Dot.com or Dot.bomb? The Unpleasant Tax Surprise of Stock Options in a Volatile Market

Abstract

This case explores the tax treatment of employee stock options as well as associated tax- and financial-planning issues. The number of employee stock option plans and related option grants has increased dramatically in the last decade. Today, senior management and rank-and-file workers alike often own substantial numbers of options and shares of employer stock acquired through the exercise of options. While these holdings can be valuable forms of compensation, exercising options also can be costly and risky. Early in 2000, following the stock market boom and its substantial decline later that same year, many employees who exercised options while the equity markets were at record highs were left with large tax bills. In some cases, the taxes owed exceeded the value of the optioned stock at year-end. This case details the tax and financial impact of option exercise on one employee that chose to retain optioned stock during the stock market crash of 2000. The educational objectives of the case include: (1) becoming familiar with the tax and financial aspects of compensatory stock options, (2) identifying the risks and rewards of option grant and exercise, (3) quantifying the cash inflows and outflows associated with stock options and their tax consequences, and (4) planning to maximize the after-tax value of stock option compensation. The case also discusses the tax treatment of options from the employer's perspective and the policy issues associated with tax deductions for option exercise.