Stock options are an important part of compensation. This column will serve as an introduction to the subject, covering the primary advantages and disadvantages of stock options as well as the different types of options that corporations can grant to their employees.

By Phil Weiss (TMF Grape)
September 8, 2000

The subject of stock options is one that comes up frequently these days, particularly in the case of technology companies, as employees view options as an important source of their compensation. Among the companies that I have seen criticized most frequently by the financial media and Fools alike for their use of stock options are Cisco (Nasdaq: CSCO) and Microsoft (Nasdaq: MSFT).

Tonight I'll lay a foundation by discussing the primary advantages of stock options, the different types, and how they're treated for income tax purposes. In future reports I'll discuss the treatment on the income statement, balance sheet, and cash flow statement.

Advantages and Disadvantages
As a rule under Generally Accepted Accounting Principles (GAAP), companies are not required to report any compensation expense in their publicly filed financial statements when they grant stock options. However, when certain options are exercised, companies receive a tax deduction, which can provide significant income tax savings.

If you've ever wondered why corporations like to use stock options as part of the overall compensation package, all you need to do is reread that last paragraph. In short, nothing could be finer than getting a tax deduction without seeing earnings penalized.

Of course there are other advantages for issuing stock options. Typically, they are used to align the interests of the employees with those of the company. The line of thinking here is that as part owners of the company, employees will work even harder to ensure the success of the company.

There are two arguments that you'll commonly find against the use of stock options: Dilution of ownership and overstatement of operating income.

When an employee exercises her stock options, the company has to either issue new shares or go out on the open market and purchase shares. If new shares are issued, then your ownership is diluted. If the company purchases shares on the open market, then the company, which only receives the exercise price from the employee, has to pay market price for the shares it purchases. This results in a net cash outflow for the company.

Since the impact of the compensation deduction that a corporation can claim for tax purposes is not included in a company's GAAP income, many take the view that using options enables the company to overstate its income.

Incentive Stock Options (ISOs)
ISOs are the more favorable for employees and less favorable for the company. Typically, you'll find that only highly compensated or key employees are granted ISOs. In order for an option to qualify as an ISO for tax purposes, it must pass certain criteria. If it does not, then it's treated as a nonqualified option. For the employee, there are two key aspects to ISOs. The first is that the grantee does not pay tax until the underlying stock is sold. More importantly, the difference between the sales price of the stock and the exercise price is taxed at capital gains rates (typically 20%).

Once stock has been purchased under an ISO, it cannot be sold within two years from the date it was granted or within one year from the date the option was exercised and the stock purchased, whichever is later. Failure to meet these holding period requirements results in the gain being subject to ordinary income tax rates (maximum 39.6%). From the company's perspective, neither the grant of the option nor the related exercise represent taxable events.

Nonqualified Stock Options (NSOs)
Simply put, NSOs are options that do not qualify as ISOs. The biggest difference between NSOs and ISOs is the tax treatment, which significantly favors corporations rather than employees. The employee is taxed on the difference between the grant price and the stock price at the time of exercise at ordinary income tax rates. For tax purposes, the corporation is allowed to claim a compensation deduction (35% rate) equal in amount to what the individual includes as income.

Here's an example of how this works for a NSO:

Number of options exercised: 200
Exercise price: $20
Stock Price on exercise date: $150
Compensation deduction
(tax purposes only): $26,000 [200 x (150-20)]
Corporate Tax Benefit: $9,100 (35% x $26,000)
Individual Income Tax Paid: $10,296 (39.6% x $26,000)

From the IRS's perspective, this situation typically works quite well. The amount of the tax deduction granted to corporations is less than the amount of tax paid by highly compensated individuals. This means that the IRS is cash flow positive in terms of the amount of net tax revenue generated upon the exercise of NSOs.

Stock options are an important part of compensation that can be viewed in different ways by different investors. There's a lot more to the situation than what's presented here, and the treatment of stock options in financial statements contains many inconsistencies. These topics will be explored more in future columns.

Related Links:
Some Thoughts on Stock Options, Rule Maker Portfolio, 2/29/00
Optionmania!: Part 1, Part 2, Part 3