RRA prompts fresh look at ISOs for corporate executives.

Incentive stock option plans (ISOs) for corporate officers and employees are facing renewed scrutiny in corporate board rooms, where serious consideration is being given to shifting away from nonqualified stock option plans (NQOs).

The renewed interest in ISOs is one of the hottest topics in executive compensation. The Revenue Reconciliation Act of 1993 (RRA) substantially increased marginal tax rates for most top executives, directly raising the immediate tax cost of exercising NQOs.

When an executive exercises an NQO, the result is ordinarily taxable compensation to the executive equal to the value of the stock on that day less its exercise price.

Example: Executive E exercises 1,000 NQOs with an exercise price of $1; the stock is worth $3. The $2 per share spread will produce compensation income of $2,000, and E must pay 1994 Federal income taxes of 41.05% or $821. (This example assumes a top Federal income tax rate of 39.6% and a hospital insurance tax rate of 1.45%.) The corporation will also have a $2,000 tax deduction.

If the options instead are ISOs, E incurs no taxable income on exercise, and the company receives no deduction. E would realize long-term capital gains taxed at a rate of only 28% if he sells the stock after the requisite holding period (two years from the date of the grant of the ISO or one year from the date of its exercise).

The ISO exercise is a preference item for the alternative minimum tax (AMT), which may lessen its attractiveness. Ignoring any AMT consequences, assume the stock from an ISO exercise at $1 per share is held the required time and is sold for $3 per share. The long-term capital gain of $2,000 would be taxed at 28% or $560 (as compared to the $821 due for the NQOs at the time of exercise, a year earlier).

The question of whether to issue NQOs or ISOs requires a look at the tax consequences to both the executive and the company. NQOs clearly are more advantageous to a corporation because of the deduction at exercise, and ISOs are generally more advantageous to executives because no income tax is due until the stock is sold.

Which is best?

NQOs are almost always superior to ISOs for a variety of reasons. This analysis has changed somewhat under the new law, however, and ISOs can be the right choice in certain instances.

Nonqualifed stock option plans usually are superior to incentive stock option plans:

1. For 1994, the corporate Federal tax benefit of about 33.55% (35% less 1.45% for the hospital insurance tax) usually exceeds the individual's tax savings of 13.05%. Another way of saying this is that the 13.05% equals the sum of the ordinary income tax rates plus the health insurance tax rate minus the long-term capital gain rate (39.6% + 1.45% - 28%). This may not be true if the stock is to be held for many years. In such cases, the tax paid on exercise by the option holder will usually exceed the tax savings to the corporation, so the carrying cost of the difference could be substantial. If so, it may be preferable to pay no tax until the stock is sold in an ISO to avoid paying income tax at exercise and the resultant carrying cost.

2. To qualify for the lower capital gains tax rate, an individual must hold the stock received after exercising an ISO for two years from the grant date and one year from the exercise date. During this holding period, the individual bears a risk that the stock's value may decline.

3. If exercising an ISO makes the individual subject to the AMT, the comparative advantage of ISOs to the executive is reduced.

4. The maximum value of ISOs a firm can grant is limited by the Code. If exceeded, the excess is treated as NQOs. The limit is determined with reference to the value of the stock at the date of grant and with reference to the year the ISOs can first be exercised. The annual limit is $100,000. Since an ISO plan by law cannot extend beyond 10 years, the limit can be illustrated by saying any ISO plan can grant to one individual at one time no more than $1 million in ISOs, first exercisable at a rate of $100,000 per year.

5. An ISO's exercise price must equal the stock's fair market value on the date the option is granted and must equal at least 110% of the stock's value if the option holder owns 10% or more of the corporation's stock. This is not a great disadvantage, since Sec. 162(m) will encourage the use of options issued at full market value. (Sec. 162(m) limits the corporate deduction for certain officers to $1 million per year.)

6. if a corporation compares its true economic cost of issuing options (defined here as the opportunity cost, or the value of the options on the exercise date minus the exercise price and minus any tax benefit), it will conclude that it can issue more NQOs than ISOs by a ratio of one minus the company's net tax saving from using NQOs.

As a result, at a net tax saving of 33.55%, the corporation should be willing to issue either 10,000 NQOs or 6,645 ISOs. The option holders almost always would prefer the higher number of NQOs because of the opportunity to generate gain from a greater number of shares.

ISOs may be preferable to NQOs in some cases:

1. An ISO may be more attractive when the corporation cannot use the tax deduction from the exercise of NQOs until a future year, such as when it is experiencing net operating losses.

2. An ISO may be preferable when it is virtually certain that its exercise will be followed by the sale of the stock in a disqualifying disposition (less than two years from the date of ISO grant and one year from date of exercise). Here the corporation and employee avoid the 1.45% hospital insurance tax under current rules. (See Notice 87-49 and Rev. Rul. 71-52.)

The IRS does not subject the income from a disqualifying disposition of stock from an ISO exercise to employment taxes, so it is not subject to the hospital insurance tax either. The Service currently is reviewing this employment tax treatment of ISO disqualifications and may change its position. Any change would apply to future ISO transactions.