FOOL ON THE HILL: An Investment Opinion
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 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 The San Francisco Chronicle and The San Jose Mercury News and the U.K.'s The Register. It even made the hourly news briefs on National Public Radio last Thursday morning.

The topic isn't exactly new. I covered it in February (Matt Richey rebutted my take), The New York Times had it on the front page back in June (free registration required), and a man named 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 (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 tax burden to its employees and wind up paying no taxes on its own income.

Microsoft was the first company to achieve tax-free status. Cisco (Nasdaq: CSCO) has recently followed suit. But dozens of other companies are copying this technique, tiny little firms like America Online (NYSE: AOL), Yahoo! (Nasdaq: YHOO), and Seagate Technology (NYSE: SEG), presenting themselves to the IRS as if they're actually losing money instead of being profitable. And the IRS is currently buying it.

The problem is, when the tax refund amount gets into the multi-billion dollar range, companies can't help but become dependent on that money. Yet the more widespread the practice becomes, the more likely Congress (or the IRS) is to act to close the loophole. Yet companies that DON'T take advantage of this technique (while it lasts) are at a competitive disadvantage: they're giving up free money from the tax refund and they can't keep scarce high-tech employees who could make more money elsewhere via enormous option grants.

Secondly, over-dependence on options is a bit like a pyramid scheme in that they benefit the company only as long as its stock is going up. If the stock stalls, or starts dropping (as Microsoft's has done this year), there are real consequences to the bottom line and to the company's operations. Employees demand more salary to replace the lost option income. Tax bills return unexpectedly and drain unanticipated cash from the company's coffers. And the cash employees pay to exercise their options (in the largest companies another billion-dollar-plus source of cash) vanishes from the corporate bottom line.

When it comes to investing, I am categorically against any momentum-based optimization becoming an integral part of an ongoing business model. I wrote an entire article about this for the Rule Maker portfolio, which is based on the idea that some companies have a strong and profitable business no matter what the stock market does to their share price. When a dip in the stock price can actually impact a company's profits (causing a further dip in the stock price in a vicious cycle), I'm simply not comfortable owning a piece. If hundreds of the largest companies in the market start doing this, a market downturn could become a self-fulfilling prophecy. This is a bad thing.

As investors, we should all pay more attention to stock options than we do. They are a growing component of many high-tech business models, and I have serious concerns about their sustainability. But don't take my word for it, read some of the articles I linked to. It isn't Foolish unless you decide for yourself.

- Oak