Fool.com: The Option Not To Pay Taxes [Fool on the Hill] October 16, 2000
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The Option Not To Pay Taxes
As investors, we should all pay more attention to stock options than we do. They are a growing
component of the business models of many high-tech companies, including Microsoft and Cisco, which
has been in the news lately. What's worrisome about a business model that significantly employs
options is that a dip in a company's stock price can actually have an impact on its profits. If
hundreds of the largest companies in the market start doing this, a market downturn could become
a self-fulfilling prophecy.
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By
[ http://www.fool.com/About/staff/rlandley.htm" onClick="openWindow('http://www.fool.com/About/staff/rlandley.htm', 'writerspage', 300, 400); return false; ] Rob Landley (TMF Oak)
October 16, 2000
If you've been following the news recently, you'll notice that Cisco admitted it didn't pay any
federal income tax this past year. What was once controversial to point out is now widely
acknowledged with coverage from newspapers like Silicon Valley's
[ http://www.sfgate.com/cgi-bin/article.cgi?file=/chronicle/archive/2000/10/09/MN3707.DTL ] The San Francisco Chronicle
and [ http://www.sjmercury.com/local/center/cisco1010.htm ] The San Jose Mercury News
and the U.K.'s [ http://www.theregister.co.uk/content/1/13852.html ] The Register .
It even made the hourly news briefs on National Public Radio last Thursday morning.
The topic isn't exactly new. I
[ http://www.fool.com/portfolios/rulemaker/2000/rulemaker000217.htm ] covered it in February
(Matt Richey [ http://www.fool.com/portfolios/rulemaker/2000/rulemaker000218.htm ] rebutted
my take), The New York Times had it on the front page
[ http://www10.nytimes.com/library/tech/00/06/biztech/articles/13option.html ] back in June
(free registration required), and a man named [ http://www.billparish.com/presslist.html ] Bill Parish
has been covering it for years. (If you want the history of this topic, go to Bill's website, which
is where I first encountered it last year. He traces the history all the way back to Microsoft's
invention of the technique several years ago. He's also kind of annoyed about it.)
There are at least three distinct issues here. One is that options are becoming exponentially more
important as a part of overall employee compensation. The second is that options are being used as
a source of cash income to companies, via a tax loophole. Investors tend to notice the first part,
although I think we usually underestimate its impact. The second point goes right past most of us,
even though the amounts involved can be billions of dollars per company per year. (The third is the
pooling method of acquisitions, which I need to study more before I can give a particularly informed
opinion on, but which several of the articles I link to go over and Mr. Parish has been miffed about
for some time now.)
The tax break from stock options works like this. By issuing stock options to its employees, a
company allows them to buy stock at below market prices. The company doesn't have to buy this
stock from the market; it can fire up the printing press and issue more shares. So although this
technique does dilute the positions of existing shareholders, it doesn't actually cost the company
any cash to do this (beyond printing costs).
The new twist Microsoft
[ http://quote.fool.com/uberdata.asp?symbols=MSFT" onClick="openWindow('http://quote.fool.com/uberdata.asp?symbols=MSFT', 'quotebox', 640, 460); return false; ] (Nasdaq: MSFT)
added several years ago was to deduct from its taxable corporate income the difference between the
amount employees paid it to buy the shares and the amount the shares are worth on the open market.
The company's employees do get taxed on this amount (when they exercise their options and buy the
stock), so according to the IRS they received taxable income from their employer, and the company
can deduct it as a salary expense. Even though it wasn't a cash expense, it's still deductible.
Issue enough stock, and a company can shift its entire corporate
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