Sunk by Options
How to avoid stock option tax catastrophes. Only a little more than a year ago it seemed that stock options were the quick path to riches. After all, the stock market seemed to be defying the laws of gravity: Everything was going up--and staying up. Then the steep market downturn rudely reminded option holders that the popular form of equity compensation is not an automatic money machine. Many learned to their dismay not only the high cost of failing to appreciate investment risks but, even worse, how the tax laws conspire to double the penalty. BLISSFUL IGNORANCE Unfortunately, many rank-and-file workers--and more than a few top executives--are blissfully ignorant of the perils of stock option ownership. A study by Oppenheimer Funds of option holders indicated 37% knew very little about the tax implications, investment and market risks. "Many employees don't really comprehend what they have been granted when they're given stock options," says Barbara Steinmetz, president of Steinmetz Financial Planning in Burlingame, California. "They know this is something they should take advantage of, but they don't know the kind of option they've got or even where it fits in with their personal investment goals," she says. "I've seen people who were shell-shocked when the tax bill arrived, and to pay Uncle Sam they're suddenly forced to sell the stock they had exercised. But when they went to sell that stock they found the value had dropped like a rock." Take the case of Internet Capital Group, a venture capital holding company that lent $76 million in the summer of 1999 to employees wanting to exercise stock options on some 33 million shares. The company went public in August 1999 at $12 a share, reaching as high as $150 in January 2000. Employees who had exercised their stock options after borrowing heavily from the company figured they had struck the mother lode and spent accordingly--buying expensive cars and homes. Then the stock started falling, hitting a nadir of about $2 in May 2001. To pay their loans some had no choice but to sell the stock at basement prices. At last report, some $52 million in loans was still outstanding. SETTING FREE THE BEARS Lower stock values and higher debt loads have made life miserable for many option holders. But ignorance is as much a culprit as Wall Street uncertainty or greed. "Not only are the rank-and-file in the dark about options," says financial planner Steinmetz, but "I've seen people at the top of their companies who are clueless. People should be banging on the doors of their companies, accountants and financial planners begging for help." However, many companies that grant stock options are leery about providing this guidance. "They don't want to be construed as giving investment advice to their employees about their own stock," explains Mike Kesner, CPA, a partner-in-charge of the executive compensation practice at Arthur Andersen, LLP, in Chicago. "If the stock goes south, that could raise a hornet's nest of [legal] trouble [for the company]." While some companies hand out educational brochures and sponsor seminars on options, these activities usually occur when the options are granted, which may be several years before an employee elects to exercise them. Since most options have a 10-year tenure, much of what they learned is usually forgotten. Options are intended to be a win-win choice for employers and employees, which is why they're the single most common form of equity compensation. Employers, for example, receive a tax deduction for the year in which some types of options are exercised (more on this later). Granting options instead of forking over more cash compensation to workers also helps companies keep salaries in check. Meanwhile, employees are motivated to become more productive since they now have a financial stake in the company. A GREAT DEAL Options also are seen as a way for companies to attract and retain higher quality employees. …