Sprint Garnered Tax Benefits
From Executives' Use of Options

NEW YORK -- While Sprint Corp.'s two top executives have lost their jobs and face financial ruin over the use of tax shelters on their stock-option gains, the company itself received big tax benefits from the options these and other Sprint executives exercised.

Regulatory filings show that Sprint had a tax benefit of $424 million in 2000 and $254 million in 1999 stemming from its employees' taxable gains of about $1.9 billion from the exercise of options in those two years. Sprint, which was burning through cash at the time as the telecommunications market bubble burst, had virtually no tax bill in 1999 and 2000, because of sizable business losses. But the Overland Park, Kan., company was able to carry the tax savings forward to offset taxes in future years.

Under the complicated accounting and tax rules that govern stock options, the exercises also made Sprint's performance look better by boosting the company's net asset value, an important measure of a company's financial health.

The dilemma facing Sprint and its two top executives over whether to reverse the options shows how the executives' personal financial situation had become inextricably intertwined with the company's interests. In Sprint's case, the financial interests of the company and its top two executives had diverged. Both were using the same tax adviser, Ernst & Young LLP. The matter has renewed debate about whether such dual use of an auditing firm creates auditor-independence issues that can hurt shareholders.

MORE ON SPRINT • Sprint President LeMay Seeks More Exit Pay   • Page One: Inside the Tough Call at Sprint: Fire Auditor or Top Executives? 02/10/03   • How the Sprint Tax Shelter Worked 02/07/03   • See profiles of key players in the Sprint CEO succession drama and related articles.   SPECIAL PAGE See continuing coverage of corporate-accounting issues at the Called to Account page.

Stock-option exercises brought windfalls to Sprint employees as the company's shares rose in anticipation of a 1999 planned merger with WorldCom Inc., which later was blocked by regulators.

Sprint Chairman and Chief Executive William T. Esrey and President Ronald LeMay sought to shield their gains from taxes using a sophisticated tax strategy offered by Ernst & Young. That tax shelter now is under scrutiny by the Internal Revenue Service. If it's disallowed, the executives would owe tens of millions of dollars in back taxes and interest.

Sprint recently dismissed the two men and intends to name Gary Forsee, vice chairman of BellSouth Corp., to succeed Mr. Esrey. Messrs. Esrey and LeMay are now trying to negotiate larger severance packages with the company because of their unexpected dismissals. (See related article.)

Sprint, like other companies, was allowed to take as a federal income-tax deduction the value of gains reaped from all those stock options that employees exercised during the year. Between 1999 and 2000, Mr. LeMay exercised options with a taxable gain of $149 million, while Mr. Esrey exercised options with a taxable gain of $138 million. Assuming the standard 35% corporate tax rate on the $287 million in options gains, the executives would have helped the company realize $100 million of tax savings in those two years.

If the company had agreed to unwind the transactions -- by buying back the shares and issuing new options -- the $100 million in savings would have been wiped out and the company would have had to record a $100 million compensation expense, which would have cut earnings.

"They would have had a large compensation expense immediately at the moment of recision equal to the tax benefit they would have foregone," says Robert Willens, Lehman Brothers tax-and-accounting analyst. "So there was no way they were going to do that."

The tax savings to Sprint revealed in the filings shed light on why the company opted not to unwind the now-controversial options exercises of Messrs. Esrey and LeMay. The executives wanted to unwind the options at the end of 2000 after learning that the IRS was frowning on the tax shelters they had used and the value of Sprint's stock had fallen markedly. However, the conditions the SEC put on such a move would have been expensive for the company. The subject wasn't discussed by the board of directors, according to people familiar with the situation. It isn't clear what role Messrs. Esrey and LeMay played in making the decision not to unwind the options.

Many tax-law specialists believe the IRS will rule against the complicated shelters, which the two executives have said could spell their financial ruin. Because Sprint's stock price collapsed after Sprint's planned merger with WorldCom was rejected by regulators in June 2000, the executives were left holding shares worth far less than the tax bill they could potentially face if their shelters are disallowed by the IRS.

If the telecommunications company had unwound the transactions, Sprint would have had to restate and lower its 1999 profits. The company could have seen its earnings pushed lower for years to come and might have been forced to refile its back taxes at a time when Sprint's cash was limited, according to tax experts.

The large companywide burst of options activity demonstrates just what a frenzy was taking place within Sprint in the wake of its proposed $129 billion merger with WorldCom. In 1998, Sprint deducted only $49 million on its federal taxes from employees exercising their stock options. That swelled to $424 million in 2000.

The push to exercise options in 2000 was intensified by Sprint's controversial decision to accelerate the timing of when millions of options vested to the date of shareholder approval of the WorldCom deal -- not when the deal was approved by regulators. The deal ultimately was approved by shareholders and rejected by regulators. In the meanwhile, many executives took advantage of their options windfalls, while common shareholders got saddled with the falling stock price.

But toward the end of 2000, it became apparent to Messrs. LeMay and Esrey that the tax shelter was turning into a financial disaster, in part because they hadn't sold any Sprint shares to pay their taxes. By then, Sprint's stock had slumped to $20 from a high of nearly $70 in 1999.

That was when the executives considered selling their shares back to the company and receiving new options -- essentially unwinding their exercise, according to people close to the situation. Officials from Sprint and Ernst & Young went to Washington to ask the Securities and Exchange Commission whether the company could do this.

But the SEC told Sprint that to reverse the executives' options, the company would have had to adopt onerous accounting rules.

Such a change would have triggered an accounting treatment for any replacement options that was much less favorable to companies than that applicable to the original options, under which they needn't be treated as a compensation expense. But under the rules known as variable accounting, which apply when options are rescinded and replaced, the company would have had to take a charge to earnings in any quarter in which the value of the options rose above the strike price to reflect that potential compensation expense to the company.

"We know that variable accounting is painful," says David Zion, the accounting analyst at Credit Suisse First Boston.

That made the reversal all the more difficult for the company to endorse, particularly because it would have been geared to benefit only two executives.

In addition, a reversal would have caused Sprint to restate earnings because the shareholder equity boost would have been lost. The benefit from the compensation expense is recorded as an increase in a company's net assets, which figures into shareholder equity.

Write to Ken Brown at ken.brown@wsj.com and Rebecca Blumenstein at rebecca.blumenstein@wsj.com

Updated February 13, 2003 9:11 a.m. EST

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