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

Article excerpt

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. …

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