No. of Recommendations: 5
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 (
"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 Lucent
Lucent'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.
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