exercise and hold employer stock may experience significant tax and financial losses. This case explores the tax and financial impact of option exercise on one employee who held optioned stock during the stock market crash of 2000. The case further demonstrates the tax, financial, and cash flow implications of compensatory stock options (for both employee and employer), and highlights the importance of planning in maximizing employee value.

CASE FACTS

Cisco Systems, Inc.

The rest of this article is only available to active members of Questia

Sign up now for a free, 1-day trial and receive full access to:

  • Questia's entire collection
  • Automatic bibliography creation
  • More helpful research tools like notes, citations, and highlights
  • Ad-free environment

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

Dot.com or Dot.bomb? the Unpleasant Tax Surprise of Stock Options in a Volatile Market
Settings

Settings

Typeface
Text size Smaller Larger
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Full screen

matching results for page

Cited passage

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited passage

Welcome to the new Questia Reader

The Questia Reader has been updated to provide you with an even better online reading experience.  It is now 100% Responsive, which means you can read our books and articles on any sized device you wish.  All of your favorite tools like notes, highlights, and citations are still here, but the way you select text has been updated to be easier to use, especially on touchscreen devices.  Here's how:

1. Click or tap the first word you want to select.
2. Click or tap the last word you want to select.

OK, got it!

Thanks for trying Questia!

Please continue trying out our research tools, but please note, full functionality is available only to our active members.

Your work will be lost once you leave this Web page.

For full access in an ad-free environment, sign up now for a FREE, 1-day trial.

Already a member? Log in now.