Executive stock options under senate review.

Over the past several years, executive stock options have drawn the attention of legislators in Washington. This is not surprising, considering that close to 50% of executive pay is attributable to stock option exercises, according to Forbes magazine (see DeCarlo, "Big Paychecks," Forbes (May 2007), available at www. forbes.com/leadership/2007/05/03/ceoexecutive-compensation-lead- 07ceocx_sd_0503ceocompensationintro.html). The most recent scandals associated with option backdating, the 2005 adoption by the Financial Accounting Standards Board (FASB) of Financial Accounting Standard No. 123(R), and the adoption of final regulations under Sec. 409A have presented human resource, compensation, and benefits professionals with complicated rules and reporting requirements.

This item summarizes recent concerns cited in U.S. Senate subcommittee hearings and recent changes affecting stock options and outlines considerations that corporate executives should evaluate in determining when to exercise stock options.

Aligning tax and accounting reporting

On June 5, 2007, a U.S. Senate subcommittee cited concerns pertaining to the inconsistencies of current accounting and tax rules related to stock options and gave examples of options reporting for financial statement and Federal tax purposes by multinational corporations. In 2005, the FASB issued accounting rules requiring companies to record a financial statement expense equal to a stock option's fair market value (FMV) at the date of grant. These rules provide for various valuation mechanisms to compute a stock option's FMV in the year of grant and allow compensation expense to be recognized over the option vesting period, as well as allowing a deduction for option grants that never vest.

When considering the FASB rules for stock option accounting, the perceived problem cited by the Senate subcommittee is that, for tax purposes, companies are allowed a tax deduction equal to the difference between the stock's FMV on the exercise date and the stock's cost, which is often higher than the book expense. The U.S. Senate recently stated that this additional tax expense has "shortchanged" the U.S. Treasury. Based on an IRS determination, this book-to-tax disparity amounted to $43 billion in fiscal year 2004 and represented 3,200 companies, 250 of which accounted for the difference (see "Statement of Senator Carl Levin (D-Mich) before Permanent Subcommittee on Investigations on Executive Stock Options: Should the IRS and Stockholders Be Given Different Information?" (June 5,2007), available at http://hsgac.senate.gov/_files/OPEN INGCARLLEVINJune52007.pdf). As a component of its comments, the Senate introduced data from nine multinational companies that showed no stock option expense on the financial statements prior to the FASB change. All nine companies presented evidence that, if the new FASB rules had been adopted, the book expense would have been lower than the tax deductions in all cases.

If options remain unexercised, there will be a book expense without any tax deduction. Finally, the issue of when a corporation can take a deduction for tax purposes depends entirely on when the corporate executive exercises the option (rather than when the options are granted), which creates arbitrary results. It is evident from the Senate's comments that Congress is reevaluating Federal tax policy on accounting for stock options and that tax and accounting policies may become more aligned.

Option backdating and sec. 409A implications

As seen in recent option backdating cases, companies issued options to employees on a certain date but backdated the issuance date (and even the exercise dates in certain cases). The backdating of the exercise date generally helped executives who exercised nonqualified stock options and then held the underlying stock acquired for more than one year. The result was to reduce the ordinary income component of the exercise, resulting in less income taxed at ordinary rates and more income taxed at the favorable 15% long-term capital gains rate.

Sec. 409A issues (discussed below) can arise in these backdating cases; the stock options are often issued with an exercise price far below the FMV on the grant date, triggering an additional 20% income tax and interest charge in addition to the amount taxed normally. The good news for certain of these employees is that Sec. 409A applies only to options vesting after 2004, and the final Sec. 409A regulations allow companies to consider option re-pricing until the end of 2007.

Final Regs. under see. 409A.

The final regulations under Sec. 409A contained no surprises when compared with the proposed regulations on treatment of stock options. Generally, nondiscounted stock options and stock appreciation rights issued to company employees that did not include any additional deferral feature were excludible from Sec. 409A. Incentive stock options (ISOs) and options granted under an employee stock purchase plan are also excluded from coverage, even if the plan offered a discounted purchase price.

A significant issue faced by many practitioners is the valuation of the stock for closely held companies. Under the Sec. 409A final regulations, the valuation of stock based on a reasonable application of a reasonable valuation methodology is treated as reflecting the stock's FMV. To meet this valuation standard, a taxpayer does not have to demonstrate that the value was determined by an independent appraisal if he or she can demonstrate that the valuation was determined by a reasonable application of a reasonable valuation methodology (including relying on recent equity sales transactions made at an arm's-length price). The regulations also contain a presumption that the stock does not reflect FMV if it is shown that the valuation is grossly unreasonable. A safe-harbor presumption applies when the valuation is based on an independent appraisal or a repurchase formula that would be treated as FMV under Sec. 83, or for illiquid stock of a start-up corporation in which a valuation was performed when there was no anticipation of a change in control or public stock offering. The start-up-corporation presumption will not apply if, at the time the valuation was made, the company could reasonably anticipate that the service recipient was to undergo a change-in-control event in 90 days or an initial public offering in six months.

Finally, the proposed regulations address modifications, extensions, and renewals of stock rights.

Option exercises: maximizing compensation benefits

The previous discussion focused on many of the key issues facing companies issuing stock options. There are certain considerations that executives (employees) can use to maximize their compensation benefits when considering stock option exercises. It is essential for the employee to understand the general tax rules and to time the exercise carefully.

There are two kinds of options--ISOs and nonqualified stock options (NQSOs). Each type has distinct tax treatment and separate exercise techniques that should be considered. With either option, there are three critical dates to watch regarding tax consequences: the date (1) options are granted to the employee, (2) options are exercised and (3) the stock acquired via the options is sold.

ISOs

There is no income tax to the employee when ISOs are granted. At grant, the exercise price for the options must equal or exceed the underlying stock's FMV. The options must also vest under a specified time frame.

ISOs usually must be exercised within 10 years of the grant date. They cannot be transferred (except on death) and can be exercised only during employment, or within three months of the employee/grant holder's leaving the company (employer). See, generally, Sec. 422.

Maximum value at grant: The FMV of the stock on the grant date, under all employer plans that vest for a particular employee for any particular year, may not exceed $100,000. To the extent the aggregate amount is greater than $100,000, such options will not be considered ISOs.

Tax treatment: When an employee exercises the options to acquire company stock, he or she does not realize any ordinary income for tax purposes. In addition, if the stock acquired by exercising the ISOs is owned at least two years from the time the options were granted or one year after they were exercised (whichever is later), a profitable sale of the stock will produce a long-term capital gain. A disposition that does not meet these time limits will result in ordinary income.

Trap: The spread between the strike (exercise) price--what is paid for the shares--and their FMV at the time of exercise is treated as an adjustment for alternative minimum tax (AMT) purposes. In other words, the spread is recognized as taxable income for individuals subject to the AMT.

Example 1: When exercising ISOs, Employee pays $10,000 to acquire stock worth $100,000. She must report $90,000 in income for AMT purposes. Under the AMT, this ISO adjustment can trigger tax at the rate of 26% or 28%. For regular tax purposes, the tax cost (basis) in the stock is the amount paid (generally, the exercise price). The basis for AMT purposes will include the AMT adjustment (making the basis for AMT higher).

Exercise timing strategies: Stock market prices dictate to a large extent when to exercise options. But the rules of an employer's particular ISO plan and the tax law also have a big effect on determining the wisest time to exercise ISOs.

It is usually advisable to exercise ISOs early in the year. If the stock price stays the same or increases during the year post-exercise, it is more advantageous to hold the stock for more than 12 months prior to selling (to obtain the 15% capital gains rate). If the stock price declines post-exercise, an employee could sell the shares before year end to reverse any AMT liability. If the shares are sold in a following year, the AMT adjustment in the year of exercise cannot be avoided. If shares acquired with ISOs are sold before the more-than-one-year holding period, the ISOs lose their unique tax treatment (in effect, they are then treated as NQSOs; see below), and the employee will have generated "compensation" by making the exercise. However, if the stock was sold prior to the end of the exercise year, the employee would not have any AMT adjustment because ISO treatment no longer applies.

Additional strategies: The employee should consider exercising NQSOs when exercising ISOs. By exercising NQSOs and ISOs in the same year, the employee would be able to eliminate any AMT liability resulting from ISO exercise. Alternatively, accelerating regular income to a year when the employee is subject to AMT can reduce the overall tax liability over multiple years, because AMT rates are lower than the highest ordinary income tax rates. If an employee will be subject to AMT for a particular year and there is no way to eliminate the tax, it may be advisable to exercise and sell ISOs on the same day during that year to escape the AMT adjustment.

NQSOs

NQSOs are granted under a company plan governing exercise terms and other aspects of the options. The taxability of NQSOs on grant, exercise and sale is quite different from ISOs.

On grant of an NQSO, the employee will not recognize any income unless there is a readily ascertainable FMV for the options. (Generally, there is no such value to NQSOs at grant.) NQSOs that are not taxed when granted will generally be taxed as ordinary income on exercise. The amount subject to tax will be the FMV of the stock on the exercise date, less the exercise price, plus any amount that was paid for the option, if applicable.

Example 2: Employee holds NQSOs giving him the right to acquire 1,000 shares for $10 per share. If Employee exercises all of them when the stock is selling for $50 per share, the so-called bargain element (compensation) is $40,000 ($50,000 -$10,000). This compensation is subject to income tax withholding as well as FICA taxes. Basis in the stock acquired from exercise will be the sum of the income recognized on exercise, the exercise price of the option and the amount paid for the option, if any. The holding period begins the day after it is exercised.

Unlike ISOs, NQSOs are transferable. However, the employee (and not the transferee) will recognize income for tax purposes on exercise of the option. When the employee later sells the stock acquired through these options, he or she reports any appreciation in the stock's value after exercise as capital gain.

Caution: The holding period starts when the shares are acquired; it does not include the time the employee held the options. For long-term capital gains, the shares must be held for more than one year from the date of the options' exercise.

When should employees exercise NQSOs? It depends. For example, if the company is privately held, the employee should consider exercising as early as possible to minimize the compensation cost and maximize future capita] gains. Because employees cannot readily sell these shares, they have to be prepared to exercise and hold them.

If the company is publicly traded, employees should evaluate the company's overall profitability expectations and its future. If the executive believes the economics will only get better, the employee may wish to hold onto the options and exercise them when the price reaches his or her target. But if the employee already owns company stock and wants to diversify, or believes that the company's future is grim, he or she may want to exercise as soon as possible and sell the shares immediately.

Also, generally it is more beneficial to exercise NQSOs just prior to their expiration date, especially if the underlying stock value is appreciating; in this way taxation of the option's value is deferred until the exercise prior to expiration. However, there is investment risk in holding concentrated equity positions that include unexercised stock options. This risk may be mitigated by exercising options prior to expiration, selling the shares acquired and reinvesting the sales proceeds in a diversified investment portfolio. Future income tax increases should also be considered in the analysis.

Conclusion

Based on recent developments and the continuing use of stock options and deferred compensation plans as compensation vehicles, executive stock options will continue to draw attention from the FASB, Treasury and governmental authorities, and other regulatory bodies. Practitioners must remain aware of these continuing issues in order to best advise clients.

FROM BRENT LIPSCHULTZ, TAX PRINCIPAL PERSONAL WEALTH ADVISORS GROUP, EISNER LLP, NEW YORK, NY