Stand-up stock options.
Amid a clamor for stronger links between executive pay and corporate performance, the use of stock-based compensation plans for CEOs and other senior executives is on the rise. But such plans are being scrutinized by shareholders, the government, the FASB, and the SEC, partly because of concerns that CEOs are paid too much and that complex stock options are not clearly explained in proxy and registration statements.
The SEC, for example, recently issued new proxy disclosure regulations that require more detailed reporting of executive compensation, including stock options. The commission also has tightened its insider trading rules, basing the definition of an insider on function rather than title and ruling that a stock option-exercise is no longer considered a purchase for purposes of matching against the ultimate sale.
For its part, the FASB reportedly is considering a change that would require companies to take a charge on the income statement related to option programs. The FASB also is reported to be considering grant date accounting for stock options based on the use of an option valuation module.
REDESIGNING STOCK-OPTION PROGRAMS
In such an environment, companies may need to reconsider both the number of options they grant and their eligibility parameters. Working with CEOs, they must strive to design equity-compensation programs that balance proxy disclosure requirements, accounting charges, and tax ramifications with the need to reward executives for creating shareholder wealth.
Toward that end, some companies and chief executives may be relying on some of the new vehicles described below.
* Restricted stock kicker: An executive receives restricted stock at the time of the option exercise. If the executive holds the option stock for a specified number of years, the restricted stock vests. This device requires a commitment of executive funds in company stock but modifies the risk and encourages stock retention through the restricted stock grant.
* Premium price stock options: With these options, the exercise price is significantly higher than the fair market value at time of grant. Often called "opportunity" options, these devices raise company performance targets, and they can send positive signals to Wall Street.
Premium options are true "incentives" and guarantee shareholder appreciation before executives reap rewards.
* Reload options: These have become increasingly common, providing a grant of a new option, consistent with the remaining term of the original option, for the number of remaining shares used to exercise a grant. Reload options help executives finance option exercise through stock without sacrificing the shareholder linkage or diluting the executive's holding in company stock.
* Stock options in tandem with restricted stock: In this scenario, there is a calculated relationship between the number of options granted and the restricted stock award. The most beneficial choice between the two will depend on potential stock appreciation.
On a more fundamental level, the increase in ordinary income tax rates may cause compensation committees to re-emphasize the awarding of incentive stock options (ISOs). Such options permit those holding them to exercise with no immediate ordinary income tax impact and to hold the option for possible long-term capital gains treatment.
STOCK OPTIONS AND FINANCIAL PLANNING
The intricacies of these new stock programs, coupled with more complex insider trading rules and a changing tax environment, make understanding basic individual planning relative to stock options that much more critical. In planning with stock options, there are three principal choices available to the option holder:
* Exercise the option and sell the shares.
* Exercise the option and hold the shares.
* Defer exercise of the option.
At year-end 1992, a great many executives chose the first strategy, on the expectation that individual income tax rates would increase and corporate tax deductibility would be limited. The flurry of exercise and sell activity was also brought on by the change in insider trading rules that allows senior executives to exercise and sell with no risk of market fluctuation.
Under the change, CEOs and other insiders can exercise and sell stock options without incurring insider liability, as long as the sale date is at least six months after the option grant date. This SEC requirement has virtually eliminated the need for stock appreciation rights--and their inherent accounting costs. "Cashless" exercise programs can be established to allow executives to take immediate profit in company stock options without putting up any of their capital.
Absent uncontrollable variables such as stock market activity and tax rates, CEOs and other insiders often emphasize the second and third strategies listed above. The overriding financial planning issue in either of these two approaches is the risk of holding too great a percentage of company stock in their investment portfolios. While such weighting is exactly what shareholders look for, executives can manage this exposure and still meet shareholder objectives.
For example, executives can effect a "stock-for-stock" exercise, which allows them to finance an option exercise by trading in currently owned company stock. In the case of an incentive stock-option exercise, old shares tendered retain their original cost basis, and new shares carry a zero cost basis. This "pyramiding" technique enables executives to exercise their options without using personal funds, which are thus freed for other investment opportunities and diversification strategies. Moreover, because this concept does not require recognition of gain on the shares tendered, an insider can realize limited profits in company stock with no tax cost.
Even if executives use personal funds to exercise options, they can be given the ability to tender shares to meet minimum withholding requirements. This technique also allows some limited profit taking--an amount equal to the withholding--leaving cash available for other investments.
LOW-BASIS SHARES: PLANNING OPPORTUNITIES
As a result of the renewed interest in incentive stock options and the increased use of stock swaps, many to whom options are granted may hold a greater number of low-basis shares in their portfolios. These low-basis shares present planning opportunities to CEOs, executives, and their families. For example, gifting low-basis shares to children and/or grandchildren who are under the age of 14 can be a tax-efficient way to liquidate company stock. The child's basis will be the same as the donor's. And, if the child has no other income, up to $22,100 of realized gain can be taxed at 15 percent.
Low-basis company shares also can be used to meet annual charitable commitments with favorable tax results. The donor of the stock receives a charitable deduction equal to the fair market value of the stock gift without recognizing the underlying gain for tax purposes.
A more sophisticated--but increasingly common--means of using low-basis shares of company stock is to fund a charitable remainder trust. Under such an arrangement, the donor receives an income tax deduction in the year the stock is contributed, further strengthening the value of this planning technique.
RETIREMENT AND ESTATE PLANNING
For CEOs and other executives with sizable estates, reducing estate taxes is usually a major financial objective. One of the most effective means of meeting this goal is to transfer out of the taxable estate those assets that are expected to appreciate in value. Such transfers not only remove from the taxable estate the assets themselves, but also their future appreciation. If properly structured, a stock-option plan may be created to provide for limited transferability of non-qualified stock options to a trust for the benefit of one's family. This shifts the future appreciation of stock options to heirs. The value of the gift could be the same fair market value reported in the new proxy reporting requirements. The executive would remain responsible for the income tax owed upon exercise, but would realize the benefit of making a tax-free gift to his heirs.
Retirement, meanwhile, presents other financial planning issues and opportunities related to stock options. Among them is the statutory limitation on ISO exercises after 90 days from retirement. In addition, retirees encounter exercise constraints within stock-option plans themselves; for example, many plans require retirees to exercise all of their stock options within one to three years after their retirement date. Postponing exercise of stock options until the retirement years can generate unusual tax problems: triggering the alternative minimum tax through concentrated ISO exercises; creating postretirement income subject to FICA withholding even after beginning Social Security benefits; and possibly incurring double state taxation of post-retirement option exercises.
Despite the pressures affecting corporate stock-option programs, we are confident the concept of stock options is flexible enough to adapt to today's environment. As they are continually revised and fine-tuned, changing stock options will allow CEOs to continue to align themselves with shareholder interests and to use their assets as a critical tool in their financial planning.
Janet Fuersich is national partner, Compensation Planning at Coopers & Lybrand, the international accounting and consulting firm.
Thomas J. Ross Jr. is regional partner, Personal Financial Services Group with Coopers & Lybrand. Contributions to this article also were made by Allison Shipley, senior associate, Personal Financial Services.
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|Title Annotation:||CEO Finance|
|Author:||Ross, Thomas J., Jr.|
|Publication:||Chief Executive (U.S.)|
|Date:||Apr 1, 1993|
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