I'm simplifying an extremely complex topic here, but in general, when an employee exercises a stock option, the issuing company can take a tax deduction equal to the gain that the employee has realized, since this is compensation to the employee.For example, let's say a company granted an employee 1,000 shares of stock a number of years ago, with a strike price of $10/share. Now, with the stock at $30, the employee exercises the option. The employee has a gain of $20,000 ($30-$10 x 1,000 shares), which is taxable to the employee and is a tax deduction to the employer, just as if the company had paid the employee a $20,000 cash bonus. (Note that when employees exercise options, they might not have sold the stock -- they have merely converted their options into stock. However, given that taxes become due when options are exercised, it is often -- though not always -- the case that employees intend to sell the stock when they exercise their options.)Options in many ways are a far better way for companies to compensate employees than paying a cash salary. Beyond deferring taxes, motivating employees and providing incentives for them to stay (most options vest over time), the company does not have to pay out any of its precious cash -- in fact, it reduces the cash taxes it must pay -- and does not have to report this compensation on the income statement, thereby making profits and margins appear higher. Of course, shareholders are diluted as the shares outstanding rise, but investors appear to pay less attention to this.The reminds me of the questions Warren Buffett asked in his 1998 annual letter (http://www.berkshirehathaway.com/letters/1998htm.html): "If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?" Further Information on LucentLucent's surge in tax benefits from employees exercising stock options in Q1 and Q2 00 does not necessarily mean that employees saw storm clouds on the horizon. A spokesperson from Lucent noted that: A “Founder's Grant” made to the majority of Lucent employees when the company was spun out of AT&T became exercisable in October, 1999 (Q1 00). Other stock grants such as IPO and officer grants became exercisable during the same period. Lucent finalized a number of acquisitions during this period. In many cases, the stock options held by employees of the acquired companies converted to Lucent stock and became exercisable. In order to better compete for talented employees with Cisco, Nortel and the like, Lucent expanded its stock option program beginning in 1998, which would naturally lead to a higher tax deduction for Lucent as these options were exercised.All of this being said, I suspect that many Lucent employees knew that something was amiss at the company and were consequently exercising their options and selling their shares. That's why I always watch this line item on the cash flow statement carefully, as a big jump can be indicative of future problems.
Thank you Whitney Tilson for this instructive post and your associated articles on the Free Cash Flow mechanics. These articles were meant just for for me as I am adding the various details to my personal Worksheet on company's valuation.Concerning the "tax deduction related to the stock option plan" : «That's why I always watch this line item on the cash flow statement carefully, as a big jump can be indicative of future problems.» I have noticed a hughes entry under this same cathegory on Cisco's Cash Flow statement on their Yr2000 report : $2495 millions. I now know how to deal with particular situation.Pierre
However, given that taxes become due when options are exercisedIs this true for Incentive Stock Options as well as Non Qualified Stock options? I thought that if I exercised my ISO and then held the stock for over a year, I was only taxed at the capital gains rate. Whereas if I exercise an NSO any difference between the option price and the current market value is taxed as ordinary income. Can you speak to the difference between ISO's and NSO's? Additionally options are considered "at risk compensation", so just because employees are exercising their options it doesn't necessarily mean they don't have faith in the company, it might they don't want too much of there retirement based on the success of one stock. Is it not true that there are many reasons to sell and only one reason to buy? I am wary of jumping to conclusions based on someone's selling stock.
[Public service announcement]Folks --If you've got ISOs or other employee stock options (and these days more and more people do), you REALLY should learn a lot about the tax implications they carry -- and learn it now. There are decisions you should be making all the time regarding them and when or whether to exercise them. I used to think that if I had options that expired in 10 years, I could postpone worrying about them for 9 years. But I've since learned that depending on how I might view the prospects of those options, it could make a lot of sense to exercise ASAP, vs. later.In some situations, exercising early can save you hundreds of thousands of dollars in taxes. Of course, there's a potential dark side, too. It's too complicated to summarize, so I concur with the earlier advice that you read more at www.fairmark.com. And consider buying Kaye Thomas' book "Consider Your Options" (http://www.amazon.com/exec/obidos/ASIN/0967498163/motleyfool-features)Also, we've got a discussion board for just this topic: http://boards.fool.com/Messages.asp?bid=100161I posted something there a long while ago that might be of some use. I'm sure others have posted even more useful messages there.http://boards.fool.com/Message.asp?mid=12747637http://boards.fool.com/Message.asp?mid=12748762 (and a correction to an error:)http://boards.fool.com/Message.asp?mid=12752318Plus, here's a related Fortune article: http://www.fortune.com/fortune/technology/2000/06/26/eco2.htmlAnd here's our tax expert Roy on the AMT:http://www.fool.com/taxes/2000/taxes000915.htmAnd finally, options are one of many topics addressed in our forthcoming book, "The Motley Fool Investment Tax Guide 2001" (http://www.foolmart.com/shopping/Product_View.asp?PRODUCT_ID=MF030_02)If you've got employee stock options, learn about them now. :)Cheers!Selena
How should Amortization of good will and other intangibles be handled on the cash flow statement. Should it be left in or removed. For example: Veritas Software shows Net cash provided by operating activity of $237,670,000. This includes an astounding $659,275,000 of good will amortization (due to an aquisition). This overwhelms every other item on the cash flow statement so while Veritas actually lost $495 million (on the income statement), good will of $659 million caused them to come out with 238 million positive cash from operating activity.I see that the same item appears on the income statement as a deduction from net income. Therefore, I guess that goodwill should be left in net cash provided meaning that $237,670,000 IS the actual cash provided by operations. Correct?
Is this true for Incentive Stock Options as well as Non Qualified Stock options? I thought that if I exercised my ISO and then held the stock for over a year, I was only taxed at the capital gains rate. Whereas if I exercise an NSO any difference between the option price and the current market value is taxed as ordinary income. Can you speak to the difference between ISO's and NSO's? ? Additionally options are considered "at risk compensation", so just because employees are exercising their options it doesn't necessarily mean they don't have faith in the company, it might they don't want too much of there retirement based on the success of one stock. Is it not true that there are many reasons to sell and only one reason to buy? I am wary of jumping to conclusions based on someone's selling stock.- - - - - - - - - - - - - - - - - - - - - - - - - - - RandGraham,Regarding ISO stock options, if you exercise the options and hold the shares - i.e. not perform a cashless exercise or "same day sale" as it is sometimes called - then the difference between the exercise price of the shares and the market value on the date of the exercise is considered the "bargain element" to the taxpayer. This item is subject to Alternative Minimum Tax. Whether or not this is a bad thing depends on your specific tax situation and you would be prudent to consult with a qualified tax advisor who could assist you in your decision making.If you exercise but sell in the same tax year, but not the same day, the AMT does not apply, but in that case the gain, if there is one, is subject to ordinary income tax and the loss, should that occur, would be limited to $3,000. Again, a qualified tax professional can advise you on your specific tax situation.drome
Hi lanenoble,I think this is an excellent question. The usual discussion about goodwill goes something like this: Goodwill amortization is an accounting memorandum. It is a non-cash charge with no economic significance and should be treated like the non-event that it is - added back to operating income and to the denominator in return on equity / capital calculations. However, I don't think all amortization should be thrown in the same bucket. You have to ask yourself whether the expense is indicative of future cash outflows. If it is, then you can't ignore it. For example, depreciation is a non-cash charge. It is NOT ignored trying to determine the cash dynamics of a firm because it represents cash that you need to spend to replace your assets. I don't follow VRTS, but I would think that the amortization on VRTS's balance sheet is a similar animal. It represents the wearing away of intellectual assets that will need to be replaced with real R&D spending or acquisitions. Ian
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