Stock Options
While the importance of stock options will most likely decline, incentive stock options (“ISOs”) will become more popular as they are not deductible anyway, which will allow recipients to get capital gains tax treatment if they hold onto the stock for at least one year.
A stock option permits the holder to purchase stock at a predetermined price for a specified period of time. Options can be tax-advantaged ISOs or no statutory stock options, also commonly called nonqualified stock options (NQSOs). Options that do not comply with the requirements for an ISO or that specifically indicate that they are not intended to be ISOs are treated as NQSOs.
In order to be considered an ISO, an option must meet all of the following requirements, which are specified in Section 422 of the Internal Revenue Code (IRC) and applicable regulations:
- Only a corporation (including an S corporation, a foreign corporation, or a limited liability company treated as a corporation for tax purposes) may grant ISOs.
- Only persons who are employees of the corporation granting the option (or employees of a related parent or subsidiary corporation) are eligible to receive ISOs; consultants and nonemployee directors cannot receive ISOs.
- An ISO must be granted pursuant to a plan that has been approved by the company’s shareholders within 12 months before or after the plan is ad-opted by the board. Certain plan amendments are also required for shareholder approval.
- An ISO must be granted within 10 years of the date the plan was adopted by the board or the date the plan was approved by the shareholders, which is earlier.
- The plan under which ISOs are granted must designate a maximum aggregate number of shares that may be issued under the plan in the form of ISOs.
- The plan under which ISOs are granted must designate the employees or class or classes of employees eligible to receive options under the plan.
- The exercise price of an ISO may not be less than the fair market value (FMV) of the company’s stock as of the date of the grant of the option (or 110% of the FMV in the case of an optionee who possesses more than 10% of the combined voting power of all classes of stock of the employer corporation or any related parent or subsidiary corporation).
- An ISO, by its terms, may not be exercisable more than 10 years from the date of grant (or 5 years in the case on an optionee who is a 10%shareholder) or more than three months after termination of employment (other than for disability, in which case the option may remain exercisable for one year after termination of employment, or for death, in which case the option may remain exercisable for its full original term).
- An ISO may not be transferable except in the event of the optionee’s death, and is exercisable only by the optionee as long as he or she is living.
For any one person, the maximum FMV of stock subject to ISOs that become exercisable for the first time in any calendar year may not exceed $100,000, which value is measured as of the date of grant. Any portion of the option in excess of this limit will be treated as an NQSO.
Example: An employee is granted an option for 50,000 shares of stock with an exercise price of $10 per share. The option vests on a pro-rata basis over 5 years. Thus, each year $100,000 of stock options vest (10,000 stock options times $10 per share (the exercise price at time of grant)), which is the limit of the ISO rule.
The tax treatment of an option hinges on whether it is an ISO or an NQSO.
- ISO. The holder of an ISO is not taxed when the option is exercised (although the excess of the FMV of the stock on the exercise date over the exercise price—commonly referred to as the option spread—is included for purposes of calculating the optionee’s alternative minimum tax (AMT) for the year of exercise). It is important to note that while the AMT provision was not eliminated under the Tax Act, the effect was substantially reduced in that a large amount of deductions were eliminated and the income levels where AMT would apply have been substantially increased.
The holder of an ISO is taxed when the acquired stock is eventually sold. In short, ISOs provide a tax advantage to optionees that NQSOs do not provide—automatic deferral of tax on the gain resulting from the exercise of the option. Moreover, if stock acquired through the exercise of an ISO is held for a specified period of time—the longer of two years from the date the option is granted or one year after the option is exercised—then any gain on the sale of stock will be taxed as long-term capital gain.
If the stock is not held for the required holding period, the difference between the exercise price and the lesser of (1) the FMV of the stock on the date of exercise, and (2) the sales price, will be taxed as ordinary income. Any additional gain will be taxed as long-term or short-term capital gain depending on how long the stock was held prior to sale. The employer is not entitled to a tax deduction upon exercise of an ISO or upon the subsequent sale of the stock if the required holding period is met. If the optionee does not hold the stock for the required holding period is met. If the optionee does not hold the stock for the required holding period, however, the employer will be entitled to a tax deduction equal to the amount of orginary income recognized by the optionee.
Example: An employee is granted an option for 3,000 shares of stock with an exercise price of $10 per share. The option vests in full in year 3. The employee exercises the option in year 4, when the FMV of the stock is $15 per share, and sells the stock in year 6 at a price of $20 per share. If the option is an ISO, the employee does not incur any tax upon exercise in year 4 (excluding, for this example, any impact of AMT which has been substantially eliminated by the Tax Act). Because the ISO holding period was met, the employee’s full gain of $30,000 upon the sale ($60,000 sales price, less the exercise price of $30,000) is taxed as a long-term capital gain, and the company does not receive any deduction.
- NQSO. The holder of an NQSO recognizes taxable income at the time the option is exercised, in an amount equal to the excess of the FMV of the stock on the exercise date over the exercise price. This amount is taxed as ordinary income. Any further appreciation in the value of the stock will be taxed when the stock is sold and will be either long-term capital gain or short-term capital gain depending on how long the stock was held prior to sale. The company is entitled to a tax deduction equal to the amount of ordinary income recognized by the optionee on the exercise price of the NQSO. Unlike ISOs, the exercise price of an NQSO can be less than the FMV on the grant date. However, an NQSO that is “discounted” is not exempt from IRC Section 409A, as discussed in the following:
Example: Assume the same facts as before, but the option is an NQSO. In that case, the employee would recognize taxable income of$15,000 upon exercise in year 4, and the company would receive a corresponding deduction. Upon sale of the stock in year 6, the employee would recognize a long-term capital gain of $15,000.
The primary advantage of stock options to the recipient is the risk-free right to appreciation in stock price and the ability to time the recognition of income. However, because it is an appreciation award, stock options can go underwater if the value of the stock drops below the exercise price. This can have a significant impact on the employee’s perception of the value of stock options. The significant accounting ad-vantage that stock options once enjoyed over other equity-based awards was eliminated under ASC 718.
As expected, there has been a gradual decline in the use of plain vanilla time-vesting options over the past several years. In the absence of the highly favorable accounting for such options, there is less compulsion to use them over other equity-based awards. While many options are still granted with solely time-based vesting requirements, compensation committees are now freer to use performance-vesting requirements, which would have resulted in variable accounting under ABP 25 and therefore were rarely used in the past.
Stock Appreciation Rights
A stock appreciation right (SAR) entitles the grantee to a payment (either in cash or stock) equal to the appreciation in value of the underlying stock over a specified time. For example, if the base price of a SAR is equal to the FMV of the company’s stock on the grant date, the grantee will be entitled to a payment upon exercise of the SAR equal to the excess, if any, of the FMV of the stock at the exercise date over the base price, multiplied by the number of SARs being exercised. If the award is settled in cash, it is generally referred to as a cash-settled SAR; if the award is settled in share of stock, it is generally referred to as a stock-settled SAR.
The FMV of the consideration paid to the grantee upon exercise of a SAR (whether settled in cash or stock) constitutes ordinary income to the grantee. The company is entitled to a tax deduction equal to the amount of ordinary income recognized by the grantee at the time of exercise.
From the grantee’s perspective, the principal advantage of a SAR is that the grantee may receive the benefit of appreciation in stock value without having to actually purchase stock. In addition, the fact that the grantee (typically) does not have to pay an exercise price to exercise a SAR eliminates the sometimes troublesome aspects of option exercises.
The principal disadvantage of SARs historically has been the requirement of variable accounting under APB 25 and, for cash-settled SARs, the requirement for liability accounting under ACC 718. In addition, similar to stock options, SARs can go underwater if the market value of the stock drops below the base price of the SAR.
Restricted Stock
Restricted stock is stock that is awarded to the grantee, usually without cost or for a nominal price. During the restricted period, the shares are not transferable and are subject to substantial risk of forfeiture based on the vesting conditions. For example, restricted stock typically is forfeited if the grantee terminates employment prior to a specific vesting date or the company fails to achieve a specified performance condition. The restricted stock may vest ratably over a period of time (graduated vesting) or become fully vested after a stated time period (cliff vesting).
Alternatively, an award of restricted stock could have performance-related vesting triggers, in addition to or in lieu of a time-based vesting date. Restricted stock is an example of a full-value award, as opposed to an appreciation-type award such as options and SARs. This means that restricted stock has value even if the stock price falls after the date of grant.
From the grantees perspective, the principal advantage of receiving restricted stock is that he or she is treated as an owner of the stock from the date of grant (usually including the right to vote the stock and receive dividends), and the grantee typically does not pay anything for the stock award. In addition, an 83(b) election gives the grantee the ability to accelerate taxation on the shares within 30 days following the date of grant to avoid a potentially higher tax as the shares vest. Also, as a full-value award, restricted stock does not go underwater if the stock price falls—it always provides some value to the grantee. From the company’s standpoint, the company is able to give an immediate benefit to the grantee and, by imposing performance or service restrictions on the shares, can use the shares to encourage the grantee to meet performance objectives or remain in service with the company.
The principal disadvantage is that the company must withhold income taxes at the time the tax liability arises (i.e., when the restrictions lapse or a Section 83(b) election is made). Although the grantee is the owner of the stock, he or she might not have the cash to pay the withholding tax. Therefore, it is common for a company to withhold shares from the award in an amount sufficient to cover the tax liability, but this results in a cash-flow cost to the company, because it must remit cash to the IRS and cannot resell the shares absent registration or an applicable transaction exemption.
Restricted Stock Units or Deferred Stock Units
Restricted stock units (RSUs) represent the right to receive stock in the future, subject to the satisfaction of vesting requirements. Deferred stock units (DSUs) represent the right to receive stock at the end of a designated deferral period. It is also possible to combine the two, such that stock is not delivered at vesting, but is deferred to the grantee’s termination of employment or some other date. In both cases, until the stock is delivered, the grantee does not own actual shares of stock and therefore does not have voting rights or the right to receive dividends. Because of this, such awards may be coupled with dividend equivalent rights such that phantom dividends are paid in cash or reinvested in additional stock units credited to the grantee’s account.
The grantee’s principal advantage in receiving stock units is that he or she is able to defer taxation until the shares are delivered or are constructively received. The principal disadvantage is that the grantee does not have voting rights in the interim and may not receive dividends (unless the award includes a dividend equivalents feature). From the company’s standpoint, an award of stock units uses fewer shares than an option to deliver equivalent value, and performance or service restrictions on the stock units can help to drive performance and retention. If awards are deferred to termination of employment, they often avoid IRC Section 162(m) deduction limits. However, stock units are not categorically exempt from IRC Section 409A and must be designed either to meet the short-term deferral exemption or to comply with the strict distribution requirements of Section 409A.
Performance-Based Awards
Performance-based awards are not really a separate type of award. Any of the equity awards described earlier (options, SARs, restricted stock, or stock units) may be referred to as performance awards if they have vesting criteria other than continued service. Cash awards that are based on performance are also performance awards. Under the executive compensation disclosure rules, all performance awards, whether cash or stock-based, are considered to be incentive awards. The compensation committee typically sets the performance goals and other terms or conditions of performance awards. As such, these awards can be used to directly correlate executive pay to strategically focused performance.
Before the tax reform, publicly traded companies were are able to designate an incentive award as a qualified performance-based award in order to make the award fully deductible without regard to the $1 million deduction limit imposed by IRC Section 162(m). Under IRC Section 162(m), in order for any other type of award to be a qualified performance-based award, a committee consisting entirely of outside directors must establish objectively determinable performance goals for the award based on one or more of the performance criteria that have been approved by the company’s shareholders (typically such performance criteria are set out in the incentive plan). For example, the list of potential criteria might include some or all of the financial or nonfinancial metrics, and the permissible performance targets might be expressed in terms of companywide objectives or in terms of objectives that relate to the performance of a business unit, division, affiliate, department, region, or function within the company or an affiliate.
In order to obtain the exemption from IRC Section 162(m) limits, a compensation committee needed to establish the performance goals within the first 90 days (or the first 25%, if shorter) of the period for which such performance goals relate, and the committee may not increase any award or, except in certain circumstances, waive the achievement of any specified goal. Any payment of an award granted with performance goals must be conditioned on the written certification of the committee in each case that the performance goals and any other material conditions were satisfied. If the performance targets are not specifically set out in the plan, but are left to the discretion of the committee based on one or more shareholder approved performance criteria, the plan’s performance criteria must be reapproved by the shareholders every five years to maintain the availability of the performance-based exemption.
Performance awards can provide an incentive for employees to accomplish a variety of targeted company and individual goals and objectives. In this sense, they can be tailored to encourage a longer-term focus than time-vesting awards, which are increasingly criticized as encouraging a short-term focus based solely on stock price. The principal disadvantage to the company is the challenge of designing meaningful and understandable performance objectives for the awards.
CONCLUSION
Most companies will still want to maintain performance-based compensation programs in order to appropriately incentivize executives and respond to the demands of pay-for-performance by proxy advisory firms and shareholders. We expect performance-based equity awards to remain prominent in public company equity plans.
While incentive plan design varies by company, there are a number of plan features recognized by investors and proxy advisory firms as best practices. The pre-Tax Reform version of 162(m) was used as a guideline for the design of these plans and helped define best practices. However, with the substantial alteration of 162(m), a review of pay practices in light of these changes may be helpful.
These changes will take about five years to take effect, but will begin in 2018 as companies begin the process. The full effect of these changes will not be apparent until about three years from now as companies determine what is right for them and then review what others have done in 2019 when the proxies are published. With a few iterations of this process, the answer will be apparent.