Nonqualified stock options and the research credit.

In Apple Computer, 98 TC No. 18 (1992), the Tax Court determined that the "spread" on nonqualified stock options (NQOs) at exercise (i.e., the difference between the fair market value of the stock at the exercise date over the exercise price) qualified as "wages paid or incurred to an employee" for purposes of claiming the research activities credit under Sec. 44F (now Sec. 41). In ruling for Apple, the court refused to stray from the statutory definition of wages. Sec. 44F(b)(2)(D)(i) (and present day Sec. 41(b)(2)(D)(i))states that such term "has the same meaning given such term by section 3401(a)," which defines wages for Federal income tax withholding purposes. If Congress again extends the research activities credit in substantially the same form the Apple Computer decision presents many interesting planning opportunities to companies that use NQOs to compensate employees performing qualifying research.

Under Apple Computer, the use of NQOs by a growing company presents a tremendous opportunity to leverage the tax savings generated by the research credit. Future appreciation in the underlying stock may generate qualifying research expenses far in excess of that which may be obtained through current cash compensation. The flip side is that marginal stock appreciation may generate insignificant qualifying expenses. In addition, growing companies may find that the increasing gross receipts generated in future years will deprive them of some of the benefits of the stock appreciation, since increased gross receipts will increase their base amount in future tax years when the NQOs are exercised.

Many companies have trouble generating a significant research credit because their research activities remain relatively stable over the years, resulting in little incremental increase in expenditures. Companies may wish to use NQOs to "load up" on their qualifying expenses in a designated year; i.e., they can encourage the acceptance of NQOs in lieu of current cash compensation and maximize the number of options to be exercised in a single year by timing the vesting and exercise period of these options to coincide in one year. This would maximize one year's qualifying wages and, hence, maximize the credit. None of the proposals introduced in Congress to extend the credit would change the base period used to determine the "fixed-base percentage" (i.e., tax years beginning after Dec. 31, 1983 and before Jan. 1, 1989 as prescribed under Sec. 41(c)(3)(A)). However, if the credit is extended and the base period floats (e.g., the period becomes the five years prior to the computation year), the "load up" strategy may also serve to decrease the fixed-base percentage generated in the intervening years.

Note that, in Apple Computer, the parties agreed that the employees who exercised the options were engaged in qualified services at the time the options were granted and during the year the options were exercised. The extent of the individual employees' research activities was not at issue. A question may arise as to how the qualified expenditure would be calculated if the recipient's participation in qualified activities varied over the years. For example, if an individual spent 9,0% of his time on qualifying research in the year of grant, and 100% of his time in the year of exercise, there would be the question as to whether the year of grant or the year of exercise would be used. Another alternative might be a weighted average over the period the unexercised options were held, or some other approach.

Apple Computer emphasizes the importance of taxpayers adequately documenting their research activities. Even if a year is closed by statute for income tax purposes, taxpayers may wish to ensure they have adequate documentation if unexercised NQOs Were granted in that year, since the extent of the recipient's activities in performing qualified research in that year may have an impact on the credit they may claim when the options are exercised.

Apple Computer withheld income taxes from the recipients on exercise, as required under Regs. Sec. 1.83-6 as a condition for allowing the deduction for the spread. Although option exercises for which the employer does not withhold income taxes would arguably still qualify as wages under Sec. 3401(a), failure to withhold (and a related denial of the deduction) might have caused the court to have determined that no qualifying expense had been "paid or incurred." Therefore, withholding taxes on the spread at exercise may be a good idea to preserve the credit (as well as to protect the deduction).

Note: Apple Computer involved only NQOs. Regardless of whether the IRS acquiesces in the decision, it will presumably continue to take the position that spreads attributable to incentive stock options (ISOs)(including disqualifying ISO dispositions) are not qualifying wages. The Service previously stated in Rev. Rul. 71-52 and Notice 87-49 that disqualifying dispositions of ISO stock are not treated as wages for purposes of Sec. 3401(a), pending restudy of that question. Therefore, companies performing qualifying research may have a distinct tax advantage if they grant NQOs rather than ISOs.

From David K. Yasukochi, CPA,

Los Angeles, Cal.