Giant Cisco Didn't Pay Any Federal Income Tax Businesses get break on employee stock options
Kathleen Pender, Chronicle Staff Writer
SAN JOSE -- Cisco Systems, the second-most valuable company in America, paid no federal income taxes for its latest fiscal year thanks to a little-known corporate tax break on employee stock options.
Microsoft, which ranks No. 4 in market value, did not pay any federal taxes either, it seems.
Like many high-tech firms, Cisco and Microsoft are allowed to take a tax deduction for money their employees earn when they ``exercise'' options and buy stock in the company at a preset price.
These options have become an increasingly popular way for businesses to reward employees, but they also have huge benefits to the companies themselves.
The tax break was established decades ago, when companies doled out stock options to only a handful of top executives and the tax benefit they generated was minimal.
But now that many companies -- including Cisco, Microsoft and most other new-economy firms -- give options to everyone, the tax break is becoming enormous.
In Cisco's case, this benefit wiped out $1.8 billion in federal taxes, and probably more than twice that for Microsoft.
Some people, even those who oppose taxes, think it is unfair that wealthy companies paid none to Uncle Sam.
For the fiscal year ended July 31, Cisco had $23 billion in sales last year, $2.7 billion in net income, and its almost $400 billion market value is exceeded only by General Electric's.
``For a company that makes that kind of money not to pay taxes raises serious tax-equity questions,'' said Jon Coupal, president of the Howard Jarvis Taxpayers Association.
He also said he believes it is ``hypocritical'' for Cisco to take this ``massive tax break'' and at the same time support Proposition 39, which would make it easier to raise property taxes on California homeowners. Prop 39 would allow local school bonds to be approved by a vote of 55 percent instead of the current two-thirds.
ENTITLED TO DEDUCTION
Cisco is entitled to a deduction for stock option income because ``in reality, that's compensation,'' and tax law has always treated employee compensation as a deductible expense, said Dennis Powell, Cisco's corporate controller.
When an employee exercises an option to buy stock, the difference between the strike price (what the employee pays) and the market price (which is almost always higher) becomes taxable income for the employee and a tax deduction for the employer.
Most Americans do not realize how enormous this tax break has become, because companies do not deduct employee stock options from the earnings they report to shareholders and the public. In fact, American companies fought long and hard to prevent employee stock options from showing up as an expense on their income statements, although they are happy to consider them as an expense for income tax purposes.
Cisco's and Microsoft's annual reports make it appear as if they had paid billions of dollars in income taxes.
Cisco's income statement for fiscal 2000, which was published about a week ago, shows net income before taxes of $4.34 billion, and a provision for income taxes of $1.67 billion.
That number includes federal, state, foreign and deferred taxes. The firm's actual federal tax liability, buried deep in the report, was $1.8 billion.
But in reality, the San Jose maker of computer networking gear paid no federal income taxes for fiscal 2000.
That is because its employees earned more than $7 billion exercising stock options in fiscal 2000. That $7-plus billion deduction generated a $2.5 billion tax benefit for Cisco, which wiped out its entire federal tax liability. The benefit shows up on Cisco's cash flow statement.
STOCK OPTIONS EXERCISED
Cisco employees exercised ``an unusually large number'' of stock options during fiscal 2000, mainly because the company's stock price more than doubled, said Cisco's Powell.
By comparison, Cisco's tax benefit from employee stock options was only $837 million in 1999 and $422 million in 1998.
Unlike Cisco, which acknowledges that it paid no federal income taxes, a Microsoft spokeswoman would not say whether that firm did or not.
But its annual report for fiscal 2000, which ended June 30, shows stock option income tax benefits of $5.5 billion, exceeding its $4.85 billion provision for income taxes. (Its actual federal and state tax liability for 2000 was $4.74 billion.)
``I'd say their federal income tax was next to nothing or probably nothing,'' said Robert Willens, a tax and accounting analyst with Lehman Brothers in New York.
Willens said another company that will be wiping out its federal tax liability is Seagate, which is undergoing a complicated leveraged buyout.
SHAREHOLDERS GET REMAINDER
When the deal is completed, ``all of Seagate's options have to be exercised. The tax deduction they're going to get is so large, it will wipe out their income for the year of the merger,'' with some left over, he said. The remainder will be passed on to Seagate shareholders as a tax-refund right.
Companies do not pay anything for stock options, at least not in the traditional sense. The real cost is borne by shareholders.
That is because stock options increase a company's shares outstanding, which reduces earnings per share. All other things being equal, that will lower the company's stock price unless earnings rise enough to compensate for the additional shares.
Theoretically, employees with stock options will want to do everything they can to increase earnings, since they are also shareholders who will benefit if the stock price rises.
``Shareholders have decided they want to share some money with employees to provide an incentive'' to increase earnings, said Powell.