The Stock Options Book
18th Edition
Alison Wright Alisa J. Baker Pam Chernoff
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The
Stock Options Book • 18th Edition
Alison Wright, Alisa J. Baker, and Pam Chernoff
Edited by Pam Chernoff
Indexed by Achaessa James Book design by Scott Rodrick
Copyright © 2004, 2005, 2006, 2007, 2008, 2009, 2010, 2011, 2012, 2013, 2014, 2015, 2016, 2017 by the authors and The National Center for Employee Ownership (NCEO). All rights reserved. No part of this book may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without prior written permission from the publisher.
The National Center for Employee Ownership 1629 Telegraph Ave., Suite 200 Oakland, CA 94612 (510) 208-1300 • (510) 272-9510 (fax) • Web: www.nceo.org
First printed May 1997; reprinted with revisions, January 1998, June 1998. Second edition, February 1999. Third edition, July 1999; reprinted with revisions, December 1999. Fourth edition, June 2001. Fifth edition, October 2002. Sixth edition, January 2004. Seventh edition, January 2006. Eighth edition, January 2007. Ninth edition, February 2008. Tenth edition, February 2009. Eleventh edition, February 2010. Twelfth edition, February 2011. Thirteenth edition, February 2012. Fourteenth edition, February 2013. Fifteenth edition, February 2014. Sixteenth edition, March 2015. Seventeenth edition, February 2016. Eighteenth edition, February 2017.
ISBN: 978-1-938220-49-4
Preface xi
Introduction 1
Part
I:
Overview of Stock Options and Related Plans
Chapter 1: The Basics of Stock Options 5
1.1 What Is a Stock Option? 5
1.2 Legal and Regulatory Framework 6
1.2.1 Tax Law 7
1.2.2 Securities Law 8
1.2.3 Accounting Rules 9
1.2.4 Miscellaneous Laws 11
Chapter 2: Tax Treatment of Nonstatutory Stock Options 13
2.1 Grant and Exercise Price 13
2.2 General Tax Rule 14
2.3 Application of Section 83 of the Code 15
2.4 Section 83(b) Election 17
2.5 Application of Section 409A of the Code 20
2.6 Employer Deduction 21
2.7 Accounting Treatment 22
Chapter 3: Tax Treatment of Incentive Stock Options23
3.1 Statutory Requirements for ISOs 24
3.2 Analysis of Statutory Requirements 26
3.2.1 ISO Plan Must Be Properly Adopted 27
3.2.2 Amendment of ISO Plan Must Be Properly Approved 28
3.2.3 Options Must Be Granted Properly 28
3.2.4 ISOs Are Only for Employees 29
iii
Contents
3.2.5 Option Exercise Price for ISOs 31
3.2.6 Limitation on Size of Option 33
3.2.7 Limitation on Term of Option 34
3.2.8 Payment for Option Shares 35
3.3 Taxation of ISO Stock 35
3.4 Alternative Minimum Tax Issues 38
3.4.1 Effect of AMT on ISOs 39
3.4.2 Effect of Disqualifying Dispositions on AMT 40
3.4.3 When to File a Section 83(b) Election for ISO AMT 40
3.4.4 Background on the AMT 41
3.5 Modifying Statutory Options 43
Chapter 4: Plan Design and Administration 49
4.1 General Considerations for the Company 50
4.1.1 Plan Perspective 51
4.1.2 Grant Perspective 52
4.1.3 Grant Acceptance 53
4.2 ISOs or NSOs? 56
4.3 Plan-Level Shareholder Approval Considerations 57
4.3.1 When Is Shareholder Approval Required? 58
4.3.2 Stock Exchange Rules 59
4.3.2.1 Shareholder Approval of Plans 59
4.3.2.2 Independence of Compensation Committee and Advisors 62
4.3.3 Proxy Advisor Influence 63
4.4 Say-on-Pay Votes 64
4.5 A Note on Plan Amendments 65
4.6 International Planning Considerations 66
4.7 Grant Timing 68
4.7.1 What Is Option Backdating? 70
4.7.2 Grant Timing: Spring-Loading, Forward-Dating, and BulletDodging 72
4.7.3 Consequences of Backdating 73
4.7.3.1 Tax Consequences 74
4.7.3.2 Accounting Consequences 75
4.7.3.3 Securities Law Consequences 76
4.7.4 Suggestions for Avoiding Backdating in the Future 77
iv THE STOCK OPTIONS BOOK
Contents v
Chapter 5: Employee Stock Purchase Plans 79
5.1 Statutory Requirements for Section 423 Plans 80
5.2 ESPP Design 84
5.2.1 ESPP Design Vocabulary 84
5.2.2 Statutory Design Limits for Section 423 Plans 85
5.2.3 Typical Structure of an ESPP: Payroll Deduction Plans 88
5.2.3.1 Enrollment Procedures/Participation Level 89
5.2.3.2 Offering Period Structure 92
5.2.4 Participating in a Section 423 Plan After Termination 96
5.3 Tax Consequences 96
5.3.1 Employee Income Taxes 97
5.3.2 Employer Taxes 100
5.3.3 Quirky Tax Outcomes for Section 423 Plans in Down Markets 101
5.4 International Planning Considerations 102
Chapter 6: Trends in Equity Compensation: An Overview 105
6.1 Aligning Equity Compensation with Shareholder Interests: Some Trends 106
6.1.1 Stock Transaction Policies 107
6.1.2 Clawbacks 108
6.1.3 Performance-Contingent Long-Term Incentives 109
6.2 Restricted Stock Awards (RSAs) 110
6.3 Restricted Stock Units (RSUs) 112
6.4 Stock Appreciation Rights (SARs) 115
6.4.1 Tax Issues: Employees 115
6.4.2 Tax Issues: Employers 116
6.4.3 Tandem SARs 116
6.5 Phantom Stock 117
Part II: Technical Issues
Chapter 7: Financing the Purchase of Stock Options 121
7.1 Broker-Assisted Cashless Transactions 122
7.1.1 Tax Issues 123
7.1.2 Insider Issues 124
7.2 Net Exercise 125
7.3 Stock Swaps 126
7.3.1 Using Nonqualified Shares to Exercise an NSO 128
7.3.2 Using Tax-Qualified Shares to Exercise an NSO 128
7.3.3 Using Nonqualified Shares to Exercise an ISO 129
7.3.4 Using Tax-Qualified Shares to Exercise an ISO 131
7.3.4.1 Using Tax-Qualified Shares for Which the Holding Period Has Been Met 131
7.3.4.2 Using Tax-Qualified Shares for Which the Holding Period Has Not Been Met 133
7.3.5 Procedure for Stock Swaps 134
7.4 Employer Loans 134
7.4.1 Recourse Notes 135
7.4.2 Collateral 136
7.4.3 Authorization in ISO Plans 136
7.4.4 Providing Adequate Interest 136
7.4.5 Loan Forgiveness 138
7.4.6 Recommendations 138
Chapter 8: Overview of Securities Law Issues 141
8.1 State Blue Sky Laws 142
8.2 Classification of Companies 143
8.3 Federal Securities Rules: Rules 144 and 701 144
8.3.1 Rule 144 Generally 145
8.3.2 Rule 144 Decision Tree 147
8.3.3 Rule 701 149
8.4 Federal Securities Rules: Section 16 151
8.5 Securities Law Information and Reporting Requirements 153
8.5.1 1933 Act: S-8 Prospectus 153
8.5.2 Exchange Act: Section 16(a) Filings 155
8.6 Exchange Act: Equity Compensation Disclosure Rules 156
8.6.1 Executives Covered by Reporting Requirements 157
8.6.2 Compensation Discussion and Analysis 157
8.6.3 NEO Executive Compensation Disclosure Tables and Related Narrative Disclosures 158
8.6.4 Special Disclosure Regarding Stock Options 160
8.6.5 Form 8-K Reporting Requirements 160
8.7 ESPP Securities Law Considerations 161
8.7.1 Securities Act of 1933 161
8.7.2 Securities Exchange Act of 1934 162
8.8 International Securities Law Issues 162
vi THE STOCK OPTIONS BOOK
Chapter 9: Tax Law Compliance Issues 165
9.1 Tax Withholding for Stock Options 166
9.2 Tax Reporting for Stock Options 169
9.2.1 Nonstatutory Options: Form W-2 or Form 1099 169
9.2.2 Statutory Options, Code Sections 422 and 423: Form W-2 169
9.2.3 Form 1099-B 170
9.2.4 FATCA Reporting 171
9.3 Section 6039 Information Reporting for Statutory Options 171
9.3.1 Information Required to Be Reported to Optionee 171
9.3.2 Tracking ESPP Qualifying Dispositions 173
9.3.3 Penalties for Noncompliance 175
9.4 Procedure for Withholding with Stock 175
9.5 Internal Revenue Code Section 409A 177
9.5.1 General Application 178
9.5.2 Specific Application of the Rules to Equity Awards 179
9.5.3 NSOs and SARs 179
9.5.4 Restricted Stock and RSUs 181
9.6 Limit on Deductions: $1 Million Cap (Code Section 162(m)) 181
9.7 Limit on Deductions: Golden Parachute Rules 185
9.7.1 When Are Options Treated as Parachute Payments? 186
9.7.2 How Are Options Valued for Purposes of Section 280G? 186
9.8 Domestic Mobile Employees 187
Chapter 10: Basic Accounting Issues189
Pam Chernoff and Elizabeth Dodge
10.1 Fair Value and Measurement Date 192
10.2 Option-Pricing Models 194
10.3 Definition of Employee 197
10.4 Recognition of Expense and Application of Estimated Forfeiture Rate 198
10.5 Equity Compensation Vehicles 200
10.5.1 Stock Options and Stock-Settled SARs with Time-Based Vesting 200
10.5.2 Stock Options with Performance Vesting 200
10.5.3 Section 423 ESPPs 201
10.5.4 Restricted Stock Awards and Restricted Stock Units 204
10.5.5 Cash-Settled SARs 204
Contents vii
10.5.6 Phantom Stock 205
10.6 Tax Accounting 205
10.7 Earnings Per Share: Diluted and Basic 207
Chapter 11: Tax Treatment of Options on Death and Divorce 209
11.1 Death 209
11.2 Divorce 211
11.2.1 Option Transfers 212
11.2.2 Tax Treatment on Option Exercise 213
11.2.3 Transfers of Optioned Stock 215
11.2.4 Securities Law Issues 215
11.2.5 Practical Issues 215
Chapter 12: Post-Termination Option Issues 217
12.1 Using Equity as Severance 218
12.1.1 Acceleration 218
12.1.2 Consulting Agreements 219
12.1.3 Extension of Exercise Period 220
12.1.4 Limitations in the Document 220
12.1.5 Tax Deductions 221
12.1.6 Inadvertent ERISA Severance Plans 221
12.1.7 Related Change-in-Status Issues 221
12.2 Forfeiture Clauses: A Note of Caution to Companies That Do Business in California 223
Part III: Current Issues
Chapter 13: Legislative and Regulatory Initiatives Related to Stock Options: History and Status 229
13.1 Legislative History: Stock Option Initiatives 230
13.2 Recent Legislation Affecting Stock Options 231
13.2.1 Sarbanes-Oxley Act of 2002 232
13.2.1.1 Loans to Executive Officers and Directors Are Prohibited 232
13.2.1.2 Forfeiture of Compensation 233
13.2.2 American Jobs Creation Act of 2004 233
13.2.3 Emergency Economic Stabilization Act of 2008 233
13.2.4 Dodd-Frank Act of 2010 235
13.2.4.1 Pay Ratio Disclosure 236
viii THE STOCK OPTIONS BOOK
13.2.4.2 Clawback Policies 237
13.2.4.3 Pay vs. Performance 238
13.2.4.4 Requirements Specific to Financial Institutions 239
13.2.4.5 Disclosure of Hedging by Employees, Officers, and Directors 239
13.2.5 Jumpstart Our Business Startups Act of 2012 239
Chapter 14: Cases Affecting Equity Compensation 241
14.1 Tax Cases and Rulings 242
14.1.1 Tax Decisions in the Courts 242
14.1.2 IRS Rulings and Announcements 244
14.1.2.1 Corporate Matters 245
14.1.2.2 Individual Matters 246
14.1.2.3 Stock Plan Administration 248
14.2 Securities-Related Matters 249
14.3 Contract Cases Related to Stock Options 252
14.3.1 Waiver, Oral Modification, and Related Claims 253
14.3.2 Inconsistent Documents and Ambiguous Language 255
14.4 Equity Issues Related to Employment Disputes 259
14.4.1 Effects of Termination 260
14.4.2 Equity as Wages 261
14.4.3 Noncompete Agreements, Recaptures, and Stock Option Forfeitures 267
14.4.4 Treatment of Equity in Corporate Transactions 268
Chapter 15: Transferable Options 271
15.1 Why the Interest in TSOs? 271
15.2 Limits on TSOs 272
15.2.1 Regulations on Option Transfers to Related Parties 275
15.3 Recommendations 276
Chapter 16: Reloads, Evergreens, Repricings, and Exchanges 277
16.1 Reloads 278
16.2 Evergreen Provisions 279
16.2.1 Tax Limitations 279
16.2.2 Nonapproved v. Approved Plans 280
16.3 Repricing Programs 281
16.3.1 Corporate Considerations 281
16.3.2 Tax Considerations 283
Contents ix
16.3.3 Securities Law Issues 283
16.3.4 Accounting Issues 285
16.3.5 Stock Exchange Listing Requirements 286
16.3.6 Proxy Advisory Guidelines 286
Appendixes
Appendix 1: Designing a Broad-Based Stock Option Plan 291 Corey Rosen
Appendix 2: Primary Sources 311
Section 83 of the Internal Revenue Code 312
Section 162 of the Internal Revenue Code 314
Section 280G of the Internal Revenue Code 321
Section 421 of the Internal Revenue Code 325
Section 422 of the Internal Revenue Code 327
Section 423 of the Internal Revenue Code 329
Section 424 of the Internal Revenue Code 332
Section 1041 of the Internal Revenue Code 335
Section 4999 of the Internal Revenue Code 336
Section 6039 of the Internal Revenue Code 336
Section 16 of the Securities Exchange Act of 1934 337
SEC Rule 144 340
SEC Rule 701 354
Glossary 359
Bibliography 369 Index 371 About the Authors 389 About the NCEO 392
x
STOCK OPTIONS BOOK
THE
Preface
Welcome to the 18th edition of The Stock Options Book. We continue to be amazed at the ever-evolving body of law and lore in our field. A version of this text has been on the shelves since 1997, but at the time of its first publication, no one could have predicted the extent to which the entire field of executive compensation in general, and equity compensation in particular, would become a cause célèbre. Attempts to rein in perceived executive greed have given rise to enormous changes since the inception of this publication, including major substantive revisions to the laws and regulations governing the tax, securities, accounting, and corporate treatment of equity-based compensation. It has been a wild ride.
The 18th edition continues our practice of fully updating and refining each prior year’s materials. Alison Wright, a partner at the law firm Hanson Bridgett LLP, and Pam Chernoff, who has been editing the book since 2005, are responsible for updating the book, which was authored by Alisa J. Baker between 2002 and 2012.
As always, we hope you find this edition useful in your practice. Please continue to let the NCEO know which issues concern you the most and how you would like to see them addressed. You can send any comments to customerservice@nceo.org.
Alison Wright
Pam Chernoff
December 2016
Thanks to Susan Berry, CEP, for her invaluable contribution to the alwayschallenging “stock swaps” section of chapter 7; to Brennan Latham, CEP, for his help with the section on broker-assisted cashless transactions; and Ellie Kehmeier for her help with the tax accounting portions of chapter 10.
xi
xii THE STOCK OPTIONS BOOK
The Basics of Stock Options
Contents
1.1 What Is a Stock Option? 5
1.2 Legal and Regulatory Framework 6
1.2.1 Tax Law 7
1.2.2 Securities Law 8
1.2.3 Accounting Rules 9
1.2.4 Miscellaneous Laws 11
1.1 What Is a Stock Option?
Generally, when an individual is granted a compensatory stock option, that individual (the “optionee”) receives a contractual right to purchase shares in a corporation for a fixed term at a fixed price—in most cases, the fair market value of the stock on the date the option was granted. Companies typically grant options to employees, consultants, or other persons providing services to the company to encourage their retention and participation in the success of the company. The optionee typically earns the right to the shares over a stated vesting period. Once the option vests, the optionee can choose when and if to exercise it (i.e., purchase the underlying shares). (Some plans allow for exercise prior to vesting, which is discussed in chapters 2 and 3.)
This book discusses stock options granted in connection with the performance of services only, as opposed to options purchased for investment purposes. The tax treatment of stock transferred pursuant to compensatory stock options is governed by the Internal Revenue Code (the Code). Sections 421 to 424 of the Code govern statutory options that are eligible for favorable tax treatment, while Section 83 of the
5
Chapter
Code governs nonstatutory options. Different rules apply to determine the amount, character, and timing of the optionee’s income inclusion as well as the availability of the corporate tax deduction when options are granted or exercised.
Most (although not all) compensatory options are granted pursuant to the employer company’s stock option plan.1 Companies generally adopt stock option plans that permit the grant of both incentive stock options (ISOs) and nonstatutory stock options (NSOs). NSOs are sometimes also referred to as nonqualified stock options and abbreviated as NQSOs. An ISO is a statutory option, subject to the technical requirements prescribed in Section 422 of the Code. ISOs may be granted only to employees of the issuing company (including employees of its parent and subsidiary corporations). Taxation of NSOs is governed by Section 83 of the Code. NSOs are not subject to special technical requirements for income tax purposes and may be granted to employees, consultants, nonemployee directors, or any other persons providing services to the company. They do not receive preferential tax treatment under the Code.
Employee stock purchase plans (ESPPs), which are another form of option plan employers can use to attract, retain, and motivate employees, may be either statutory (under Section 423 of the Code) or nonstatutory (under Section 83 of the Code). Because ESPPs are subject to distinct planning and tax considerations, they are discussed separately in chapter 5.
1.2
Legal and Regulatory Framework
As we will see throughout the book, the laws and regulations governing stock options are complex and ever-changing. Options are subject to tax and securities laws and regulations and accounting standards that often diverge in their requirements. In the federal tax and securities arenas, once a bill is signed into law, federal agencies are charged with interpreting and enforcing it.2 Those agencies then promulgate binding regulations that govern the application of the laws. Proposed regulations generally go through a comment period during which interested
1. When used for tax purposes, the term “compensatory option” may have a different meaning than when used for accounting purposes. See chapter 10, “Basic Accounting Issues.”
2. The legislative history of stock options is discussed in detail in chapter 13.
6 THE STOCK OPTIONS BOOK
parties (such as stock plan professionals) can review them and make suggestions to the agency that is responsible for them. In addition, a body of case law has developed as various stock-option-related matters have been litigated. Recent developments in case law, as well as current agency rulings, are discussed in detail in chapter 15.
The accounting rules are unusual in that the Securities and Exchange Commission (SEC) has delegated its authority to set and interpret financial accounting standards to a private body called the Financial Accounting Standards Board (FASB).
In all three arenas (tax, securities, and accounting), compliance with complicated laws, regulations, or standards is sometimes made easier by the inclusion of a list of requirements called a “safe harbor.” Companies that adopt safe harbor provisions are considered to have automatically satisfied the associated rule or law and are shielded from legal responsibility. Companies using a safe harbor may be sheltered from more complex compliance testing. For example, the SEC’s Rule 144 is a safe harbor exemption that allows optionees who are not issuers, dealers, or underwriters to publicly resell stock (acquired on exercise) that otherwise would be restricted for securities law purposes under Section 4(1) of the Securities Act of 1933. To do so, the optionee must follow all of the rule’s requirements.
In designing and administering stock option plans, practitioners must pay equally careful attention to tax, securities, and accounting issues, because they are distinct bodies of law and regulation. For instance, a transaction or plan design feature that is legitimate for tax purposes might not work for securities law purposes. An example of this arises when a company CEO wants to sell shares purchased by exercising an ISO. The CEO may well have satisfied the statutory holding period under the Code, making him eligible for preferential tax treatment on sale. However, he may nonetheless be barred from selling his shares by securities laws that do not allow him to buy or sell shares if he is in possession of “material nonpublic information” that would give him an advantage over other investors.
1.2.1 Tax Law
The Internal Revenue Service (IRS), an agency of the U.S. Department of the Treasury, is authorized to promulgate Treasury regulations that
The Basics of Stock Options 7
interpret and elaborate upon the Code. Thus, in many cases throughout the book, references to Code sections are interspersed with references to the corresponding Treasury regulations. While a specific section of the Code may be only a few pages long, the corresponding regulations can be much longer as they delve into much more detailed discussions of what the Code does and does not allow and in some cases offer examples of specific applications. For example, the portion of Section 422 of the Internal Revenue Code that describes the maximum value of stock options that may become exercisable in a given year and still be considered to be ISOs is just three short paragraphs, while the corresponding regulations take up four pages of the Code of Federal Regulations. In addition to the Code itself and Treasury regulations, the IRS occasionally rules on specific circumstances. Its revenue rulings and revenue procedures officially interpret the Code and its related statutes and regulations. Taxpayers can rely on them in determining how to proceed on a specific issue. IRS notices are pronouncements that may provide substantive interpretations of the law and may provide guidance on the substance of forthcoming regulations. In addition, when a taxpayer has questions about how to handle a specific circumstance, it can request a private letter ruling (PLRs). These do not set precedent; they apply only to the taxpayers to whom they are addressed. However, they are often studied as an indication of the IRS’s views on certain issues about which there has been little previous guidance. Other forms of IRS guidance are also available; these are described in more detail in section 15.1 of chapter 15.
1.2.2 Securities Law
The SEC is charged with oversight and enforcement of federal securities laws, which are designed to protect investors by ensuring that adequate information is available to them and by prohibiting fraud in the sale of securities. The primary securities laws that affect stock options are the Securities Act of 1933 and the Securities Exchange Act of 1934, which Congress passed in the hope of restoring investor confidence after the stock market crash of 1929. The 1933 Act requires that securities be registered with the SEC before they are sold unless they qualify for an exemption from registration. The 1934 Act is a far-reaching law that
8 THE STOCK OPTIONS BOOK
9
includes requirements for corporate reporting, proxy solicitations, tender offers, and trading by corporate insiders. Both have since been amended by subsequent legislation, most recently by the Dodd-Frank Act of 2010 and the Jumpstart Our Business Startups (JOBS) Act of 2012.
As the IRS does with tax laws, the SEC promulgates legally binding regulations that interpret the securities laws. Many regulations have built up around the 1933 and 1934 acts in the 75-plus years since their passage. The regulations that affect stock options and other forms of equity compensation are discussed in detail in chapter 8. Regulations aside, the SEC has numerous avenues for making public pronouncements. The commission itself occasionally issues interpretive releases that reflect its views of legal and regulatory issues. Additionally, the commission’s staff issues periodic legal bulletins that are not legally binding but may be indicative of their views on certain issues about which there has been little published guidance. In other cases, when an issuer of securities, such as a company granting stock options, asks the SEC for a ruling on a specific set of circumstances, the agency will issue a no-action letter saying that as long as the issuer does exactly what it proposes, the agency will not seek enforcement action for an alleged violation of securities laws.
The SEC has delegated regulatory authority for stock markets such as the New York Stock Exchange (NYSE) and Nasdaq to the Financial Industry Regulatory Authority (FINRA), which was created in 2007 to consolidate the regulation of U.S. exchanges with one body. FINRA is a self-regulatory organization, meaning it is a non-governmental entity with the power to create and enforce regulations.
In addition to federal securities laws, most states have their own securities laws that apply to private companies. These are known as “blue sky laws.” The term apparently originated with judicial characterizations of “speculative schemes which have no more basis than so many feet of ‘blue sky.’”
1.2.3 Accounting Rules
The Securities Exchange Act of 1934 gives the SEC the authority to set accounting standards, but the agency has historically delegated that authority to a private-sector organization. That organization, the FASB,
The
Basics of Stock Options
is responsible for both establishing financial accounting standards and offering guidance on the implementation of those standards. The SEC retains the authority to veto FASB decisions and to punish companies that fail to follow FASB standards.
All of the authoritative pronouncements that make up U.S. generally accepted accounting principles (GAAP) are arranged by topic, subtopic, section, and paragraph in a codified system. In the case of stock options, the most notable FASB standard is Accounting Standards Codification Topic 718 (ASC 718). The portions governing compensatory equity granted to nonemployees are part of ASC 505.
The SEC’s staff occasionally issues accounting bulletins that interpret accounting rules as they pertain to securities laws. For example, Staff Accounting Bulletin (SAB) Topic 14, Share-Based Payment (previously SAB No. 107 (SAB 107)), describes the SEC’s interpretation of ASC 718 as it pertains to stock option valuation.
In 1984 FASB created the Emerging Issues Task Force (EITF), which is charged with addressing new issues that arise before widespread practice develops that complicates rulemaking. In the late 1990s and early 2000s, the EITF addressed many issues related to stock option accounting. However, because equity compensation accounting has been on FASB’s front burner in recent years, the EITF has had little to do in the area of late.
Accounting standards updates (ASUs) give notice of changes to the codified standards. According to the FASB website, “An Update is a transient document that (1) summarizes the key provisions of the project that led to the Update, (2) details the specific amendments to the FASB Codification, and (3) explains the basis for the Board’s decisions. Although ASUs will update the FASB Codification, the FASB does not consider Updates as authoritative in their own right.” Once the comment period on an ASU has lapsed, any resulting modifications to authoritative GAAP are made within the codification system, regardless of the source of the updates or whether the changes are substantive or editorial.
10 THE STOCK OPTIONS BOOK
1.2.4 Miscellaneous Laws
In addition to the rules described above that specifically address equity compensation, such as stock options, many other laws affect the use of stock in exchange for services. Federal and state labor laws, state employment laws, the federal Employee Retirement Income Security Act of 1974 (ERISA), state corporate and choice of law rules, and general common law contract principles all have a bearing on how and when equity can be used as compensation. The cases discussed in chapter 15 offer some insight into how these areas of the law interact with technical equity compensation issues.
The Basics of Stock Options 11
12 THE STOCK OPTIONS BOOK
Tax Treatment of Nonstatutory Stock Options
Contents
2.1 Grant and Exercise Price 13
2.2 General Tax Rule 14
2.3 Application of Section 83 of the Code 15
2.4 Section 83(b) Election 17
2.5 Application of Section 409A of the Code 20
2.6 Employer Deduction 21
2.7 Accounting Treatment 22
Section 83 of the Code governs the tax treatment of property transferred in connection with services (as opposed to the payment of cash for services). For these purposes, the NSO transaction is no different than any other form of service-related property transfer: the service recipient (the company) receives services from the service provider (the employee, director, or contractor) in exchange for payment with property (in this case stock, but it also could be any other form of real or personal property). This chapter discusses the ways in which the general rule of Section 83 applies to NSOs.
2.1 Grant and Exercise Price
Who can receive grants? NSOs may be granted not only to employees, but also to outside directors and independent contractors who are not employees of the company. NSOs may be granted under an employee stock option plan or under a separate contract outside of a plan. In
13
each case, the grant and exercise of NSOs will be subject to applicable securities laws (including blue sky laws). In privately held companies, NSOs granted outside of a plan are not eligible for state or federal securities law exemptions for sales made under an employee plan. Separate exemptions will need to be relied upon for such grants.1 In publicly held companies, federal securities laws may apply to limit the exercise of options by public company “insiders” under Section 16(b) of the Securities Exchange Act of 1934, as further described in section 2.3 of this chapter.
What constitutes an appropriate exercise price? The federal income tax laws impose no statutory limit when it comes to setting the exercise price of an NSO. They may be granted at fair market value, at a premium over fair market value, or at a discount to fair market value without triggering a tax event at grant 2 However, Section 409A of the Code provides a serious disincentive to granting NSOs at a discount by imposing steep taxes and penalties on the recipients of such options at vesting if the time of exercise is not fixed at the date of grant, as described below. Note, too, that there may be other limitations on setting the exercise price: for example, in a private company, state corporate and/or securities laws may place a limit on the NSO discount.
2.2 General Tax Rule
An individual service provider who has been granted an NSO will be subject to income tax only at the time the option is exercised, unless Section 409A of the Code applies (and other conditions are not met) or the option is exercised before it becomes vested (see below). The amount taxed will be the spread between the exercise price and the fair market value of the stock at time of exercise. As a general rule, the
1. See, e.g., “the accredited investor” exemption in Section 4(6) of the 1933 Act; California Commissioner’s Rules 25102(f) (personal knowledge exemption).
2. Note, however, that if the exercise price is too deeply discounted, the IRS has indicated the grant could be considered to be an outright grant of stock and taxed at grant or vesting. In this case, the exercise price is not considered a barrier to stock ownership.
14 THE STOCK OPTIONS BOOK
company will be entitled to take a tax deduction in an amount equal to the amount included in income by the optionee.3
For the optionee, any appreciation in the stock’s fair market value between the exercise date and the sale of the shares acquired upon exercise will be treated as capital gain, which will be long-term if the shares are held for more than one year or short-term if the shares are held for one year or less. If the stock price drops between exercise and sale, the result will be a capital loss. The holding period for capital gain or loss purposes generally begins at the date of exercise (with the narrow exception of stock acquired one-for-one in a stock swap, described in chapter 7).
An exception to the general rule occurs when the NSO has a “readily ascertainable fair market value,” as determined under Treas. Reg. § 1.83-7. In such rare cases, the option may be taxed on the date of grant. Ordinarily, an NSO will not have a readily ascertainable fair market value unless the option itself is publicly traded on an established securities market.
2.3 Application of Section 83 of the Code
As described above, the spread on exercise of an NSO represents compensation income to the optionee and accordingly is subject to the special rules of Section 83(a) of the Code that govern the timing of income inclusion for tax purposes. Under Section 83(a), the value of property (in this case, stock) received for services must be included in income in the year the optionee’s rights to the property become “vested.” Section 83(c) provides that vesting occurs at the first time an optionee’s rights in the property are (1) transferable or (2) not subject to a “substantial risk of forfeiture.” When a vested NSO is exercised, the property (in this case the stock acquired on exercise) is vested and is not subject to a substantial risk of forfeiture. Thus the optionee is taxed on the exercise of the NSO.
For these purposes, a substantial risk of forfeiture exists when the transfer of property (1) is conditioned on the performance or nonperformance of substantial services in the future, or (2) is subject to a condition related to a purpose of the transfer and there is a substantial possibility of forfeiture if the condition is not satisfied. As a general rule,
3. Section 83(h) of the Code; Treas. Reg. § 1.83-6(a).
Tax Treatment of Nonstatutory Stock Options 15
the determination of whether a condition constitutes a substantial risk of forfeiture is based on the relevant facts and circumstances. However, under the regulations to Section 83(c) of the Code, a substantial risk of forfeiture exists if: (1) there is an expectation of regular and timeconsuming future services; (2) the transfer of stock to an underwriter is conditioned on the successful completion of a public offering; or (3) return will be required if earnings of the company do not meet certain milestones.
A requirement for repurchase at fair market value, the risk that the value of the property will decline over a period of time, and nonlapse restrictions do not by themselves mean an award is subject to a substantial risk of forfeiture. Examples of conditions that do not create a substantial risk of forfeiture are: (1) a request for services in the future that may be declined by the employee; (2) a requirement that property be returned if the employee commits a crime (a clawback); (3) a covenant not to compete when there is little likelihood that it will need to be invoked or that it will be enforced; and (4) a requirement of future consulting services by a retired employee that is likely to be neither enforced nor fulfilled.4 Furthermore, with one important exception, “insider trading” restrictions that limit transferability after exercise do not constitute a substantial risk of forfeiture for these purposes. In Rev. Rul. 2005-48, the IRS ruled that a post-exercise lockup period that took effect eight months after grant did not present a substantial risk of forfeiture, notwithstanding the limitations imposed on the optionee by the company’s insider trading policy. Under final regulations to Section 83 that were published in March 2014, the IRS further clarified that neither the potential that a company might claw back stock or options under some circumstances nor insider trading restrictions constitute a substantial risk of forfeiture.
A substantial risk of forfeiture does exist, however, for public company officers, directors, or more-than-10% shareholders within six months of grant, provided that the option grant and any exercise that occurs within those six months are subject to Section 16(b) of the Securities Exchange Act of 1934. Under Section 83(c)(3) of the Code, stock is considered to be restricted if its beneficial owner could be subject to suit upon sale of the stock under Section 16(b) of the Securities Exchange Act of 1934 and is not otherwise exempt. As described in 4. Treas. Reg. § 1.83-3(c)(2).
16 THE STOCK OPTIONS BOOK
chapter 8, the Exchange Act provides a six-month short-swing profits period during which time any insider who sells and purchases shares must disgorge any profit to the company. The insider is subject to suit by the company for any profit realized during the six-month period. Treas. Reg. § 1.83-3(j)(1) provides that, for purposes of Section 83(a), the Section 16(b) restriction lapse at the earliest of: (1) the end of the Section 16(b) six-month period, or (2) the first day that sale at a profit will not subject the holder to suit.5
2.4 Section 83(b) Election
Some companies allow optionees to exercise unvested NSOs. In such cases, the company retains a right to repurchase the shares for the lower of the option exercise price or the stock’s fair market value at the time of repurchase until the stock becomes vested. When full vesting does not occur in the year of exercise, tax is deferred until the restrictions lapse. This means that if the value of the stock appreciates between the date of exercise and date of vesting, the optionee will be subject to tax on a greater spread than the spread at the date of exercise. The tax (and in the case of an employee, the associated withholding) will be due regardless of whether the optionee sells or otherwise disposes of the stock in order to finance the liability.
To avoid an unknown future tax event, an optionee who exercises unvested options may wish to file an election under Section 83(b) of the Code, which allows the optionee to “freeze” the compensation element of the spread (if any) on exercise and pay tax in the year of exercise as if the stock were already vested. If the election is filed timely, there will be no tax consequences as the stock vests. In other words, filing the election avoids ordinary income tax on any appreciation between the date of exercise and the date of vesting but does not avoid ordinary income tax on the excess of fair market value on the date of exercise over the exercise price. Exhibit 2-1 gives an example of taxation with and without a Section 83(b) election.
The drawback to a Section 83(b) election occurs if the stock is forfeited or depreciates in value after exercise of the option. In that
5. See also Tanner v. Comm’r, 117 T.C. 2001 (construing 16(b) restriction period for purposes of Section 83(c)(3)).
Tax Treatment of Nonstatutory Stock Options 17
