1. finance
2. investing
3. options

Spring 2009
Issue I
Stock Option Plans
I.
Introduction
Inside this issue
I.
Introduction
II. Types of Stock Option Plans
III. Exercising Options
IV. Taxation of Stock Options
V. Option Strategies
VI. Application of Section 409A
VII. Accounting
VIII. Conclusion
The challenge many employers encounter
is deciding what to do to retain the key
employees that are essential to the
continued growth of the business. ERISA
has created prohibitions which require
that qualified plan benefits be offered to
eligible employees on a nondiscriminatory basis. This would result in
substantial increase in the employer’s
costs yet does not adequately address
the employer’s concerns. The Department
of Labor restricts non-qualified deferred
compensation plans to the “top hat” group
of employees. While non-qualified
deferred compensation may only be
offered to select key employees, the plan
may provide a benefit to the employee
even though there may not be an
increase in the value of the business. In
addition to governmental restrictions,
many employers may not be able to afford
to increase expenditures for cash based
benefits.
Start-up companies are at a particular disadvantage since these companies often
have a period of sustained losses, cannot afford to increase employee benefits,
and need to continue to invest in the ongoing operation of the business. These
companies are often looking for a non-cash way to incent their employees and
retain those individuals that are essential to the success of the enterprise. In the
1990s, many of the hi-tech companies turned to stock option plans precisely
because such plans require an only nominal cash outlay by the employer and tie
the employee’s benefit to the fortunes of the employer. This resulted in an
explosion in the popularity of stock options as an employer tool for rewarding and
retaining key employees. The fact that the non-discrimination rules that apply to
qualified plans do not apply to stock options has helped to fuel the growth of
stock options as an employee retention tool.
This article will examine the similarities and differences between the types of
stock options plan, the tax consequences to both the employer and the
employee, the different ways of exercising options, as well as some option
strategies holders of options should consider.1
II.
Types of Stock Options Plans
A stock option plan can take many different forms and there is no one type of
option or plan that will be used by every employer. In fact, it is likely that an
employer may create different types of stock option plans depending upon the
employee’s job level and the overall importance of the employee to the continued
growth and viability of the company. Senior management may participate in a
certain plan while other members of management may participate in an entirely
different type of plan. The plans that will be reviewed in this article include
Incentive Stock Option plans (ISO), Non-Statutory Stock Option plans (NSO),
Restricted Stock plans, and Phantom Stock plans.
There are a number of terms that are used when discussing various types of
stock option plans. The grant date is the date the employer grants to the
employee the right to purchase a specific option or creates a stock option plan.
The employee may not actually be notified on the grant date but this is the date
in which the employer and/or its board of directors declare the existence of the
stock option plan. The strike price is the price which the employee must pay for
the shares of employer stock granted under the terms of the stock option plan.
Finally, there is the exercise date which, as the name implies, is the date in which
the employee exercises the right under the stock option plan to purchase a
specific number of shares of the employer.
1
The term option in this article will be used to refer to the general grant of an option as well as the
exercise of an option for a specific number of shares.
2
Incentive Stock Options (ISO)
There are a number of specific requirements which a plan must meet in order for
a stock option plan to be treated as an Incentive Stock Option plan.2 The failure
to adhere to the specific requirements of IRC §422 will result in the option no
longer being considered an incentive stock option. This has tax implications,
which will be discussed later in this article, to both the employer and the
employee.
An ISO can only be granted pursuant to a written plan which has been approved
by the shareholders of the corporation within twelve months before or after the
date such plan is adopted.3 For obvious reasons, it would be prudent to obtain
the consent of the shareholders before the plan is adopted. There may be an
element of risk in granting an option subject to shareholder approval. The
employees that are notified as to the granting of stock options, subject to
shareholder approval, may be disillusioned if the shareholders reject the plan.
However, shareholders will often follow and vote according to the
recommendation of the board of directors so this may not be a tremendous risk
on the part of the employer.
The option agreement must also specify the number of shares subject to the
agreement, the exercise price, the employees or class of employees eligible to
participate in the plan and the restrictions on exercise, e.g. a vesting schedule.4
The exercise price must be equal to the fair market value of the stock at the time
the option is granted. It is possible to provide for an exercise price that is greater
than the fair market value of the stock. A price less than the fair market value of
the stock on the grant date will result in the option not being treated as an ISO.
There is an exception to this rule for an option granted to a shareholder owning
10% or more of the outstanding shares. In this situation, the option exercise price
must be at least equal to 110% of the fair market value.5
An ISO is also subject to a term limitation which must not exceed ten years.6 The
option agreement must provide that the option cannot be exercised after the
expiration of 10 years from the date the option is granted. A different rule applies
when an ISO is granted to a shareholder owning 10% or more of the shares of
the corporation. In this instance, the 10 year period is reduced to 5 years from
the date the option is granted.7
Another requirement that the plan must meet in order for an option plan to be
treated as an ISO is that the option cannot be transferred other than by will or a
2
Internal Revenue Code (hereinafter IRC) §422. This type of option is also known as a statutory option
or a qualified option.
3
IRC §422(b)(1).
4
Id.
5
IRC §422(b)(6).
6
IRC §422(b)(3).
7
IRC §422(c)(5).
3
state’s laws of descent and distribution.8 This means an employee who has been
granted an ISO cannot make gifts of the unexercised options as part of an estate
planning strategy.
There is also a dollar limitation on the aggregate value of stock that may be
exercisable for the first time in any one calendar year. This may require some
planning on the part of the employer to avoid having some of the options lose
their classification as an ISO. The maximum aggregate value of stock which is
exercisable for the first time in any one calendar year cannot exceed $100,000
for any employee.9 There is an ordering rule so that those options first granted
will be accorded ISO status while later granted options will not be treated as an
ISO.10 The value is determined based upon the value of the stock at the time at
the option is granted.11 The following examples will help explain the application of
the $100,000 limitation.
Example 1: The Acme Corporation has an ISO program and in 2007
granted Mary Executive an option to purchase 5,000 shares with an
exercise price of $50. Mary will be vested in half of the options (2,500)
after one year and fully vested in all the options after two years. The value
of the exercisable options after one year is $125,000 (2500 x $50) which
exceeds the $100,000 limitation by $25,000. For this reason, only 2,000
(2,000 x $50) of the 2,500 options exercisable after one year will qualify as
incentive stock options because of the $100,000 limitation. This same
result will also occur with regard to the options that vest after the
expiration of two years.
Example 2: Same facts as above except the exercise price for the 2007
option grant is $40 and in 2008 Mary is granted another option for 4,000
shares of stock with the same vesting schedule and an exercise price of
$50. Mary exercises her option to purchase 2,500 shares in 2008 at $40 a
share. All 2,500 (2,500 x $40 = $100,000) shares will be treated as
exercised pursuant to an ISO. The remaining 2,500 options from the 2007
grant and 2,000 options from the 2008 grant are vested and can be
exercised in 2009. However, since the value of the option from the 2007
grant is worth $100,000 (2,500 x $40), the 2,000 share option exercisable
from the 2008 grant cannot qualify as an ISO. In 2010, the option for the
remaining 2,000 shares may be exercised and all 2,000 will qualify as an
ISO because the value of the stock that is exercisable for the first time in
2010 does not exceed $100,000 (2,000 x $50).
The recipient of an incentive stock option must remain in the continuous
employment of the employer granting the option. An exception to the continuous
8
IRC §422(b)(5).
IRC §422(d)(1).
10
IRC §422(d)(2).
11
IRC §422(d)(3).
9
4
employment requirement may be allowed provided the option is exercised during
the 3 month period following the employee’s termination of service.12 Additionally,
Section 422(c)(6) extends to 1 year the permitted 3 month post-termination of
employment period if an optionee’s employment terminates due to disability.13
Otherwise, while it is possible to permit an option to be exercised more than 3
months after termination of service, the option will no longer be treated as an ISO
if it is exercised after this date.
Finally, there is a holding requirement that must be satisfied or the stock option
will no longer be treated as an ISO. After an employee has exercised an ISO, the
employee must not dispose of the shares within two (2) years of the grant of the
option and one (1) year from the exercise of the option.14 The failure to satisfy
the holding requirement will be considered a disqualifying disposition which
creates some adverse tax results for the employee which will be addressed later
in this article.
The holding requirements discussed above will not apply to either the estate or
an heir of the employee.15 However, the holding period for determining whether
the sale of stock should be treated as either a short-term or a long-term capital
gain will continue to apply. In addition, where the deceased employee satisfied
the employment requirements at the time of his or her death, it is not necessary
for the employment requirement to be satisfied by either the estate or an heir of
the estate. This means the employee will not be treated as having separated
from service and the estate or heir will not have to exercise the option within
three months of the employee’s death.16
Non-Statutory Stock Options (NSO)
Another type of stock option that is frequently issued by employers is a nonstatutory stock option or NSO. A non-statutory stock option is any stock option
that is not an incentive stock option. Employers will often find the NSO plan much
simpler to issue and administer than an ISO plan because many of the
restrictions and requirements that apply to an ISO do not apply to the holder or
issuer of an NSO. For an employee, the NSO does not offer some of the tax
advantages (see Section IV) that make an ISO an attractive employee benefit.
However, from an employer perspective, the NSO offers tax benefits that simply
do not exist with an incentive stock option plan.
12
IRC §422(a)(2).
Regs § 1.422-1(a)(3). The disability must be as described in § 22(e)(3).
14
IRC §422(a)(1).
15
IRC §421(c)(1)(A). The estate or heir may be allowed to exercise options received or to sell shares
received without disqualifying the option.
16
Id.
13
5
Some of the differences between an NSO and an ISO include the following:
•
•
•
there is no holding requirement for an NSO;
an NSO can be granted at less than fair market value; and
the $100,000 limitation does not apply.
The reduced regulatory requirements may make the NSO more attractive to the
employer as a tool to be used to retain those employees the employer believes
are essential to the continued long-term growth of the business.
Restricted Stock
The third type of plan involving employer stock is the restricted stock plan. .
Under this plan an employee will receive actual stock, not simply a legal right to
buy stock as with a true option plan. An employer’s grant of restricted stock to an
employee will not generate a tax consequence to the employee so long as the
stock remains subject to a substantial risk of forfeiture. The employer will often
provide the employee with a grant of shares at either no cost or for a nominal
cost. This stock will often be subject to a vesting schedule or require the
employee to continue working for the employer for a specified term. During this
period the stock is subject to a restriction that prohibits the employee from
transferring the stock. Failure to satisfy either the vesting schedule or a
termination of service prior to the completion of the specified term will result in
the employee forfeiting the shares granted by the employer.
Phantom Stock
A phantom stock plan is another type of compensation arrangement in which the
employee’s compensation is tied to the fortunes of the employer.17 However,
unlike the plans previously discussed, the phantom stock plan does not
necessarily involve the issuance of employer securities to the employee. In fact,
this type of plan may appeal to an owner of a closely-held business since it does
not result in the dilution of the owner’s interest. Like the other plans discussed,
the benefit to the employee is tied to the continued success of the business.
How does this plan work? The employee is not given an actual interest in the
business but instead receives hypothetical units in the business. The value of the
employee’s hypothetical units will fluctuate either up or down depending upon the
performance of the issuing company. One of the keys to the plan is determining a
method for valuing the employee’s interest. Using the value of the business as
the measuring tool may be expensive for the business since it would require an
annual business valuation. However, it may be possible to use a change in book
value, an increase in revenue or some other method to measure the benefit
provided to the executive. This would be less expensive for the business owner
and provide an easier method for determining the value of the employee’s benefit
under the plan.
17
“The Phantom Stock Plan: How to Keep Key People on the Job”, National Underwriter, March 17,2008.
6
III.
Exercising Options
What options or methods are available to the employee for the exercise of the
stock options granted under the plan? There are three primary ways in which an
employee can exercise stock options: pay cash upon the exercise of the options,
purchase the stock in a cashless transaction, or sell stock already owned to pay
for the stock being purchased upon the exercise of the stock options.
The cash method is the simplest and most straight forward of the three ways of
exercising a stock option. The option holder determines the number of shares to
be exercised and pays the strike price for each option that is exercised. This
method will work with both incentive stock options and non-statutory options.
Example 3: Emily Stone received a stock option award granting her the
right to purchase 1,000 shares of Acme Corp. at the strike price of $45 a
share. Emily decides to exercise the option on all 1,000 shares utilizing
the cash method which requires a payment from her in the amount of
$45,000.
A cashless exercise is, as the name implies, an exercise of a stock option in
which the holder of the option pays the option strike price with no out of pocket
cost. The holder of the option exercises the option and simultaneously
directs the brokerage firm to sell a sufficient amount of stock to pay the strike
price. The employee retains whatever number of shares remain after the
purchase price has been paid. In a variation of this method the holder
of the option directs the sale of the number of shares necessary to pay the
purchase price plus the amount of any taxes that may be due upon the exercise
of the option. Finally, the last option under the cashless method is to exercise the
option and immediately direct the brokerage firm to sell all shares. The cashless
method will not work with an ISO since it will be considered a disqualifying
distribution.
Example 4: Emily Stone received a stock option award granting her the
right to purchase 1,000 shares of Acme Corp. at the strike price of $45 a
share. She decides to exercise the option on all 1,000 shares when the
stock for Acme Corp. is trading at $90 a share. The total cost of exercising
the option to purchase 1,000 shares is $45,000. Therefore, Emily would
have to sell 500 shares in order for her to pay the total cost of purchasing
the 1,000 shares. She would be left with 500 shares.
The stock sale method entails the option holder selling a sufficient number of
shares in the employer’s stock to enable the employee to pay for the exercised
stock options. Some plans may have a “reload” feature which grants the
employee additional options to replace the stock that was sold to pay for the
exercised options. This can be a very attractive feature from the employee’s
perspective since the employee will receive a new option award. However, these
7
options will generally have a new strike price which may reflect the current value
of the stock and not the strike price of the options the employee just exercised.
This method may be utilized with non-statutory stock options and incentive stock
Options, although care must be taken to ensure the sale of stock does not create
a disqualifying disposition.
Example 5: Emily Stone received a stock option award granting her the
right to purchase 1,000 shares of Acme Corp. at the strike price of $45 a
share. She decides to exercise the option on all 1,000 shares when the
stock for Acme Corp. is trading at $90 a share. The total cost of exercising
the option to purchase 1,000 shares is $45,000. Therefore, Emily would
have to sell 500 existing shares in order for her to pay the total cost of
purchasing the 1,000 shares. Because her plan contained a reload feature
her employer granted her an option to purchase 500 shares at a strike
price of $90 a share (the current fair market value).
IV.
Taxation of Stock Options
As previously stated, stock option plans appeal to employers because the plans
marry the interests of the employee with the interest of the employer in sustaining
continued long-term growth of the business. Most employees are quite pleased
to receive stock options as they represent an addition to their overall
compensation package. The discounted purchase price is something of value,
assuming the prospects for increasing stock price are good. However, the
exercise of a stock option will trigger some type of tax result for the employee.
Incentive Stock Options
The tax treatment to an employee upon the exercise of an ISO is significantly
different, and can be more favorable, than the exercise of a non-statutory stock
option. The exercise of an ISO does not trigger an immediate taxable event for
the employee. The difference between the strike price and the fair market value
of the stock on the date of exercise does not result in taxable income for the
employee. However, the difference between the strike price and the fair market
value of the stock on the date of exercise is considered a preference item for
purposes of the alternative minimum tax (AMT). This may result in the employee
paying AMT in the year of exercise.
Example 6: Kay Person is granted an option (ISO) to purchase 1,000
shares of Acme Corporation on January 5, 2007 and the strike price is $25
a share. She exercises the options on April 1, 2008 when the stock is
trading at $38 a share. Kay does not recognize any income at the time she
exercises her option to purchase 1,000 shares of Acme Corporation stock.
She does, however, have a preference item in the amount of $13,000 ($38
(FMV) - $25 (strike price) x 1,000 = $13,000) for purposes of the AMT
calculation in the year 2008.
8
As the above example illustrates, the holder of an ISO does not recognize
income, other than as a preference item for AMT purposes, upon the exercise of
the ISO. The gain in excess of the strike price will not be recognized until the
stock is ultimately sold by the employee.
Example 7: Same fact pattern as in Example 6 except that Kay Person
decides to sell the stock on June 10, 2009, when the stock is trading at
$46 a share. Kay will realize a gain of $21,000 ($46 (sale price) - $25
(strike price) = $21 gain per share or $21,000 ($21 × 1,000 shares). This
gain will be treated as long-term capital gain since the stock was sold
more than two years after the grant date and more than one year after the
exercise date.
If Kay had sold the stock on the same date but the purchase price was
$23, then she would have had a long-term capital loss of $2 a share or
$2,000.
In the above example, Kay Person satisfied the holding period since the stock
was not sold until more than two years from the grant date and more than one
year after the exercise date. The tax results of this transaction would have
differed if Kay had sold the stock before satisfying both the two year and the one
year holding requirement
Example 8: Same fact pattern as in Example 6 except that Kay Person
sells the stock on February 27, 2009, when the stock is trading at $44 a
share. While Kay has satisfied the two year from the grant of option
requirement, she has not satisfied the one year from date of exercise
requirement. The failure to satisfy both holding requirements is considered
a disqualifying disposition, resulting in two adverse tax consequences.18
First, the difference between each option’s strike price of $25 and the $38
FMV on the date of exercise will be treated as wages, taxed at ordinary
income rates and subject to employment taxes (though deductible by the
employer). Second, the gain on the stock sale will be short term capital
gain. As a result, Kay’s would have ordinary income of $13,000 ($38 $25 × 1,000) and short term capital gain of $6,000 ($44 - $38 × 1,000).
The exercise of an ISO does not create wages for purposes of determining
income that is subject Social Security, Medicare, and Federal Unemployment
Taxes or FUTA. Nor will the exercise of an ISO create a deduction for the
employer. This exclusion from wages will also apply to any income received as a
result of the exercise of an ISO after October 22, 2004, including any amount
received from the disposition of any stock acquired by exercising the ISO
(whether or not a disqualifying disposition).19 What this means is that even a
disqualifying disposition will not be treated as wages and will not be subject to
18
19
IRC §422(a)(1).
IRS Publication 15-B, pages 10-11, (2009).
9
the usual taxes that apply to wages. In addition, there is no federal income tax
withholding required on a disqualifying disposition after this date. The employer
will, however, be required to report the income from a disqualifying disposition on
the employee’s Form W-2 (box 1) in an amount equal to the difference between
the exercise price and the fair market value of the stock on the date of exercise.
The employer will be entitled to a deduction in the year in which the disqualifying
disposition occurs. This deduction is equal to the amount recognized by the
employee as ordinary income due to the disqualifying disposition.20
Non-Statutory Stock Option
The tax consequences of the exercise of a non-statutory stock option differ
significantly from the tax consequences of an ISO.21 This differing tax treatment
is true for both the employer and the employee. From an employer’s perspective,
a non-statutory stock option may be preferable to the granting of an ISO. This is
because the exercise of a NSO by the employee creates a deduction for the
employer equal to the difference between the strike price and the fair market
value of the stock at the time of exercise. However, the employer will incur an
additional cost since the income received by the employee is considered wages
so the employer will have to pay Social Security, Medicare and FUTA taxes.
Many employees that receive stock option have income that exceeds the Social
Security wage base ($106,800 in 2009) so the employer may only be responsible
for the Medicare portion of this tax.
Example 9: Peter Grant receives an option award effective January 30,
2007, granting him the right to purchase 1,000 shares of Acme
Corporation stock at an exercise price of $40 a share which is equal to the
fair market value of the stock on that date. The options will vest at the rate
of 50% a year and Peter will be fully vested at the end of two years. He
decides to exercise his entire option award on July 3, 2009, when the
stock is trading at $62 a share. When Peter exercises the options, he will
have ordinary income in an amount equal to the difference between the
strike price and the fair market value on the date of exercise. In this
example, Peter would recognize $22,000 of ordinary income ($62 -$40 ×
1,000) in the year 2009.
The above example illustrates the tax consequences to an employee upon the
exercise of an NSO. The income recognized by the employee is ordinary income
and is considered wages, reported on Form W-2 and subject to Social Security,
Medicare, and FUTA. The income is included in both box 1 and also in box 12
(code V).22 A cashless transaction may generate a reporting form being issued
by the brokerage firm that handled the exercise and sale of the options.23
20
IRC § 421(b)
IRC §83(a) determines the tax treatment when property is transferred for the performance of services
and applies to non-statutory stock options.
22
See 2009 IRS Form W-2 Instructions.
23
IRS Form 1099-B.
21
10
Because this amount is not reported by the employee as a capital transaction, it
is possible the IRS may issue a deficiency notice. Explaining that the income was
the result of exercising a non-statutory stock option and that the income was
included in box one should be sufficient to satisfy the Service.
Example 10: The same facts as found in Example 9 except Peter sells
the Acme Corp. stock on August 10, 2010, for $70 a share. The sale of the
stock generates a long-term capital gain since Peter held the stock for
more than a year from the exercise date. Peter’s basis in the stock is
equal to the exercise price ($40) plus the ordinary income recognized
upon the exercise of the options ($22) or $62. Therefore, Peter sale of the
stock will result in a long-term gain of $8,000 ($70 sale price minus $62
basis). If Peter had sold the stock before one year had elapsed from the
date of purchase, the gain would have been considered a short term
capital gain which is taxed at ordinary income rates.
Restricted Stock
Internal Revenue Code Section 83 governs the taxation of restricted stock. This
section of the Code provides that property transferred for the performance of
services shall generally be taxable to the recipient in the year in which the
property is either transferable or no longer subject to a substantial risk of
forfeiture. The amount of taxable income will be equal to the fair market value of
the transferred property reduced by the amount, if any, that was paid for this
property.24
Example 11: Paul Key works for Acme Corp. and received a restricted
stock grant of 2,000 shares in which he will be fully vested after two years
from the date of grant. The fair market value of the stock on the date of
grant is $10 a share. This stock was non-transferable and the entire grant
was forfeitable if Paul left the employee of Acme Corp. before being fully
vested in the stock. The fair market value of the stock on the date Paul is
fully vested is $40,000 (2,000 shares × $20 a share) and Paul will
recognize this amount as ordinary income.
It is possible for an employee to elect to be taxed on the fair value of the
transferred property before the property is transferable or the substantial risk of
forfeiture has lapsed. This election, referred to as an 83(b) election, must be
made no later than 30 days after the transfer of the property.25 A primary benefit
of making this election is that any growth in the stock that occurs after the
election will be taxed as a capital gain. A disadvantage to making this election is
that there is no deduction if the property is forfeited because the employee did
not satisfy the restrictions contained in the grant.26 Additionally, if the stock price
declined by the vesting date, there is a risk that the employee would pay more
24
25
26
IRC §83(a).
IRC §83(b)(2); Reg. §1.83-2.
IRC §83(b)(1).
11
tax based on the fair market value on the grant date than he/she would be
obligated to pay at vesting based on the fair market value of the stock at vesting.
Example 12: Same facts as above except Paul make a timely §83(b)
election (stock trading at $10 a share) and then leaves Acme Corp. before
the vesting period lapses. In the year of the stock grant, Paul would
recognize income of $20,000 (2,000 shares × $10 a share. When he
leaves Acme Corp., he will leave without the stock since he didn’t remain
with the Company for the full vesting period.
Generally, the taxation of dividends received on restricted stock will be treated as
additional compensation, and appear on the employee’s Form W-2. However, the
dividend will be reported on Form 1099-DIV if the employee has made the §83(b)
election discussed above. The employer can determine whether or not the
restricted stock will possess voting rights prior to the employee being
substantially vested.
Phantom Stock
A phantom stock plan will generally provide that a benefit will be paid out after a
specific period or upon the attainment of certain company objectives. The
employee will be taxable on the entire phantom stock interest upon vesting, even
if the benefit is not paid out until a later date. The phantom stock plans is
considered a type of non-qualified deferred compensation and the plan will be
subject to the rules under IRC §409A.
V.
Option Strategies
Every individual who is the recipient of a stock option award needs to develop a
strategy for when to exercise stock options, how much of their assets will be held
in employer stock and when the employer stock should be sold. The selling of
employer stock may be complicated somewhat by an employer requirement that
executives must own a certain number of shares. If an employer requires the
employee to own a specific number of shares, the employee should then review
all shares of employer stock currently owned, including stock in a qualified plan,
to determine if the employer’s ownership requirement is satisfied and whether the
employee’s investments are over weighted in employer stock.
When it comes to exercising stock option, some employees employ a strategy of
waiting until the exercise period has almost expired. This works well if you
assume the value of the stock will only increase and there will never be a market
correction. The stock market decline in 1999-2000, as well as recent events, has
shown that market corrections will happen and those who wait to the very end to
exercise their options may end up possessing a right that is worthless. There
may be insufficient time for the market to recover when an employee delays
exercising the option until shortly before the option period expires.
12
An employee could also consider a strategy whereby the options are exercised
when the stock attains a certain target price or has appreciated by a certain
percentage over the strike price. Even in the face of a market correction an
employee may still have the potential later to exercise an option that is currently
underwater. Obviously, this will depend upon the target price or growth set by the
employee, when and if the stock reaches this target, when a market correction
occurs, as well as the severity and duration of the correction.
This works very well for an employee who does not have an ownership
requirement or has already met their employer’s ownership requirement. This
individual has the option of retaining the employer stock or immediately selling
the stock after exercise to lock in the gain that exists at the time of exercise.
The use of put options may provide the employee with downside protection while
still receiving the benefit of any additional increase in the share price of the
employer’s stock. The employee will of course incur a cost in the purchase of the
put option which will have an impact on the amount of gain ultimately realized.
Another possibility is the use of a cashless collar which will reduce the downside
risk as well as the upside potential of the stock options.27 Brian T. Denney wrote
an interesting article that discusses the use of, and the benefits to be derived
from, both of these concepts28. The article also contains a discussion of the
constructive sales rules under IRC section 1259 and whether or not it applies to
either of these two ideas.
VI.
Application of Section 409A29
Section 409A was added to the Internal Revenue Code to address the abuses
that the Service felt were prevalent throughout many non-qualified deferred
compensation plans. The Service was of the opinion that many participants in
these plans had retained a significant amount of control and a substantial risk of
forfeiture did not truly exist. In addition, employees at companies such as Enron
and WorldCom were collecting their benefits at a time when these companies
were experiencing financial difficulties and many shareholders and creditors
suffered significant losses. Section 409A was added to address this perceived
abuse and also targets other non-qualified executive benefits that offer what is
tantamount to deferred compensation, even when the benefit offered is referred
to as something else.
Does Section 409A apply to stock options? This section will apply if the option
exercise price is less than the fair market value of the stock on the grant date of
the option. It is clear that 409A does not apply to an ISO because an ISO cannot
have an exercise price that is less than the fair market value on the day of the
27
A discussion of puts and calls is beyond the scope of this article.
“Tax Planning: Implications of Hedging a Client’s Employee Stock Options”, Brian T. Denney, MBA,
Journal of Financial Service Professionals, July 2007.
29
A complete review of §409A is beyond the scope of this article.
28
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grant or it will not satisfy the definition of an ISO. However, IRC §409A will apply
to a NSO plan if the exercise price is less than the fair market value on the grant
date. This code section applies because of the built in gain that exists when an
option is granted with a discounted exercise price and this gain is considered a
form of deferred compensation.30
Example 13: The Acme Corp. grants to Don Smith the option to purchase
1,000 shares of Acme stock at $15 a share at a time when the stock is
trading at $20 a share. Section 409A applies because the exercise price
($15 a share) is less than the fair market value of the stock ($20 a share)
on the day of the grant.
Generally, Section 409A will not apply to a restricted stock plan provided the
terms of the grant do not permit the deferral of income beyond the vesting date
included in the plan. A phantom stock plan will, however, be subject to the rules
of Section 409A and the plan will have to comply with the tax and penalty
provisions, rules regarding timing of deferral elections and requirement against
the acceleration of benefits and distributions only upon the occurrence of
permitted specified events. A phantom stock plan is subject to the rules of
Section 409A because the benefit is paid to the employee at the end of a term of
years and, therefore, resembles deferred compensation.
VII.
Accounting
The rules for accounting for stock options became more uniform with the
issuance by the Financial Accounting Standards Board of FASB Statement 123
(revised).31 This FASB Statement eliminates the intrinsic value method utilized in
Accounting Principals Board Opinion No. 25 and instead uses a fair value based
method which will result in similar transactions being accounted similarly. Entities
will now be required to recognize the cost of employee services in exchange for
awards of equity instruments. The requirement that companies account for stock
options using the fair value based method has impacted company earnings and
may be responsible for some employers cutting back on the number of options
issued as well as the number of employees receiving options.
VIII. Conclusion
Stock options can be an effective way, even in this turbulent market, to reward
and retain key employees by tying the overall compensation of the employee to
the financial future of the employer. This results in the goals of both the employer
and the employee being aligned. The employer may have a number of different
plans which may be utilized to accomplish its objective. The different rules
pertaining to incentive stock options, non-statutory stock options, restricted stock
30
IRC §409A(d)(1); Prop. Reg. §1.409A-1(b)(5).
This Statement generally became effective in 2005. It revises FASB Statement 123 and super cedes
Accounting Principals Board Opinion No. 25.
31
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and phantom stock plans afford the employer the opportunity to implement a plan
that may meet the needs of both the employer as well as the needs of the
employee.
Legal & Tax Trends is provided to you by a coordinated effort among the
advanced markets consultants. The following individuals from the Advanced
Markets Organization contribute to this publication: Thomas Barrett, Michele
Beauchine, Kenneth Cymbal, John Donlon, Lori Epstein, Jeffrey Hollander,
Jeffrey Jenei, Lillie Nkenchor and Barry Rabinovich. If you have any comments
or suggestions, please contact Tom Barrett or John Donlon, Co-Editors, at
[email protected] or [email protected]
Pursuant to IRS Circular 230, MetLife is providing you with the
following notification: The information contained in this document is
not intended to (and cannot) be used by anyone to avoid IRS
penalties. This document supports the promotion and marketing of
insurance products. Clients should seek advice based on their
particular circumstances from an independent tax advisor.
MetLife, its agents, and representatives may not give legal or tax advice. Any
discussion of taxes herein or related to this document is for general information
purposes only and does not purport to be complete or cover every situation. Tax
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appropriateness of any product for any specific taxpayer may vary depending on
the facts and circumstances. Clients should consult with and rely on their own
independent legal and tax advisers regarding their particular set of facts and
circumstances.
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