United States: Tax Issues Related To Discounted Stock Options

In recent months the SEC has initiated investigations of over 100 companies with respect to backdating and various other stock option practices. Much of the attention has focused on the civil and criminal securities investigations, internal and/or independent committee investigations, accounting restatements, and derivative lawsuits. However, as most or all of the affected companies and accountants will sooner or later need to understand, there are very significant tax issues which arise when corporations issue stock options at a discount from the fair market value of the stock on the date of the grant.

This alert will address the three primary federal income tax issues related to discounted stock options:

• Section 409A rules regarding deferred compensation;

• ISO vs. NSO status; and

• Section 162(m) limitations on tax deductibility of compensation paid to highest compensated officers of publicly held corporations.

A brief clarification should first be noted. The press has most often used the catch phrase "backdated options" to describe the questioned stock option practices. Executive compensation and tax professionals use the term "discounted options," which means that the options have an exercise price that is less than the fair market value of the stock on the date of the grant. If an option is discounted, the tax issues described below will generally apply, whether or not the option was backdated.

Congress enacted Internal Revenue Code section 409A in the American Jobs Creation Act of 2004, effective January 1, 2005. The statute was aimed at nonqualified deferred compensation plans in general and imposes an acceleration of income recognition as well as a 20% penalty and interest obligations on the recipient of the deferred compensation if the deferred compensation arrangement violates the requirements of the new statute.

This new statute does not apply to options which qualify as incentive stock options (ISOs), which must be granted at no less than fair market value. In addition, section 409A does not affect non-qualified stock options which are granted at no less than fair market value. Thus, the general rule for most options is that the optionee will ordinarily not recognize income until the time of exercise of the option (or upon subsequent sale of stock, in the case of ISOs). There is a deferral of the compensation income recognition until that point in time. However, in the case of discounted options, section 409A will cause an income recognition event to take place at the time the option vests, no matter when, if ever, it is exercised.

Because section 409A is so new, there is limited guidance on the specifics of how it will apply to discounted stock options and in particular with regard to the application of the penalty provisions. For example, no guidance has been issued on the actual measurement and calculation of penalties. Pending future guidance, the amount subject to the penalty tax could be based on the value of the option measured on the date of grant or the date of vesting, plus increases in that value through the date of exercise. The value of the option might be the excess of the value of the stock over the exercise price, or the "fair value" of the option determined under a Black-Scholes or similar valuation methodology.

At this point, Treasury has given some tentative guidance on the effective date rules for section 409A. The present guidance generally provides that section 409A will apply to discounted options which were:

• Granted on or after January 1, 2005, or

• Granted before 2005 but (i) not vested before 2005, or (ii) materially modified after October 3, 2004 (including grants under a program not in effect on October 3, 2004).

Under the Treasury guidance provided to date, a discounted option which would otherwise be subject to section 409A under these effective date rules is not subject to section 409A if the option was exercised or otherwise terminated on or before December 31, 2005. Of course, this rule does not help much for planning purposes in years after 2005.

However, even if a discounted option would be subject to section 409A under the above effective date rules, there are a few ways in which a company may still remedy the section 409A problem with respect to such discounted options. On October 4, 2006, the Internal Revenue Service issued a notice extending the period during which discounted options may be corrected until December 31, 2007. However, this extension does not apply to options granted to Section 16 officers of public companies which expect to report a financial expense in connection with the discount that was not timely reported. For those officers, action will still be required by December 31, 2006.

• Some companies are offering to replace the discounted options with options having an exercise price equal to the fair market value of the stock on the legal date of the grant. Companies may provide employees with some kind of compensation for the value of the lost discount. Under the applicable guidance, any compensation to employees in consideration of the increase in the exercise price of stock options cannot vest or be paid in the same year as the cancellation and reissuance. It should also be noted that there will be employment tax withholding whenever the additional consideration is paid.

• Some companies are offering to cancel the old options and pay the employees an amount equal to the Black-Scholes value of the cancelled options. Again, this amount may not be paid until a year subsequent to the cancellation of the option, and is subject to employment tax withholding.

• Some companies have offered to amend the discounted options to require that they be exercised at fixed times in the future. The fixed exercise time may generally be any date or year in the future (prior to the expiration of the option), such as the year in which the option vests; but if the employee chooses not to exercise an option at the designated time, it would have to be forfeited. While this solution may avoid the application of section 409A, it may not be an attractive solution for the employee, because the stock price may fall and the fixed period chosen for exercise may turn out to be an unfavorable time for exercising the options.

It must be noted that offers to amend options may be subject to federal securities law tender offer rules (requiring filing of Schedule TO by public companies and provision of disclosure documents and 20 business days to consider the offer).

Pending further guidance from the Treasury, it may be too late to correct discounted options exercised after 2005 and prior to correction.

The Treasury Department has announced that it plans to issue final section 409A regulations later this year.

Finally, the American Bar Association Section of Taxation and other organizations have asked Congress to repeal or narrow the scope of section 409A. They argue the new statute has created a regulatory system that is largely unnecessary, will impose enormous administrative burdens on taxpayers, their advisors, employers and others, as well as on the Internal Revenue Service and Treasury, and is not a measured response to the underlying problems.

If an employee exercised options intended to qualify as ISOs, but the options could not qualify as ISOs because the exercise price was less than fair market value on the date of grant, the employee may be subject to additional income and employment taxes (and late payment penalties and interest), and the employer may be subject to liability for failure to withhold and report.

The basic tax treatment of an ISO is quite different than the treatment of a non-qualified stock option (NSO). In essence, the primary rules are as follows:

• Upon the exercise of an ISO, the employee does not recognize ordinary compensation income, and the employer is not required to report or withhold income or employment taxes (although the option spread at exercise is included in calculating the optionee’s alternative minimum taxable income).

• Upon the sale of ISO shares prior to completion of the ISO holding periods (i.e. more than two years from the grant of the option and one year from the exercise), a portion of the gain - equal to the excess of the value of the stock on the date of exercise over the exercise price – is taxable to the optionee as ordinary compensation income.
  
  The employer does not have an obligation to withhold income or employment taxes on a premature disposition of ISO shares, but is required to report the ordinary compensation income recognized.

• Upon the exercise of an NSO, the employee recognizes ordinary compensation income equal to the excess of the fair market value of the stock on the date of exercise over the exercise price. The employer is required to report the income and withhold applicable income and employment (FICA/FUTA) taxes.

Accordingly, if a company believed that it had issued an ISO, but the option was discounted, the company would have actually issued an NSO. The company could therefore have failed to withhold applicable income and employment taxes and may have failed to report properly the amount of compensation income recognized. The company may well have to pay the amounts it should have withheld (and worry about claims by optionees) and file amended information returns. In addition, if the option is subject to section 409A, then the potential adverse tax consequences of that statute would apply.

Limits on Federal Tax Deduction for Publicly Held Companies (Section 162(m))

Discounted stock options may cause publicly held companies to lose--permanently--some significant compensation deductions.

In general, compensation paid by a company to its employees is deductible under Internal Revenue Code section 162. However, section 162(m) limits the deductibility of "non-performance based" compensation paid to certain executives of publicly traded companies. This limitation applies to the CEO and the next four most highly paid officers of such companies, and the limit is one million dollars per officer per year.

The corporation’s deduction for compensation recognized by employees at the time of exercise of non-qualified stock options (including options intended to be ISOs that were granted at a discount and therefore failed to so qualify and the deduction for ISO shares that are disposed of in disqualifying disposition) generally will not be subject to this one million dollar cap if:

• The options were granted under a plan that limits the number of options that can be granted to each person during specified periods,

• They were granted by a compensation committee of the board of directors comprised solely of two or more outside directors,

• The plan was approved by the public company shareholders, and

• The options were granted at or above fair market value (so that the amount of compensation that the employee could receive is based solely on an increase in the value of the stock after the date of the grant).

If these conditions are met, the compensation paid at exercise of such stock options is considered "performance based" compensation, and therefore not subject to the section 162(m) cap. However, if the stock options were discounted, the compensation on such discounted options is considered to be non-performance based compensation and the deduction related to those options will not be exempt from the cap which applies for each officer on a year-by-year basis.

The section 162(m) deduction limitation does not apply to payments, including payments in the form of stock options, made pursuant to a compensation plan that existed during the time when the corporation was not publicly held. This exception may be relied upon generally until the earliest of:

• The expiration of the plan or agreement,

• A material modification of the plan or agreement,

• The issuance of all employer stock that has been allocated under the plan, or

• The first meeting of shareholders at which directors are elected that occurs after the close of the third calendar year following the calendar year in which the initial public offering (IPO) occurs or the first calendar year following the calendar year in which the corporation becomes publicly held if there is no IPO.

Companies must look carefully at all the effects of section 162(m). The obvious impact is that a company which initially treated the compensation recognized on discounted stock options as performance based compensation may have overstated the compensation deductions for the CEO and next four highest paid officers. As a result, these companies will be required to amend tax returns, pay overdue taxes, and pay interest and penalties for the improper income tax deductions (or at a minimum adjust their tax reserves or deferred tax accounts).

Restatement of Financial Statements

Many of the stock options investigations being conducted today will result in restatements to the company’s financial statements to reflect the proper accounting for discounted options. In preparing these restatements, the company should also consider the tax reserve or deferred tax account changes resulting from the effects of the above-described tax rules, and also any attempts to remedy or avoid the application of section 409A.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.