Stock options revisited.

The Revenue Reconciliation Act of 1993 (RRA) introduced several factors that will influence decisions regarding whether stock options are an attractive compensation technique for top executives. In addition, under the new law, employers and employees will need to reevaluate strategies to produce the greatest after-tax benefit for options previously issued, but not yet exercised. As this article will illustrate, these issues require an understanding of the tax treatment of employee stock options and an analysis of how the RRA changes affect them.

Types of Employee Stock Options

There are two basic types of stock options (with many variations on the basic themes): incentive stock options (ISOs) and nonqualffied stock options (NQSOs). Under each alternative, the employer grants an employee, usually an executive, the right to purchase company stock at some time in the future at a specified price. There are three critical dates to be considered in determining the taxabihty of employee stock option transactions: the date (1) the option is granted to the employee (date of grant), (2) the employee exercises the option and purchases the stock (date of exercise) and (3) the employee sells the stock (date of sale).

* ISOs

Under Sec. 422(b), an ISO must meet the following conditions:

* The option must be granted pursuant to a plan approved by the shareholders within 12 months of the date the plan is adopted. The plan must include the aggregate number of shares that may be issued, and define the employees eligible to receive options.

* The option must be granted within 10 years of the date the plan is adopted.

* The option must not be exercisable more than 10 years after it is granted.

* The option must be nontransferable, except by will or intestacy.

* The option price must not be less than the stock's fair market value (FMV) at the date the option is granted.

* The employee must not own, on the date the option is granted, more than 10% of the voting power of the employer or its parent or subsidiary.

* If the employee owns more than 10% of the company's voting stock, the option is still an ISO if the option price is at least 110% of the FMV of the stock at the date of grant and the option is exercisable within five years of the date of grant.(1)

To obtain the tax benefits of an ISO, Sec. 422(a) requires that --stock received on exercise of the ISO must not be disposed of within two years from the date the option was granted, nor within one year after its exercise; and --the holder must be an employee of the corporation, its parent or subsidiary from the date of grant until up to three months before the date of exercise.

An employee may only exercise ISOs up to $100,000 FMV of stock per calendar year.(2) FMV is determined at the date of grant.(3) Excess options are treated as options not qualifying for ISO treatment, or NQSOs.

* NQSOs

Options that are designated as not being ISOs by the grantor, or that do not meet the statutory criteria for ISO treatment, are NQSOs governed by Sec. 83.(4) Thus, an option may be an NQSO because the employer prefers it to be, or because the option's provisions automatically preclude ISO treatment (e.g., the option price is less than FMV at the date of grant, or the option will be exercisable for a period longer than 10 years).

The critical factor in determining the treat ment of NQSOs under Sec. 83 is whether the option has a readily ascertainable FMV at the time of grant. If there is a readily ascertainable FMV, the grant of the option is subject to taxation.(5) If not, Sec. 83 will apply to the transfer of the stock at the time the option is exercised.(6) An NQSO is unlikely to have a readily ascertainable FMV unless it is publicly traded. Therefore, for most NQSOs, there is no readily ascertainable FMV at the date of grant, and the remainder of this discussion assumes that NQSOs are not taxable at the date of grant.

Tax Treatment of ISOs and NQSOs

The table below sets forth the tax effect of ISOs and NQSOs to the employee and the employer at three critical dates: grant, exercise and sale. As the table shows, there are two primary advantages if the employee receives an ISO and holds the stock for the requisite time period: income recognition is deferred until the stock is ultimately sold, and the entire appreciation over the option price is capital gain.(7) As noted in the table, the bargain element (FMV of stock at date of exercise less the exercise price) is a positive adjustment for alternative minimum taxable income (AMTI) in the year the option is exercised. (8)

                          Income to             Corporate
                          executive             deduction

                       ISO        NQSO         ISO    NQSO

Date of grant          None       None         None   None

Date of exercise(a)    None(b)    Ordinary     None   Ordinary
                                  income(c)           deduction(d)

Date of sale           Capital    Capital       None   None
                       gain(e)    gain(f)

(a) This treatment assumes that the stock is not subject to a
substantial
risk of forfeiture on exercise.
(b) The bargain element (FMV at time of exercise - exercise price)
is a positive adjustment for AMTI.
(c) The bargain element is ordinary income.
(d) The bargain element is deductible as compensation by the
corporation.
(e) Sales price - cost (i.e., exercise price) = capital gain.
(f) Sales price - FMV at exercise = capital gain.

If the ISO holding period requirements are violated (i.e., the executive disposes of the stock before two years from date of issue or one year from the date of exercise), the "disqualifying disposition" affects both the executive and the corporation. First, gain on the sale of the stock is ordinary income to the holder up to the amount of the bargain element, and any excess gain is capital gain. Second, the corporation is allowed a deduction for the ordinary income recognized.

If the employee receives an NQSO, income is deferred only to the date of exercise, and the bargain element is then taxable as ordinary income. Any further appreciation after exercise is capital gain when the stock is subsequently sold. Thus, the bargain element of the NQSO is subject to ordinary income tax at a time when the employee has received no cash from the transaction.

The tax treatment to the employer also differs for ISOs and NQSOs. The employer receives no deduction from the ISO transaction unless the employee disposes of the stock early and triggers ordinary income.(9) In contrast, the employer receives a deduction equal to the bargain element at the date of exercise of an NQSO.(10) This difference provides a strong incentive to the employer to issue NQSOs, even though ISOs appear to be more advantageous to the employee.

The RRA's Effect on Stock Options

Several RRA provisions affect the usefulness of stock options as a form of executive compensation. First, the enactment of the 36% and 39.6%(11) tax rates will penalize the recognition of ordinary income and make the recognition of capital gain (taxed at a maximum rate of 28%(12)) more desirable. The maximum rate benefit of capital gains over ordinary income under prior law was 3% (31% - 28%), compared to a current spread of up to 11.6% (39.6% - 28%). The increase in the alternative minimum tax (AMT) rate from 24% to 26% or 28%(13) can also increase the cost of ISOs to the executive, since the bargain element is an adjustment for AMT purposes.

Starting in 1994, the RRA removed the cap on wages subject to the Medicare hospital insurance wage tax.(14) This 1.45% tax applies to all wages, without limit. Thus, the effective tax rate to executives on the bargain element of NQSOs may be as high as 41.05% (39.6% + 1.45%).

Three changes that affect corporations may also have an effect on executive compensation and whether stock options will be attractive after the RRA. First, the maximum corporate tax rate has increased from 34% to 35%.(15) The RRA also denies a deduction, beginning in 1994, for certain compensation in excess of $1 million per year paid by a publicly traded corporation to each of its top five officers.(16) However, the statute exempts compensation linked to productivity that is approved by independent directors and shareholders.(17) Stock options issued at FMV at date of grant, if properly approved by the directors and shareholders, should be exempt from these limits. While the $1 million maximum may seem high, publicly traded companies often pay their executives such amounts, and are most likely to use stock options. This exception to the $1 million compensation deduction limit, coupled with the other benefits of stock options to the executive, should be a real impetus to the creation of more stock option plans in the future.

Also, beginning in 1994, qualified retirement plan contributions are limited to per-employee maximum annual compensation of $150,000 (compared to $235,840 in 1993).(18) This change will significantly reduce the compensation that executives can receive in the form of qualified plan benefits, and could lead to the consideration of other forms of compensation, including stock options.

The RRA's Likely Effect on Stock Options

* Short-term issues

Executives who have been exercising ISOs in a program to avoid the AMT will need to rethink this plan. The increase in regular tax rates will raise the threshold before the AMT will apply. Perhaps this strategy can be altered to exercise a greater number of ISOs annually and still avoid the AMT. Taxpayers with unexercised NQSOs may want to accelerate their exercise, realize the ordinary income currently and have future appreciation taxed at capital gains rates. In anticipation of any significant changes in future tax law, corporations and their executives should review current stock option plans and the outstanding options under them. It may be, for example, that NQSO plans should be canceled and ISOs adopted in their place.

* Long-range effects

The tax environment under pre-RRA law made cash compensation look quite desirable, because the tax rate on ordinary income and capital gains was virtually the same, and there was no major motivation to take on the cash outlay of exercising stock options, or the ensuing market risk of owning the stock. There was also a foreboding sense of doom (now proved to be well-founded) that tax rates were probably as low as they were going to get, and that they would not last forever. This encouraged a "take the money and run" philosophy.

With the hefty increase in tax rates, capital gains take on an added significance. Also, deferral is more advantageous because the current tax rate of up to 41.05% is severe, and executives can probably anticipate lower income and reduced tax rates after retirement. All of these changes make stock options, particularly ISOs, appealing as a form of compensation for executives.

* Relative advantages of ISOs and NQSOs

ISOs tend to look better from the executive's position, even more so after the enactment of the RRA. However, the relative desirability of each type of option cannot be fully evaluated until the effect on the corporation has been determined. An ISO does not generate a tax benefit to the corporation unless the executive makes a disqualifying disposition. However, the bargain element taxed to the executive on exercise of an NQSO is also deductible to the corporation. Under prior law, when the top individual tax rate was lower than the top corporate tax rate, there was an opportunity to pair a cash bonus with the exercise of the NQSO in such a way that everyone was a winner--except the IRS. The corporation would pay the executive a cash bonus designed to compensate him for the ordinary income tax due on the exercise of the NQSO. With the top tax rate for individuals now well above the corporate rate, that opportunity is not as attractive. The example on page 52 illustrates the dynamics of the tax rate changes and the corporate tax deduction for NQSOs.

It is no longer possible for a corporation to bear all of the tax on the exercise of the NQSO. However, in the example, X can pay a $540 bonus and still break even, thereby bearing 82% ($326 of $396) of E's cost at exercise of the NQSO Under this type of tandem plan, the executive is reimbursed for the lion's share of the ordinary income tax on exercise, and comes out ahead with the NQSO/bonus.

Certainly, the issuance of an ISO is simpler and will be preferred if the executive plans to hold the stock indefinitely, thereby deferring all tax indefinitely. In many cases, an executive views an option plan as a means for increasing compensation and has no desire to establish a large equity position in the stock. Often, the executive will not want to tie up capital in the purchase of the option stock, nor will he relish being at risk of the market after the exercise. This executive's preference will be to select a time when the bargain element is attractive, exercise the option and immediately sell the stock. Under these economic conditions, the tandem stock/bonus plan continues to produce the best after-tax results under the RRA.

An alternative would be for the corporation to reimburse the executive only for the tax generated by the rate differential between ordinary income and capital gains. This choice would be attractive to the executive who wants to sell the stock immediately. It would also produce a net benefit to the corporation, which would be entitled to deduct the entire bargain element and the cash bonus paid.

Other Corporate Issues

Often, a corporation is more concerned with the effect that a compensation plan has on its reported earnings than it is with saving money through some cleverly conceived tax plan. Under present accounting rules, a corporation is not required to charge earnings for stock options issued with a strike price at least equal to FMV at date of grant. This rule covers all ISOs by definition, and has also inhibited the use of NQSOs with an option price below FMV.

The Financial Accounting Standards Board (FASB) released an exposure draft on June 30, 1993, Accounting for Stock-Based Compensation, recommending that earnings be charged for the value of all stock-based compensation, including options issued at FMV. How that value would be determined has been the subject of intense discussion. If the exposure draft were to be adopted, public companies would be motivated to reduce the issuance of stock options, at a time when the tax climate seems to favor them.

In the first round of six public hearings conducted by FASB on its exposure draft, the proposed statement was severely criticized.(19) Corporate accountants, CPAs and accounting firms expressed concern that the standard would make it difficult to produce accurate, meaningful and consistent numbers. Practitioners feared that stock compensation would no longer be a viable way for a young company to reward employees for their efforts while it was in the start-up phase and could not afford high salaries. However, many users of financial statements expressed support for the proposed statement. On Dec. 14, 1994, the FASB voted not to require that earnings be charged for the expense of stock options; however, it will "encourage" such expensing based on the stock's estimated FMV.

Conclusion

As with any business decision, economic factors, such as the expected price performance of the stock, efforts to lock the executive into the corporation and the effect on earnings must be considered. These factors, coupled with their tax ramifications, will determine whether stock options should be a part of the executive compensation package of the future.

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(1) Sec. 422(c)(5). (2) Sec. 422(d)(1). (3) Sec. 422(d)(3). (4) Regs. Sec. 1.83-7(a). (5) Id.; Sec. 83(e)(3). (6) Id.; Sec. 83(a) and (b). (7) Temp. Regs. Sec. 14a.422A-1, Q&A-1. (8) Sec. 56(b)(3). (9) Sec. 421(b). (1O) Sec. 83(h). (11) Sec. 1(a)-(d). (12) Sec. 1(h). (13) Sec. 55(b)(1)(A). (14) Sec. 3121(x), repealed by RRA Section 13207(a)(2). (15) Sec. 11(b)(1)(D). (16) Sec. 162(m). See Kautter, "The $1 Million Cap on Compensation Deductions," 25 The Tax Adviser 327 (June 1994); Notice 94-68, IRB 1994-26, 12. (17) Sec. 162(m)(4)(C). (18) Sec. 401(a)(17)(A). (19) "FASB Hears First Comments on Stock Compensation," 62 Tax Notes 1447 (3/14/94).