Year: 2001

You may have seen the e-mail about Presidential IQs. I’ve gotten it 8 or 10 times. It’s the one that purports to have scholars assessing modern presidents’ IQs inferentially, based on their writings, public pronouncements and so on. It shows Kennedy at 174 (which if based on his speeches may have more to do with Ted Sorenson’s IQ or Arthur Schlessinger’s) and Bill Clinton at 182 (well, they got that right). But it shows George the First with an IQ of 98 and George the Second at 91. These are patently absurd, leading me to imagine that either the whole thing is a hoax – it purports to come from a thing called the Lovenstein Institute in Scranton, PA – or else just very badly done.

By definition, an IQ of 100 is the median, with as many of us above as below. It’s certainly possible that the Bushes are below average intelligence for American presidents. But for the general population? Ridiculous. In the old days, when a thing called the Stanford-Binet scale was used, 140 was defined as ‘genius’ (1 in 1000), and 120 was required to become an officer in the Army. In the last few decades, a different test has been used, where I believe you have to score 160 to be 1 in 1000. Either way, though, 100 is the median, and you are just not going to tell me that George I, who was a Yale graduate, successful businessman, 10-year Congressman, US ambassador to China, head of the Central Intelligence Agency, for crying out loud, and President, has an IQ of 98. It’s just silly. My own guess is that George I’s IQ (on the more modern 160-is-genius scale) is probably around 145, and that George II’s is around 130. (‘I worked with W. as governor,’ a governor told me recently, ‘and he is not unintelligent – just disinterested.’)

Of course, I question our own IQ for having elected the second Bush, but my problem with him is not that he has an IQ of 91 – which he clearly does not (‘Second floor, women’s sportswear, women’s coats, evening wear . . .’ would be the extent of his public speaking, if it were) – but rather his policies. His massive tax relief for the wealthy – which were it ever to be fully phased in would be far, far greater than the $1.35 trillion he advertised – has knocked what had been a highly successful balance totally out of whack, and all but assured economic and social crises down the road. His tilt away from environmental concerns is deeply discouraging. His enthusiasm for a new arms race has alarmed half the world. And so on. Can you believe that they have shifted from an anti-cigarette to a pro-cigarette stance? Cigarettes are the world’s leading cause of preventable death! From a crackdown on off-shore tax-havens to a pullback from that crackdown?

In this last regard, did you see the report a couple of weeks ago – the jaw-droppers come so fast from this administration, one can’t possibly keep up with them – of Treasury Secretary Paul O’Neill’s July 18 Senate testimony? According to the New York Times, the Secretary ‘dismissed as meaningless a document, based on government data … indicating that fewer than 6,000 of more than 1.1 million offshore accounts and business were properly disclosed” to the IRS.  “Pressed by [Michigan Democratic] Senator Carl Levin about whether the disparity … was significant, Mr. O’Neill replied, ‘I find it amusing.’”  Later that day, Manhattan District Attorney Robert Morgenthau “described a scale of bank deposits in tax havens far greater than most experts suspected.  Citing previously secret Federal Reserve Bank data, Mr. Morgenthau said that more than $800 billion of American money is on deposit in just one tax haven, the Cayman Islands.  That sum, equal to one-fifth of all the bank deposits in the United States, he said, is so large that it cannot be solely, or even primarily, the fruits of criminal activity like drug dealing.  Rather, Mr. Morgenthau said, these funds must be the product of huge and growing tax evasion by wealthy Americans who have little, if any, fear of prosecution.”

“The hearing was prompted by Mr. O’Neill’s balking in April at a plan by the Organization for Economic Cooperation and Development to pressure the Cayman Islands and other tax havens into cooperating with criminal investigations of tax evasion and money laundering,” the Times went on to report.  “That plan was thrown into disarray after Mr. O’Neill declared that the project was too broad and ‘not in line with this administration’s priorities.’”

The article went on to cite the letter that seven former IRS chiefs sent O’Neill in June “questioning his stance on the O.E.C.D. effort to make foreign tax havens cooperate with investigations of tax crimes.  Mr. O’Neill said today that he was ‘frankly thunderstruck when I got the letter; they responded to misinterpretations in the press.’”

In fact, the Times article concluded, the IRS chiefs’ letter “came in response to an article, in the May 10 Washington Times, which appeared under Mr. O’Neill’s own by-line.”

This is a positively grand time to be a rich in America.  And a positively spectacular time to be a rich white Texas oil man.  (Or, for that matter, a rich black Texas oil man, a rich female Texas oil man, a rich gay Texas oil man.)  It’s a less good time to be a child without health insurance going to a school desperately in need of renovation . . . a senior citizen facing huge costs for prescription drugs . . . a gay or lesbian kid trying to form some sense of self worth . . . a kid who really does have an IQ of 91, and faces what may be a lifetime of minimum-wage work . . . or just a kid worried about what sort of planet his or her kids and grandkids will inherit.

Meantime, you gotta love this column praising New York Republican Mayor Rudy Giulliani, by Frank Rich.  Bush, et al, could take a few lessons.

If you don’t have stock options at work, do yourself a HUGE favor and skip this column. Seriously.

Sreenivas I. Rao: ‘Lot of people have lost their houses paying the Alternative Minimum Tax (AMT) on ‘phantom gains’ here in the Silicon Valley. Check reformAMT.org. Some of the strategies discussed can backfire, with disastrous consequences.’

☞ For a specific human face on one of these horror stories, click here.

Marcus Wu: ‘Individuals selling ISOs should also beware of the 30-day wash sale rule under the Internal Revenue Code. Here’s an example of how those rules could zap you:

Xavier exercises an incentive stock option in March when the stock is trading at $100/share. By December, it’s down 99% to $1/share.

Xavier doesn’t want to pay AMT on stock valued at $100/share. He knows that if he sells the stock before the year is up, then the option is not treated as an ISO and there is no AMT due. WHEW! Xavier is relieved and sells. But he believes in the company and wants to ride the stock back up. So he buys some stock and makes the horrible mistake of doing so within 30 days of selling his ISO shares.

Oh, no! Xavier owes the AMT — see 422(c)(2)(B) of the Code — because his December sale is negated (for tax purposes) as a ‘wash sale.’

☞ Oh, no, indeed.

The estimable Less Antman: ‘I have one quibble with a comment from one of your readers:

As for paper millionaires stuck with AMT, they could always sell off some of their junk to generate some AMT loss (and get some cash to pay AMT on the rest of the gain). The AMT basis is the fair market price at exercise (the value used to compute the AMT gain).

‘Perhaps the reader meant selling the shares within the same calendar year (as another reader recommended when proposing that exercising should be done in January to allow time to decide), but this won’t help the Silicon Valley paupers stuck with the tax bills of millionaires:

‘(1) The net capital loss deduction for AMT purposes is limited to $3,000 per year, just as it is for regular purposes. If you exercised ISOs when there was a $1,000,000 spread, then sold the next year after a collapse caused it to totally disappear (or worse), you’d eventually get to claim the loss of $1,000,000 for AMT purposes, but might have to spread it out over the next 334 years. So unless there are lots of other capital gains lying around waiting to be had, this isn’t going to work.

‘(2) Any credit in a later year for AMT paid in an earlier year can only reduce the regular tax bill. After the high technology party ended, most of these people were left with only their regular salary (assuming their company wasn’t actually dot-gone), and the regular tax bill on the 2001 salary is going to be a pittance compared to the AMT paid in 2000. Even if they had later capital gains, the AMT rate is 28% on ISO exercises, so it is going to take a lot more long-term capital gains at 20% to get the tax benefit from all the ISO losses. Most of these people will NEVER recover the AMT paid, or anything remotely close.

‘The reader was correct in saying the ideal approach is to figure out how many ISOs can be exercised without triggering the AMT in the first place. And that it is a complicated calculation, which really means people with profitable options ought to pay for the services of a tax professional. But most of the Silicon Valley crowd thought they could do their own taxes with TurboTax, so they only found out when they sat down in April 2001 what they had done to themselves by exercising in early 2000 and holding for a year and a day. And then it was too late.

‘Which gets back to the point that the safest thing to do with any employee stock option, non-qualified or incentive, is hold until you have a good gain and then sell the shares immediately after exercise. Forget the taxes: it is almost inconceivable that the beneficiary of a giant stock option windfall isn’t, after exercise, going to have the majority of his net worth in a single stock, in the company which also pays his salary, and which is likely to be an overpriced stock given the price rise needed to create the windfall. The need for prudent diversification overrides the potential benefit of saving the spread between the ordinary and long-term capital gains rates by holding for over a year. The stock market as a whole can’t go to zero, but plenty of individual stocks drop below the exercise price of employee options, and some of them stay there permanently.

‘P.S. Kaye Thomas’ brilliant book, Consider Your Options, discusses this topic in excruciating detail.’

But first, for those with no options but a TV . . . it’s Wednesday, and not too late for those of you who missed it earlier in the year to catch The West Wing re-run at 9pm on NBC . . . and then, after a suitable break to savor it and switch moods, Prime Time Glick on the Comedy Channel at 10:30. The thing to know about Jimminy Glick is that he is really Martin Short with about 100 pounds of make-up. If you have never heard of Martin Short, this may not mean much to you. But if you have, I think you will soon come to wish his talk show were nightly instead of weekly.

And is it too early to start looking forward to Sunday? Malcolm in the Middle at 8:30pm on Fox is the best thing on commercial television, barring only The West Wing. And on HBO – which we finally broke down and started paying for 15 years after everyone else – there’s Sex in the City at 9pm followed by Six Feet Under. I have set the latter two in purple to indicate that they are on the racy side, and not for everyone. But they are terrific.

[Note: As with any series you join in midstream, you really need to watch two episodes to give them a fair chance. I came this close to abandoning The Simpsons after a single episode (‘What are they saying? I can’t understand them!’), and shudder now to think what I would have been missing had I not come back for more. I still can’t understand much of what they’re saying on South Park, but for this I blame Canada.]

Now, for those of you with no TV but incentive stock options . . .

Beth Moursund: ‘Not all options work the same as your description in Tuesday’s column. I used to work at Microsoft, and had a very nice pile of options granted to me. Those particular options (and I don’t remember the particular IRS type-code) counted the difference between option price and current price as ‘ordinary income’ on the day exercised. Not short term gains — ordinary income, with Social Security and Medicare and all the rest of the taxes due without even getting AMT involved, whether you kept the stock or sold it. Anyone thinking about exercising options should check on the details and make sure they know which rules apply to the ones they have.’

☞ Indeed. (See Michael Young, below.)

Martin Fleisher: ‘What I advise clients to do about exercising ISOs is to do so as early in the year as possible, e.g., January 2. If the stock stays above the exercise price by the end of December, hold on to it and sell the following week when the 1-year holding period has passed. If the stock has declined below the exercise price, sell by 12/31 and no AMT.’

Andy Long: ‘I tell my students that there are only two times an option should ever be exercised: 1) When they are about to expire (assuming that they are in the money) or 2) Immediately before you plan to sell the stock. This has nothing to do with tax consequences, it is simply a matter of maximizing the underlying leverage of the option. There is no reason to give up the advantages of leverage until you are forced to.’

Michael Young: ‘Your write-up today on stock options really applies only to ISOs (*qualified* incentive stock options). Because of some of the qualifications and limitations, as well as corporate tax ramifications, many companies give out NQSOs (non-qualified stock options), instead of, or in addition to, ISOs. For example, IBM offers ISOs only to ‘executive level employees,’ but NQSOs to other people they want to retain. Even some startup companies have gone to issuing some NQSOs.

‘The tax treatment is quite different. When an NQSO is exercised, the difference between fair market value and strike price is immediately taxable as regular income. (On the bright side, there’s no AMT to worry about.) Not nearly as good as ISOs, but still better than no options at all.

‘As for paper millionaires stuck with AMT, they could always sell off some of their junk to generate some AMT loss (and get some cash to pay AMT on the rest of the gain). The AMT basis is the fair market price at exercise (the value used to compute the AMT gain).

‘The approach I recommend for ISOs that look like they’ll stay in the money is to exercise and hold as much as you can afford without running into AMT. Most people have a fair spread between their regular tax and AMT to work with. For me, the hassle to estimate the spread is worth it to get the long-term gains rate, but I recognize that many would balk at the complication.

‘But, one reason not to exercise until you’re ready to sell (which you may have implied but didn’t come right out and say): you don’t tie your money up. If you’re a startup founder, and your exercise price is a pittance, this isn’t a factor, but for most people, it can be.’

He may be wrong on most of the issues, and a modest choice, at best, to entrust with more responsibility than anyone else on Earth. But you’ve got to give him this: the man can dance. Click here.

Janice B: ‘Recently, I read that the tax consequences are different for the same options depending on whether they are exercised when they are “in the money” (what does that mean exactly?). For instance, suppose you have options at $10, exercise them (buy the shares), and then later they go to $20 and you sell. Is that different tax-wise from waiting until they go to $20, then exercising (buying at $10) and selling right away?’

☞ In the first place, ‘in the money’ means ‘worth something if exercised today.’ So if your employer’s stock is $8 and YOU have the privilege of buying it any time in the next 5 years at $10, well, that is a privilege . . . but not one you’d want to exercise today. Your options (in this example) are out of the money. When the stock gets to $12 (or even to $10.01) your options are ‘in the money.’ And when it gets to $20, they are very nicely in the money.

So what happens if you exercise your option? One of two things:

• Exercise and sell and you have a taxable short-term gain.

• Exercise and don’t sell, planning to wait a year and report a more lightly-taxed long-term gain, and you have the alternative minimum tax to worry about.

For AMT purposes, the excess of the fair market value of the stock over the exercise price is included in income immediately, even if you don’t sell and the stock you hold then collapses. That’s what happened to a horde of Silicon Valley “option millionaires” who exercised incentive stock options in early 2000, planning to hold the stock a year and a day to get long-term gains treatment. The value of their stock plunged, but their Alternative Minimum Tax bills remained huge. Not only did they not make a huge profit on their options, they lost a fortune because of the taxes.

So . . . two rules:

1. Only exercise options when they’re sufficiently “in the money” to make you a nice pot of money. Obviously, there’s rarely any point in exercising an out-of-the-money option. (Why exercise and buy at $10 when you could buy on the open market at $8 and preserve your option, to boot?) And generally, an only-slightly-in-the-money option shouldn’t be exercised either, at not least not until shortly before it expires, because the general trend of stock prices (speaking very broadly here) is up. If options have a long way to run, think twice about cashing them in, because you give up their remaining “time value.” (Having the option but not the obligation to do something for the next few years can be very valuable.) It certainly makes sense to cash in if the stock has gone nuts, as the dot-coms did. But if it’s stock in a company whose profits tend to grow, and whose stock price might grow along with profits, then the longer you wait, the deeper into the money might your options be when you exercise.

This is a very tough decision, and depends on: (a) how well you think the company will do; (b) how well you think its stock will do (if interest rates rise, even the stock of companies doing well may fall); and (c) your own personal circumstances. Two people with identical stock options could very rationally make different decisions if one were living hand-to-mouth (exercise! sell! pay off those credit card balances!) and the other had a $2 million inheritance and could afford to risk that the stock would go down instead of up.

(Because it’s such a tough decision, what most people naturally and sensibly do is hedge their bets, exercising a little bit at a time instead of all at once.)

2. Once you do exercise . . . SELL immediately and pay the taxes.

JUNK BONDS

Bob Price: ‘I guess we can forgive your 88 year old friend for not understanding how bonds work when apparently American Express doesn’t either. Sigh.‘

☞ For those who skip the Business headlines, Amex wrote down its bond portfolio by yet another $400 million, explaining that it hadn’t understood the risks it was taking. Ouch.

WOBBLY GYROS

In acknowledging my misuse of the phrase ‘begs the question’ last week, I lamely explained, ‘You’re right. My gyro was wobbly. I’ve gone back and fixed it.’

Chris Williams: ‘Technical tidbit. Gyros don’t wobble anymore. Gyros are now made from lasers and fiber optic tubes formed into rings. The standard is now RLG, Ring Laser Gyro. [Ah, yes. But my gyro was built in 1947, and it definitely wobbles.] A laser is pointed into the fiber optic ring and a sensor is placed at the other end. The sensor is so accurate is can tell if the light coming into it changes its ‘phase.’

‘Phase of a light signal is . . . well, visualize a sinusoid. You know, like a wave on the ocean. Up and down and back up. Each position on the sinusoid is a position of ‘phase.’ A change of phase means you are at a different point on the sinusoid.

‘If the laser is pointed into the tube, illuminated continuously, and the entire assembly is torqued (twisted) around the axis of the ring, a phase change will occur in the sinusoid. The light has either farther or less far to travel than it did when it left the laser and the twist wasn’t in progress. The sensor can detect this, and measure the amount of twist, and command something to twist it back to the original position. Note this twist measurement was all mechanical gyros ever did, and they would slow down due to friction over time and lose accuracy. RLGs don’t. Who makes ’em? Litton (Northrup Grumman) and Honeywell.’

☞ Sure, sure, but doesn’t that beg the original question? What was the original question?

MARRIAGE BONDS

From the op-ed page of the Wall Street Journal comes this conservative’s view of gay marriage.

Tomorrow: Exercising Your Stock Options