by Stan Shaw

NEWS STORY Window Dressing How did Bill Gates make his billions? A local pension-fund consultant says it has as much to do with tricky accounting as selling Windows. BY NIGEL JAQUISS njaquiss@wweek.com

For a fuller discussion of Bill Parish's argument, see www.billparish. com.   Parish analyzed the annual reports of such companies as Cisco Systems, America Online and Dell Computer and found that all benefit significantly from the option loophole, but none nearly as much as Microsoft.

While an army of federal regulators accuses Microsoft of illegally thwarting competition, a local pension-fund consultant is on a one-man crusade to expose what he considers the company's exploitation of an arcane tax loophole. Bill Parish believes that everyone who invests in the Seattle software giant either directly or indirectly--through mutual funds or retirement plans--should be aware of how Bill Gates generates such sparkling results. "The average person on the street has no idea what Microsoft is doing," he says. Parish maintains he's motivated not by a hatred for the world's largest company (as measured by market capitalization), but by concern for unsuspecting stockholders. "I have nothing against Microsoft," Parish says. "I use their software, and I think they do a great job at most things and have great people." Described by a former colleague as more Labrador retriever than pit bull, Parish nonetheless foams at the mouth at the mention of Microsoft's accounting practices. He thinks that the software giant has latched onto an enormously lucrative tax strategy that, while legal, is understood by almost nobody. Over the past six months, he has bombarded The New York Times, Forbes, Newsweek and other publications with his analysis, issuing press releases at his own expense. He has hammered at the Securities and Exchange Commission and the Federal Reserve--so far to little avail. It's tempting to dismiss Parish as a kook. But the fact is, Microsoft doesn't deny the substance of his claims, and at least one stock analyst is disturbed by Parish's findings. The way the option loophole works is simple. In lieu of cash compensation, high-tech companies have increasingly chosen to grant employees stock options. Over the past decade, Microsoft has issued more than 500 million such stock options. Each option gives an employee the right--but not the obligation--to buy shares over a several-year period at a price set at the time of issue. For example, an employee might own 1,000 options to buy Microsoft stock at $30. If she exercises those options and then sells the shares at a current market price of, say, $150, she pays $30,000 and receives $150,000. The resulting $120,000 of profit is taxable as regular income. Although Microsoft didn't pay the employee that $120,000, IRS rules allow the company to treat the $120,000 as an expense for tax purposes. The net effect, Parish contends, is to make the company's financial results look better than their operating results. As Microsoft's stock has soared, employees have exercised their options and sold shares in the market. In 1998 alone, Microsoft employees earned $4.4 billion from exercising stock options, resulting in a tax credit to the company of $1.55 billion. "It's a cash machine for Microsoft," Parrish says. As long as the company's share price holds steady or rises, employees will exercise ever more options resulting in even bigger tax credits. Currently, employees hold options on more than 400 million shares, which are, on average, exercisable at more than $120 less than the current market price. The options cost about $30 apiece, and the current market price is about $160. This means employees may collect over $50 billion in income, all deductible by Microsoft. Microsoft spokeswoman Caroline Boren doesn't dispute Parish's analysis of the options program. "It lowers Microsoft's taxes and accordingly increases net income," Boren says. "Is the company able to take a deduction? Sure. Because those are the tax rules." Boren defends Microsoft's heavy option issuance, saying that high-tech workers both expect such perks and know their risks. She concedes, however, that the tax implications remain unknown to most investors, even though the options tax benefit is disclosed in the company's financial reports. Even market professionals have little understanding of Microsoft's options program says Mike Kwatinetz, an analyst at Credit Suisse First Boston in New York. Kwatinetz agrees that Microsoft generates uniquely large tax deductions from options but argues that other factors minimize their significance on the overall balance sheet. But another analyst, Larry Woods, was astounded after he recently evaluated Parish's spreadsheets. "Parish is on to something that I think is extremely significant," says Woods, editor of The Technology Review. In terms of its balance sheet, Woods says, Microsoft resembles a hedge fund more than a software company. He adds that although the tax benefit received from employee options is disclosed in Microsoft's financial statements, it's not stated in a way that's clear to the average investor. "I think the number of people who are aware of this is extremely small," Woods says. It's precisely such investor ignorance that Parish hopes to address. He worries about what will happen if Microsoft's share price ever heads south or if the IRS reduces the tax benefits of employee options. Either way, Parish says, Microsoft's results could suffer; the company could lose a giant tax benefit and possibly have to pay employees in cash rather than options. Both eventualities would hurt shareholders. Parish believes accountants should push to close the options loophole. In the meantime, he wants an open discussion of Microsoft's financial practices. "Employees in the programs and investors, particularly those in retirement plans, deserve to know what's going on," he says. - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - Willamette Week | originally published March 10, 1999