PLANNED GIVING & ENDOWMENTS
MAY 31, 2007
Outline and Presentation by
Howell Bramson, Esq.
McCarthy Fingar LLP.
11 Martine Avenue
White Plains, New York 10606
This outline covers various ways to compensate key employees using non-ERISA compensation plans. Most of the outline covers the types of equity compensation plans. The final part of the outline covers non-equity deferred compensation plans. Section 409A, enacted as part of the American Jobs Creation Act of 2004, must be considered when dealing with non-qualified deferred compensation plans.
In general, Section 409A provides that if a nonqualified deferred compensation plan fails to satisfy specific requirements related to timing of elections and distributions and to funding, amounts deferred under the plan for the current taxable year and all preceding taxable years are includable in gross income to the extent not subject to a substantial risk of forfeiture and not previously included in income.
I. Equity Compensation Plans
Equity compensation plans can be broadly divided into three categories: (1) actual equity ownership, such as restricted stock plans; (2) potential equity ownership plans, such as stock options; and (3) those plans which do not result in actual or potential equity ownership but give a contractual right to a cash payment based on appreciation in the company's value, such as stock appreciation rights. Each of these equity compensation plans aligns the employee's interest with the interest of the shareholders by rewarding the employee for increases in stock value. Most plans are subject to vesting provisions that are tied to continued employment, company performance goals, or more specific performance goals tailored to the individual employee or the division.
A. Restricted Stock Awards.
1. Description. A restricted stock award is the grant of stock or sale of stock at market value or discounted value to an employee subject to a vesting schedule. Unvested shares are typically subject to forfeiture or resale to the company at the original purchase price upon the employee's termination of employment or resignation.
2. Employee's Tax Consequences.
a. Grant. No tax upon receipt of unvested restricted stock, unless the
employee make the Section 83(b) election as discussed below. IRC § 83(a).
b. Disposition Prior to Vesting. An arm's-length disposition of restricted stock will trigger compensation income equal to the value of the stock as of the date of the disposition less any amount paid for the stock. Treas. Reg. § 1.83-1(b)(1). A non-arm's-length disposition such as a gift or contribution to a related entity does not close the compensation element and the employee is still subject to tax when the stock becomes vested even though the employee no longer owns the stock. Treas. Reg. § 1.83-1(c).
C. Vesting. Employee recognizes compensation income (i.e., ordinary income) when restricted stock is transferable or no longer subject to substantial risk of forfeiture (i.e., upon vesting). IRC § 83(a). Amount of gain at time of vesting equals the difference between fair market value of the stock at that time less any amount paid for the stock. IRC § 83(a). The employee's holding period begins at time of vesting for purposes of the one-year requirement for long-term capital gains and the five-year requirement for the 50% exclusion under Section 1202. IRC § 83(f). For purposes of determining fair market value, restrictions on the stock such as securities law, lock-up, and similar restrictions are ignored. IRC § 83(a). The only restriction that is taken into account in determining value is one that by its terms will never lapse such as a buy-sell agreement. IRC § 83(a).
d. Sale of Stock. Future appreciation in stock is taxed as capital gain when employee sells stock. If the employee held the stock for one year from the vesting date, then the 20% long-term capital gains rate will apply.
e. Section 83(b) election
(1) The value of restricted stock may increase substantially prior to vesting, resulting in a large ordinary income tax liability for the employee upon vesting. Moreover, at the time the restricted stock becomes vested it may still be illiquid, resulting in phantom income to the employee (i.e., taxable income with no cash).
(2) An employee can avoid this result by making an election under Section 83(b) to recognize compensation income at the time restricted stock is granted. Amount of compensation income is the difference between fair market value of stock at time of grant less any amount paid for stock. Fair market value is determined without regard to any restrictions other than restrictions which by their terms will never lapse. A Section 83(b) election also starts the employee's holding period. IRC §83(f).
(3) Any future appreciation in stock value from grant date is taxed as capital gain when employee sells stock. If the employee held the stock for one year from the original grant, then the 20% long-term capital gains rate will apply.
(4) The Section 83(b) election must be filed with the IRS within 30 days after employee receives the restricted shares. This is an absolute deadline with no exceptions.
(5) The Section 83(b) election can provide employees substantial tax benefits under the right circumstances. The election is usually made when the stock has little value when received, or when employee paid close to fair market value for the stock, and employee anticipates stock value to appreciate substantially during the vesting period.
3. Employer's Tax Consequences
a. Deduction. Employer receives tax deduction for restricted stock at the time the employee recognizes compensation income in an amount equal to the employee's income. IRC § 83(h).
b. Requirements for Deduction. The regulations provide that the employer is entitled to the deduction if the employee “included the amount in income.” Treas. Reg. § 1.83-6(a)(1). Significantly, an employee will be deemed to have included the amount in income if the employer timely satisfies applicable Form W-2 or Form 1099 reporting requirements. Treas. Reg. § 1.83-6(a)(2). Under this deemed inclusion rule, employers will be entitled to the deduction if they satisfy the reporting requirements even if they fail to withhold and the employee fails to report the income. Thus, employers should carefully comply with the reporting requirements to preserve their deduction.
C. Withholding Requirements. Although companies are not required to withhold in order to obtain the tax deduction, companies are still required to withhold and pay applicable income and employment taxes. Failure to do so can subject employer to liability for the taxes that should have been withheld plus interest and penalties.
4. Summary of Restricted Stock Advantages.
a. Substantial tax benefits to the employee if stock is issued when the value is low. The employee can make the Section 83(b) election and thereby preserve capital gains treatment and potential Section 1202 exclusion on all future appreciation in the value of the stock. Thus, restricted stock plans are especially popular for founders and other senior executives in start-up companies.
b. Gives employee an immediate ownership interest in company.
5. Summary of Restricted Stock Disadvantages.
a. Potential for substantial phantom ordinary income. If the stock value is high when issued, the employee would likely not make the Section 83(b) election. Instead, the employee would be taxed when the stock became vested, potentially resulting in substantial phantom ordinary income if the employee cannot immediately sell a portion of the stock. Thus, restricted stock plans are usually not a viable choice for private companies with substantial current value, unless the company expects to be public when the restricted stock becomes vested and the employee would be able to sell, a portion of his stock to avoid phantom income.
b. Employee shareholders have certain state law rights such as right to:
(1) Receive notice of meetings;
(2) Inspect company's books and records; and
(3) Hold the company and its controlling shareholders accountable
for fiduciary duties.
c. Issuance of restricted stock to employees may make employer less attractive to venture capitalists or other financiers who do not wish to see such dilution without a corresponding cash inflow at the stock's fair market value.
B . Stock Option Plans.
1. Description. Stock options are the most common equity compensation plan. A stock option is a right to buy stock at the exercise price at some point in the future. Exercise of stock options is typically subject to vesting provisions. Unvested options are forfeited upon the employee's termination or resignation. There are two types of stock options: incentive stock options ("ISOs") and nonqualified stock options ("NQOs"). ISOs are options that provide employees favorable tax consequences under Section 422. ISOs must meet the rigid requirements set forth in Section 422. Any option that does not meet the ISO requirements is an NQO. Section 409A does not apply to ISOs, but does apply to NQOs unless certain conditions are met.
2. Incentive Stock Options.
a. Employee's Tax Consequences
(1) Grant. No tax upon the grant of an ISO. IRC § 421 (a).
(2) Exercise. No tax upon the exercise of an ISO except may be subject to alternative minimum tax ("AMT") as discussed below. IRC § 421 (a).
(3) Sale of Stock. Full appreciation in value of the stock is subject to tax at the capital gains rate when the stock is sold. Thus, ISOs provide two benefits: (i) employees generally defer tax until the underlying stock is sold; and (ii) all of the gain is treated as capital gains.
b. Employer's Tax Consequences
(1) No Deduction. No deduction for employer upon either the grant or exercise of an ISO or the employee's sale of the underlying stock. IRC § 421(a)(2).
(2) Reporting Requirements. Employer must furnish a statement to each employee who exercises an ISO during the year by January 31 of the following year setting forth: (i) the employer's name, address, and taxpayer identification number; (ii) the name, address, and taxpayer identification number of the person to whom the ISO shares are transferred; (iii) the name and address of the corporation issuing the ISO stock if different from the employer corporation; (iv) the ISO grant date; (v) the ISO exercise date; (vi) the fair market value of the stock on the exercise date; (vii) the number of ISO shares transferred upon exercise of the ISO; (viii) statement that the option was an ISO; and (ix) the exercise price. IRC § 6039(a)(1); Prop. Treas. Reg. § 1.6039-2(a).
C. Example of ISO Tax Consequence
Year 1: ISOs for 5,000 shares granted at $8 exercise price when fair
market value of stock is $8.
Year 3: ISOs are exercised when fair market value of stock is $12.
Year 5: Employee sells stock for $16.
Year I Grant:
Employee has no income,
Employer has no deduction.
Year 3 Exercise:
Employee has no income (except for potential AMT)
Employer has no deduction
Year 5 Sale
Employee has $40,000 capital gain ($80,000 - $40,000
exercise price) resulting in $8,000 tax (at 20% capital gains
Employer has no deduction.
Cash Flow Consequences
Employee receives $32,000 ($80,000 - $40,000 exercise price - $8,000 capital gains tax).
Employer has no cash flow benefit in ISO situation.
d. Holding Period Requirement and Disqualified Dispositions
(1) To obtain the favorable ISO tax consequences, employees must hold the stock received on the exercise of an ISO for the later of (i) 2 years from the grant of the ISO or (ii) 1 year from the exercise of the ISO. IRC § 422(a)(1). Thus, both holding periods must be satisfied.
(2) Failure to satisfy the holding period requirement does not disqualify the ISO but rather results in a disqualifying disposition. Any gain recognized by the employee on a disqualifying disposition will first be treated as ordinary income to the extent of the difference between the stock's fair market value on the date the ISO was exercised and the exercise price. IRC §421 (b). Any remaining gain will be treated as long-term capital gain if the employee held the stock after the exercise of the ISO for at least one year or short-term capital gain if the employee did not hold the stock for a year.
(3) The employer is entitled to a deduction in the year of a disqualifying disposition in an amount equal to the employee's ordinary income recognized on the disqualifying disposition. To ensure that it is entitled to the deduction under the deemed inclusion rule discussed in Part III(A)(2)(b) above, the employer should file Form W-2 on or before the due date for the employer's return for the year in which it is claiming the deduction.
(4) In many cases, employees will not satisfy the requirement that they hold the stock for one year from the exercise date. This is especially true for employees who hold ISOs in a start-up company that goes public or a company that is sold.
e. Alternative Minimum Tax Adjustment
Although the exercise of an ISO does not result in a regular tax liability, the exercise may result in the 26% or 28% AMT. The difference between the fair market value of the ISO stock on the exercise date and the exercise price is treated as an adjustment for AMT purposes. IRC § 56(b)(3). The starting point in calculating AMT is the taxpayer's regular taxable income. The taxable income is then adjusted upwards and downwards for the AMT adjustments such as the ISO adjustment and the AMT exemption amount to arrive at alternative minimum taxable income ("AMTI"). AMTI is then multiplied by the AMT rate of either 26% or 28% depending on the amount of AMTI. If the resulting amount exceeds the taxpayer's regular tax liability, the excess amount is the taxpayer's AMT.
f. ISO Requirements. ISOs must meet each of the statutory requirements set forth in Section 422. Failure to satisfy any requirement will result in the ISO being treated as an NQO.
(1) Employees of Granting Corporation or Affiliated Corporation. ISOs can be granted only to employees of the corporation granting the ISOs or a parent or subsidiary corporation of the granting corporation. IRC § 422(a)(2).
(a) Employees Only. ISOs may be granted only to employees. Whether an individual is an employee is determined under the withholding tax rules of Section 3401(c), which generally follow the common law factors. Treas. Reg. § 1.421-7(h)(1); Ellison v. Commissioner, 55 T.C. 142 (1970), acq. 1971-1 C.B. 2. Thus, ISOs may not be granted to directors or independent contractors.
(b) Termination of Employment. If the recipient of an ISO leaves employment for any reason, including death, then the employee or his legal representative must exercise the ISO within 3 months in order to preserve the ISO treatment. The only exception is if the employee leaves due to a disability, in which case the 3 -month period is extended to one year. IRC § 422(c)(6). Leaves of absences of less than 90 days for whatever reason are not considered leaving employment. Treas. Reg. § 1.421-7(h)(2). If the leave extends beyond 90 days, however, employment will be considered terminated at the end of the 90-day period and the employee has 30 days from that date to exercise the ISO.
(c) No Nondiscrimination or Coverage Rules. There are no nondiscrimination or coverage requirements like there are for qualified plans. Thus, ISOs can be granted to whichever employees the employer desires, including only to highly compensated employees.
(2) Plan Requirements. ISOs must be granted pursuant to a plan that (i) states the aggregate number of shares that may be issued to employees; (ii) specifies the eligible employees or class of employees; and (iii) is approved by shareholders 12 months before or after the date that the plan is adopted by the Board of Directors.
(a) Addback Provisions. Plans which provide that shares received by the company on a share-for-share exercise go back into the plan may not satisfy the ISO requirement that the plan specify the maximum number of shares which can be issued under the plan. A potential solution is to add language that the recycled shares could only be issued for nonqualified options. Alternatively, a definite limit could be set on the number of shares which can go back into the plan.
(b) Evergreen Provisions. Companies may want to automatically add more shares to the plan each year without having to get shareholder approval to replenish an option plan. Alternatively, companies may want the maximum number of ISO shares to be a percentage of the total outstanding shares. If drafted incorrectly, such a provision may not satisfy the ISO requirement that the maximum number of shares subject to the plan must be specified. For example, a plan that merely specifies a stated percentage of outstanding shares will not meet the requirement. Prop. Treas. Reg. § 1.422A-2(b)(3). Plans which provide that the total number of shares added will be the lesser of a set number or a set percentage of the total outstanding shares should satisfy the ISO requirement. A public company may want to include a "sunset" provision so that existing shareholders are protected from excessive dilution in the future.
(c) ISOs and NQ0s. A plan that offers both ISOs and NQOs does not need to state how many ISOs and how many NQOs can be granted. The plan can simply state the total options, regardless of whether an ISO or NQO. Treas. Reg. § 14a.422A-IT (Q&A-22).
(d) Designation of Eligible Employees. Plan may provide that employees designated by the President, the compensation committee or some other individual or group of individuals are eligible for ISOs. Prop. Treas. Reg. § 1.422A-2(b)(3)(iii). This gives the company maximum flexibility in granting ISOs.
(e) Amendments to the Plan. The only amendments that require shareholder approval for ISO purposes are changes to the number of shares or the eligible employees. Prop. Treas. Reg. § 1.422A-2(b)(3)(iii).
(3) Fair Market Value Exercise Price. Exercise price of ISO must not be less than the fair market value of the stock at the time of grant. IRC §422(b)(4).
(a) Greater than 10% Shareholders. Exercise price on ISOs granted to a 10% or greater shareholder by vote must not be less than 110% of fair market value on the date of grant. IRC §422(c)(5)
(b) Determination of Fair Market Value. The Board of Director's good faith determination of fair market value is sufficient in this instance. Treas. Reg. § 422(c)(1); Treas. Reg. § 14a.422A-IT (Q&A 2(c)(4)); Prop. Treas. Reg. § 1.422A-2(e). Thus, the Board will not later be second guessed if the determination, in hindsight, appears to be wrong. The Board must, however, establish that it made a good faith determination of fair market value given all the facts and circumstances at such time. The Board should memorialize its fair market value determination in the Board minutes. See Keogh v. Commissioner, T. C. Memo 1992-13 1, affd by unpublished op., 95-2 U.S.T.C. 1 1995 (2d Cir. 1995), cert. denied No, 95-1014 (U.S. 1/22/96)(denying ISO treatment where no evidence that the option price was intended to be the stock's fair market value).
(c) Effect of Restrictions on Stock. In making its good faith determination of value, the Board must ignore any restrictions (e.g., securities law restrictions) other than those which, by their terms, will never lapse. IRC § 422(c)(7). This is the same rule under Section 83 discussed in Part III(A)(2)(c)(I) above.
(d) Grant Date. Because the exercise price must equal fair market value on the grant date, it is important to determine the grant date. In general, the grant date is the date when the corporation completes all corporate action constituting an offer to sell stock under the ISO. Treas. Reg. § 1.421-7(c)(1).
(e) Conditional Grants. A conditional grant is not a grant for ISO purposes. For example, if an individual is granted an ISO on the condition that he become an employee, the grant date will not be until the first date of employment. Treas. Reg. § 1.421-7(c)(2). It is crucial to distinguish between conditions to the grant (i.e., conditions precedent) and conditions to the exercise of the option. For example, the grant date for an employee who is hired and granted ISOs conditioned on continued employment for 6 months may be treated as the six-month anniversary date. If the value of the stock increased during this 6-month period and the employee was given an exercise price based on the value as of the hire date, then the option would fail to qualify as an ISO because the exercise price would not equal the stock value on the grant date six months later. To avoid this issue, employers should make clear that the grant of the ISO is unconditional but that the employee has to remain employed for six months to exercise the ISO subject to any other vesting provisions. One exception is that the grant of an ISO conditioned on subsequent shareholder approval will not be viewed as a conditional grant for ISO purposes so that the grant date is when the ISO is granted. Treas. Reg. § 1.421-7(c)(2).
(4) 10-Year Grant Period. ISOs must be granted within 10 years from the date that the plan is adopted by the Board or approved by the shareholders (whichever is later). IRC § 422(b)(3).
(5) 10-Year Exercise Period. ISO agreement must state that the ISO may not be exercised more than 10 years from date of grant. IRC § 422(b)(3).
(6) Non-Transferrable. ISO agreement must state that the ISO may not be transferred except by will or by laws of descent. IRC § 422(b)(5).
(7) $100,000 Per Year Limitation. Aggregate fair market value (determined as of the grant date) of stock that can be purchased by employee pursuant to ISOs exercisable for the first time during any one calendar year under all plans may not exceed $100,000. IRC § 422(d).
(a) For example, assume an employee is granted 60,000 shares with a fair market value exercise price of $10 with the ISOs vesting 1/6 per year over 6 years. In any given year, the maximum that the employee could exercise, based on the grant date value, is $100,000, thereby satisfying the $100,000 per year limitation. By contrast, if the employee vested over 3 years, the employee could exercise, based on the grant date value, $200,000 per year, thereby failing the $100,000, per year limitation.
(b) The ISO plan may permit more than $100,000 per year so long as it specifies that the excess over $100,000 will be treated as NQOs. Notice 87-49, 1987-2 C.B. 355. The company can designate which options are ISOs and which are NQOs and when an ISO is exercised it can designate the stock as ISO stock. If this is not done, then a pro rata share of each option will be an ISO and a pro rata share of each stock will be ISO stock.
g. Methods to Exercise
(1) Stock. ISO plans can allow employees to exercise ISOs with stock of the employer corporation rather than cash. IRC § 422(c)(4)(A). The employee will recognize no gain on the use of the appreciated employer stock to pay the exercise price. IRC § 1036.
(a) Mature ISO shares for 1S0s. When ISOs are exercised with stock acquired pursuant to another ISO that satisfies the ISO holding period ("Mature ISO shares"), no disqualifying disposition occurs. The new ISO shares are divided into two groups: (1) New ISO shares that match the number of exchanged Mature ISO shares will have carryover basis and holding period, and (2) remaining New ISO shares will have basis equal to the cash paid at exercise (likely zero). PLR 9736040; IRC § 1036
(b) Immature ISO shares for ISOs. Disqualifying disposition and recognition of compensation income occur when ISOs are exercised with previously acquired ISO shares that do not satisfy the ISO holding periods ("Immature ISO shares"). IRC § 424(c)(3). New ISOs are divided into two groups: (1) New ISO shares that equal the number of Immature ISO shares exchanged will have carryover basis, increased by compensation from disqualifying disposition, and (2) remaining new ISO shares will have basis equal to the cash paid at exercise (likely zero). PLR 9736040; IRC § 1036
(2) Reload Provisions. ISO plans may provide a reload provision under which an employee who uses employer stock to exercise an ISO will automatically be granted a new ISO for the same number of shares used to exercise the ISO.
h. Modifications and Repricing of ISOs
(1) Deemed Grant of a New ISO. If the terms of an ISO are modified to give the employee additional benefits, the modification will be treated as the grant of a new ISO and all of the ISO requirements must be met as of the modification date. IRC § 412(h). Most importantly, the exercise price must equal the fair market value on the modification date. If the value of the stock has gone up since the original grant and the exercise price is not changed to reflect the higher value, the modified ISO will no longer qualify as an ISO.
(2) Change in Exercise Price and Shares. A change in the exercise price and the number of shares to reflect a decrease in stock value is a modification. Rev. Rul. 69-535, 1969-2 C.B. 90. By contrast, a change in exercise price and number of shares to reflect a stock split is not a modification. Treas. Reg. § 1.425-1(e)(5)(ii)(a).
(3) Change in Payment Terms. A favorable change in payment terms such as allowing the employee to pay with stock rather than cash constitutes a modification. Treas. Reg. § 1.425-1(e)(5)(i).
(4) Acceleration of Exercise. Acceleration of the time within which the ISO may be exercised does not constitute a modification. IRC §424(h). For example, accelerating the vesting of an employee's options upon termination without cause does not constitute a modification. PLR 8308062.
(5) Administrative and Legal Changes. Administrative changes such as the method for designating beneficiaries are not treated as a modification. Rev. Rul. 69-648,1969-2 C.B. 103. Similarly, changes made by the employer to satisfy securities law or other laws are not modifications. Rev. Rul. 71-166, 197 1 -1 C.B. 13 5; Rev. Rul. 74-144, 1974-1 C.B. 105; Rev. Rul. 69-328, 1969-1 C.B. 136.
j. Summary of ISO Advantages.
(1) Allows employees to defer tax until stock is sold, and then pay only a 20% capital gains rate on the full amount of the appreciation in the stock if they hold the stock for one year; this favorable tax treatment makes ISOs very popular with employees.
(2) Holding period requirements encourage employee to remain with employer for a longer term.
k. Summary of ISO Disadvantages.
(1) Strict ISO requirements.
(2) Available only for employees of corporations (or a partnership
or LLC electing to be taxed as a corporation).
(3) Must be granted "at-the-money."
(4) The $100,000 rule limits the usefulness of ISOs for senior executives of established companies and makes them especially popular for "rank and file" employees. For start-up companies, however, it is easier to grant ISOs to senior management due to lower valuations.
(5) Lack of transferability by employee.
(6) Potential AMT issues.
(7) No deduction for employer at either the time of grant or the
time of exercise.
3. Nonqualified Stock Options
a. Employee's Tax Consequences
(1) Grant. The grant of an NQO is generally not subject to tax.
(a) NQOs With Readily Ascertainable Fair Market Value.The grant of an NQO with a readily ascertainable fair market value is subject to tax. IRC § 83(e)(4). An NQO will have a readily ascertainable fair market value if it is actively traded on an established market. Treas. Reg. § 1.83-7(b)(1). If the NQO is not actively traded, it will have a readily ascertainable fair market value only if (i) the NQO is transferable; (ii) the NQO is immediately exercisable; (iii) the NQO is not subject to restrictions that have a significant effect on value; and (iv) the value of the option privilege can be readily ascertained. Treas. Reg. § 1.83-7(b)(2). The practical effect of the regulations is that the grant of an NQO will not be subject to tax except in the rare case where it is traded on an established market.
(b) Deeply Discounted NQOs. Section 409A has completed changed the tax implications of deeply discounted NQOs. See Section (d) below. The discussion in this Section (b), therefore, applies mainly to options not covered by the provision. 409A generally applied to amounts that are “deferred” in taxable years beginning after 12.31.04.
The grant of an NQO with an exercise price substantially below the stock's fair market may be treated as a taxable grant of the underlying stock. The IRS has informally raised concerns about deeply discounted options and has announced that it is going to study deeply discounted options. Rev. Proc. 89-22, 1989-1 C.B. 843, as corrected by Announcement 89-42, 1989-13, I.R.B. 53. Unfortunately, the IRS has yet to issue guidance on what it considers an excessively low exercise price. The only IRS authority is in the foreign personal holding company context where the IRS applied the substance-over-form doctrine and ruled that an option to buy stock for a price equal to 30% of the stock's value should be treated as ownership of the underlying stock. Rev. Rul. 82-150, 1982-2 C.B. 110. Despite the IRS's apparent opposition to deeply discounted options, case law supports treating discounted options as options for tax purposes. See Commissioner v. LoBue, 351 U.S. 243 (1956) (holding that options with a 75% discount should be taxed at exercise and not a grant); Victorson v. Commissioner, 326 F2d 264 (2d Cir. 1964) (treating an option granted to an underwriter with an exercise price equal to .2% of the stock value as a grant of an option); Simmons v. Commissioner, 23 T.C.M. 1423 (1964) (same where exercise price was equal to .1% of the underlying stock value); but see Morrison v. Commissioner, 59 T.C. 248, 260 (1972), acq., 1973-2 C.B. 3 (holding that the grant of an NQO with an exercise price of $1 to purchase stock with a value of $300 that was “the substantial equivalent of the stock itself”). Notwithstanding the favorable case law, prudence dictates that deeply discounted options should be avoided if the taxpayer wants to avoid the risk of immediate taxation. A prominent treatise suggests that a 90% discount creates a high risk; a 75% to 90% discount creates moderate risk; and a 50% or less discount creates very little risk. Martin D. Ginsburg and Jack S. Levin, Mergers, Acquisitions, and Buyouts
1314.1.2 (1999); see also Keith A. Mong, Discounted Options as an Alternative to Deferred Compensation, 39 Tax Mgmt. Memo 167 (1998) (concluding that only discounts in excess of 75% would likely be challenged by the IRS). If the grant of a deeply discounted NQO is treated as the issuance of the underlying stock, the employee will be taxed under the restricted stock rules discussed in Part III(A) above.
(c) No IRC §83(b) Election. Employees may not make a Section 83(b) election with respect to NQOs. This is one of the potential disadvantages of NQOs over restricted stock.
(d) Effect of Section 409A. NQOs generally are covered under 409A unless (i) the exercise/strike price may never be less than the fiar market value of the underlying stock on the date of grant and the number of shares subject to the option is fixed on the date of grant, (ii) the option is taxed under the Section 83 rules, and (iii) the option does not provide for any additional deferral of income. If an NQO is subject to Section 409A, taxation would occur on the date of vesting of the option, even if it is not exercised at that time.
(2) Transfer of NQ0. An arm's-length disposition of an NQO will trigger compensation income equal to the amount realized on the sale less the tax basis in the NQO (which will usually be zero). Treas. Reg. § 1.83-1(b)(1). A non-arm's-length disposition such as a gift or contribution to a related entity does not close the compensation element and the employee is still subject to tax when the NQO is exercised by the transferee even though the employee no longer owns the NQO. Treas. Reg. § 1.83-1 (c).
(a) Gift Tax Issues. Transfer of NQO is treated as a completed gift when the donee's right to exercise the option is no longer conditioned on the donor's future services. Rev. Rul. 98-21, 1998-18 IRB 7. Thus, if the NQO is not vested, the gift will be when the NQO becomes vested, at which time the value of the stock may be higher. In valuing the gift of an NQO, Rev. Proc. 98-34 sets forth a methodology that requires valuing the option privilege.
(b) Estate Tax Issues. An NQO that is gifted prior to death will not be included in the employee's estate upon his death, so long as he does not retain any rights or powers associated with the transferred NQO.
(3) Exercise. Employee recognizes ordinary compensation income upon exercise of the NQO in an amount equal to the value of the stock at exercise less the exercise price. IRC § 83(a).
(a) Stock Restrictions are Ignored in Determining Value. For purposes of determining fair market value upon exercise of the NQO, restrictions on the stock such as securities law, lock-up, and similar restrictions are ignored. IRC § 83(a). The only restrictions that are not ignored are those which by their terms will never lapse. See Part III(A)(2)(c)(I) above.
(b) Receipt of Restricted Stock. If the stock received upon exercise of the NQO is subject to a substantial risk of forfeiture (i.e., not vested), then the employee will not be taxed on exercise of the NQO. Instead, the rules for restricted stock discussed in Part III(A) above will apply to the receipt of the restricted stock. In general, the employee would be taxed when the stock became vested. Alternatively, the employee could make a Section 83(b) election to be taxed on the restricted stock as of the exercise date.
(4) Sale of Stock. Any future appreciation in the stock after exercise of the NQO is taxed as capital gains when the employee sells the stock. IRC §§ 1001, 1221 and 1222. If the employee holds the stock for at least one year after exercising the NQO, the capital gain will be long term subject to the 20% preferential long-term capital gains rate. The holding period does not begin to run until the employee exercises the NQO. IRC § 83(f).
b. Employer's Tax Consequences
(1) Deduction. Employer receives tax deduction at time the employee recognizes compensation income in an amount equal to the employee's compensation income. IRC §83(h). To take advantage of the deemed inclusion rule, the employer must satisfy the applicable Form W-2 or Form 1099 reporting requirements. See Part III(A)(3)(b) above.
(2) Withholding Requirements. Employer is subject to income and employment tax withholding at the time the employee has compensation income. The option agreement should specify how the withholding is to be handled. Oftentimes, the employee will be required to remit cash or shares equal to the withholding amount as a condition to exercising the NQO. Alternatively, the employer may provide employee with a "grossed up" cash bonus to allow the employee to pay the tax liability.
C. Example of NQO Tax Consequences
Year I NQOs for 10,000 shares granted at exercise price of
$ 10 when fair market value of stock is $ 10.
Year 3 NQOs are exercised when fair market value of stock
Year 5 Employee sells stock for $20.
Year I Grant:
Employee has no income
Employer has no deduction.
Year 3 Exercise:
Employee has $50,000 in ordinary income ($150,000
FMV - $100,000 exercise price); results in $19,800
tax to Employee (using 39.6% rate).
Employer gets $50,000 ordinary deduction resulting in
$17,000 tax reduction (using 34% rate).
Year 5 Sale:
Employee has $50,000 capital gain ($200,000 -
$50,000 ordinary income - $100,000 option price)
resulting in $10,000 tax (using 20% rate).
Employer has no deduction.
Cash Flow Consequences
Employee receives $70,200 ($200,000 - $100,000 exercise price - $19,800 ordinary tax - $ 10,000 capital gains tax).
Employer receives $17,000 tax benefit.
Comparison to ISO Cash Flaw Consequences
Employee receives $80,000. Employer has no cash flow benefit.
d. Use of Employer Stock to Exercise. The NQO agreement may allow the employee to pay the exercise price with stock of the employer. Under Section 1036, the employee will not recognize gain on the exchange of the employer stock. Rev. Rul. 80-224, 1980-2 C.B. 234.
(1) Use of ISO Shares to Exercise NQ0s. An employee may choose to exercise NQOs using ISO shares. The tax consequences are the same regardless of whether Mature ISO shares or Immature ISO shares are used. The use of the ISO shares will not be a "disqualifying disposition," even if immature ISO shares are used. IRC §424(c)(1)(B). The basis and holding period of the ISO shares exchanged will carryover to an equal number of NQO shares. The remaining NQO shares will be treated as compensation. For example, if 25 ISO shares are used to exercise 100 NQOs, then basis and holding period will transfer as to the first 25 NQO shares, the remaining 75 NQO shares are treated as compensation to their FMV. PLR 9629028; Rev. Rul 80-244; IRC §1036.
e. Summary of NQO Advantages
(1) Due to lack of statutory requirements, NQOs offer maximum
flexibility in establishing their terms.
(2) Useful when designing plan for senior management because NQOs are not subject to $100,000/year cap as are ISOs and the exercise price can be set below fair market value at time of issuance in order to create immediate benefit for executive. See, however, the effects of Section 409A, as above.
(3) Can be issued by wide range of business entities (not just corporations).
(4) Can be issued to non-employees (such as directors and
f. Summary of NQO Disadvantages
(1) Employee has tax liability at ordinary rates at time of exercise. This can result in significant tax liability if stock has appreciated in value since the time the NQO was granted.
(2) The Section 83(b) election is not available for NQOs.
(3) Employer has withholding obligation, but may not have a source of employee funds from which to withhold at the time of exercise.
D. Stock Appreciation Rights and Other Phantom Equity Plans.
1. Description. A stock appreciation right (SAR) is a contractual right to receive a cash payment based on the value or increase in value in the company's stock. The SAR payment can be tied to: (a) a fixed settlement date; (b) the employee's exercise of the SAR; or (c) upon certain events (such as sale of the company). A phantom equity plan is where the employee is granted an "interest" in a phantom ownership account. Employer promises to pay the value of all vested fictional interests in the employee account at a specified future date. A performance unit plan uses a more specific performance measurement (e.g., performance of a division) in lieu of overall company performance when determining amount of reward to be received by the employee. SARs and other phantom equity plans may be subject to a vesting schedule. The tax consequences of SARs and other phantom equity plans are the same.
2. Employee's Tax Consequences.
a. Grant. Employee is not subject to tax on grant of award. The grant is treated as an unfunded, unsecured promise to pay that is not "property" for poses of Section 83. Treas. Reg. §1.83-3(e); PLR 8230147. Consider the effect of Section 409A, however.
b. Payment. Employee recognizes compensation income when he receives payment pursuant to the award.
3. Employer's Tax Consequences.
a. Grant. Employer is not entitled to a deduction at time of grant regardless of whether a cash method or accrual method taxpayer. For accrual method taxpayers, the all events test for deductibility has not been satisfied. Treas. Reg. § 1.461-1(a)(1).
b. Payment. Employer is entitled to a deduction in the year the employee includes the payment in income regardless of whether a cash method or accrual method taxpayer. IRC § 404(a)(5); PLR 8230147. Employer must satisfy income and employment tax withholding obligations.
a. Useful in closely-held company where management does not want to give actual or potential equity ownership in the company to employees and wants to avoid minority shareholder issues.
b. Permits employee to realize the appreciation inherent in stock without payment of the option price upon exercise.
C. SARs are often issued in conjunction with NQOs in order to alleviate employee's cash flow problems at the time of the exercise of the NQO. SARs are designed to provide sufficient liquidity to allow the employee to pay the tax due at exercise.
a. Least favorable to employee because entire amount received by employee is treated as ordinary compensation income.
b. Employee may prefer a "true equity" interest to a SAR.
II. Nonqualified Deferred Compensation Plan (“NDC Plan”)
1. Definition - An NDC Plan is a plan or arrangement providing for the payment of compensation for services to an employee or independent contractor after the year in which the individual performs the services.
2. Tax Considerations – Generally try to structure arrangement to defer tax to employee until the employee receives payment. If not properly structured, could be taxed under the constructive receipt doctrine or the economic benefit doctrine, or under Section 409A. See Rev. Proc. 92-65. Generally, must elect to defer before the beginning of the period of service for which the compensation is payable.
B. Rabbi Trusts
Irrevocable trust used to fund employee’s benefit under an NDC. Assets must remain subject to general creditors of the employer to avoid economic benefit doctrine from currently taxing the employee. Employer is treated as the grantor of the trust under §671 and 677(a), so the employer is taxed on the income.
IRS started issuing rulings on Rabbi trusts in 1986, but the trust has to meet three conditions:
(1) Trust assets have to be available to all the general creditors of the employer if the employer files for bankruptcy.
(2) Involevency triggers to hasten payments to the employee when the employer’s net worth falls below a certain point are not permitted.
(3) The employer is required to adopt a procedure to porvide notice to the trustee in the event of its bankruptcy or financial hardship, and if such event occurs, payments to participants have to be suspended.
In Rev. Proc. 92-64, 1992-2 C.B. 422, the IRS provided a model rabbi trust to serve as a safe harbor for the taxpayers that adopt and maintain grantor trusts in connection with unfunded NDC plans. To get an IRS ruling, the model language of Rev. Proc. 92-64 must be adopted verbatim except where substitute language is expressly permitted. The Trustee must be an independent third party and must be given same investment discretion.