Numerous Recent Law and Accounting Changes Affect Stock Options

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1 Numerous Recent Law and Accounting Changes Affect Stock Options Stock option plans have been significantly impacted by recent changes in the law, including final regulations on incentive stock options issued on August 3, 2004 and new tax rules in the American Jobs Creations Act (AJCA) enacted on October 22, Also, the Financial Accounting Standards Board (FASB) has issued final rules for expensing equity-based compensation. All stock option plans should be reviewed now for compliance with the new rules and, in many cases, amendments or other action may be required. Here are some of the most significant changes (followed by more detail on the new rules): Employers are required to provide a written statement by January 31, 2005 to employees who exercised an incentive stock option (ISO) between August 3, 2004 and December 31, 2004 (and, for all later exercises, by January 31 st of the following year). The new ISO regulations focus more strongly on proper valuation for purposes of ensuring that the exercise price is no less than fair value at the grant date. There is now a safe harbor whereby the price will be deemed to be fair value if it is based on an average of two or more independent appraisals. AJCA makes it impractical to have options with an exercise price that is less than the fair value of the stock at the date of grant. (Below market options that have a single date on which they are exercisable are possible without AJCA's adverse tax consequences, but such a design defeats the purpose.) AJCA creates adverse tax consequences for stock appreciation rights (SARs) in private companies, as well as SARs settled in cash in public companies, and because a cashless exercise feature granted with an option is economically identical to a SAR, cashless exercise features in private company stock option plans are now impracticable as well. Employee stock purchase plans (ESPPs) are broad-based stock purchase programs. Statutory plans with no more than a 15% discount on the stock's price and meeting other requirements of Code Section 423 are exempted from the AJCA deferred compensation rules. Employee stock purchase plans that provide a discount and do not meet the requirements of Code Section 423 are subject to the new rules, and need to be reviewed carefully to avoid adverse tax consequences. -1-

2 Options (even below-market ones) granted before October 3, 2004 and vested by December 31, 2004 are generally grandfathered and not subject to AJCA as long as they are not materially modified, but an option committee's exercise of discretion may be a modification. FASB rules now require stock options to be expensed for financial accounting purposes, using one of a number of approved valuation systems as selected by the employer. These rules apply for all reporting periods after June 15, 2005 for public companies, and after December 15, 2005 for non-public companies. FINAL INCENTIVE STOCK OPTION REGULATIONS. These regulations detail the requirements that a stock option plan must meet in order for options granted under it to constitute ISOs and qualify for favorable tax benefits. ISOs allow the employee to defer recognition of any income or gain on exercise of the option until the date the stock issued pursuant to exercise is sold (except for employees subject to the Alternative Minimum Tax). In order to qualify for this favorable tax treatment, the option and plan must meet numerous statutory requirements, and the new rules clarify many of those requirements. Here are some of the more important highlights of the final rules: Prior regulations required the maximum number of ISOs that could be issued under a plan be stated in the plan document. Plans have typically provided for issuance of options and other stock-based compensation up to a certain percentage of shares outstanding from time-to-time with a flat number of shares stated as the maximum that can be issued as ISOs. Proposed regulations would have prohibited listing a percentage of outstanding shares as the maximum that could be issued under the plan in all types of awards. Fortunately, the final regulations did not retain this rule, and a flat number of shares may be stated for ISOs and the total number of shares that can be issued in all types of awards under the plan can continue to be referenced to a percentage of the number of outstanding shares. ISOs are required to have an exercise price no less than the fair market value of the stock on the date the option is granted. The rules still allow the use of any reasonable valuation method to determine fair market value, but the rules now provide a safe-harbor for private companies that use an average of two or more independent appraisals to determine the fair market value. Many option plans provide that options which are granted but expire before they are exercised are not counted toward the maximum number of shares that can be issued as ISOs under the plan. The new rules allow this counting method, and also allow plans to count only the net number of shares issued in a cashless exercise. (Note the AJCA problems with cashless exercise described above and the requirement that there be no discretion about cashless exercise for ISOs below.) -2-

3 The new rules address when shareholder approval of an option plan is required where a corporate transaction has changed the shares that will be issued pursuant to an option. Where the conversion of options for shares of a new entity is disclosed in materials approved by shareholders (such as an acquisition agreement) in connection with the transaction, shareholder approval of converted outstanding ISOs is not required. However, shareholder approval is required before new ISOs can be issued under an acquired plan. The new rules also address what constitutes a modification of an existing ISO. If an existing ISO is modified, then the favorable ISO tax treatment is lost (unless all of the ISO requirements are met at the date of modification, which is rare). The new rules provide that adding or exercising discretion regarding cashless exercise is considered a modification. Many plans and option agreements have historically had a discretionary cashless exercise provision. The final regulations apply differently to ISOs issued on or before June 9, 2003 and options issued after that date. For ISOs issued before that date, taxpayers may continue to rely on the 1984 proposed regulations, the 2003 proposed regulations, or the final regulations. For options granted after June 9, 2003 and before January 1, 2006 or the first regularly scheduled stockholders meeting occurring six months after August 3, 2004, either the 2003 proposed regulations or the final regulations must be applied. Taxpayers must operate under either the proposed or final regulations in their entirety, and cannot look to part of one regulation and part of another. In addition, all ISOs granted during this transition period must be treated consistently. An option committee resolution as to choice of law for these options might be wise. NONQUALIFIED OPTIONS. Keep in mind that the final regulations described above apply only to ISOs. The taxation of nonqualified stock options is unchanged. Nonqualified stock options are not taxable at issuance (as long as they are not readily tradable and transferable), but the difference between the exercise price and the value at exercise is taxable as ordinary income at the time of exercise. Because any gain at exercise of ISOs is taxable for alternative minimum tax purpose and the structure of alternative minimum taxes has caused them to be applicable to a wider array of taxpayers over recent years, many employers are using more nonqualified stock options. REPORTING REQUIREMENT FOR ISO EXERCISES. The final regulations issued in August 2004 triggered a reporting obligation for employers for ISOs, under Section 6039 of the Code. Upon the exercise of an ISO, employers are required to provide the employee exercising the option a written statement by January 31 of the year following the year in which the option is exercised. The statement must contain the following information: The name, address, and EIN of the corporation transferring the stock; The name, address, and SSN of the person to whom the shares were transferred; -3-

4 The name and address of the corporation whose stock is the subject of the option (if other than the corporation transferring the stock); The date the option was granted; The date the shares were transferred to the person exercising the option; The fair market value of the stock at the time the option was exercised; The number of shares transferred; and A statement that the shares were acquired pursuant to the exercise of an ISO. This reporting requirement should be added to your option plan administration for compliance beginning immediately. AJCA. Two provisions of the AJCA impact stock options. The first is an exemption from income and employment tax withholding requirements for exercise of ISOs, and upon a disqualifying disposition of stock acquired by exercise of an ISO. AJCA amended the Code to exclude income from the exercise of an ISO, or from disposition of the stock acquired through such exercise, from the definition of wages for purposes of Federal income tax withholding, and for FICA and FUTA tax purposes. The AJCA also amended the Code to provide specifically that no withholding (or employment tax) obligations apply to a disqualifying disposition of stock acquired through the exercise of an ISO. These changes are effective for ISOs exercised after October 22, 2004 (although this same rule has been in effect for a few years under a temporary IRS Notice). The AJCA also added a new Section 409A to the Code, which impacts the taxation of "deferred compensation." Section 409A imposes a number of requirements on deferred compensation, and if those requirements are not met, there is accelerated recognition of income tax and a 20% excise tax. Deferred compensation was defined very broadly in the new law, but legislative history indicates that certain compensation could be exempted by IRS in regulations or other releases. The IRS issued its first guidance under Section 409A in December 2004, and that guidance provides that ISOs are not treated as deferred compensation under Section 409A. The guidance also stated that nonqualified stock options will be exempt from Section 409A as long as the exercise price is the fair value at grant, the options are subject to tax when exercised and there is no feature allowing deferral of taxation past the exercise date. Private company SARs are treated as deferred compensation and will generally not be useful any longer for that reason. Public companies can still issue SARs if they can only be settled in stock, and are based on the stock's fair market value at grant, but plan terms should be scrutinized carefully. Although ISOs and nonqualified options with a 'fair value at grant' exercise price are currently exempt from Section 409A requirements, it appears that a cashless exercise feature granted with either type of option (for non-public companies, at least) will be subject to Section 409A. A cashless exercise feature allows the optionee the choice to have the employer withhold shares that would otherwise be issued upon exercise as payment of the exercise price. This is identical to a stock appreciation right (SAR), which is specifically -4-

5 prohibited under the new rules except for certain public company SARs settled only in stock. While the IRS might exempt cashless exercise features of otherwise exempt options from the new rules, use caution until and unless IRS specifically exempts them. Grandfathered options (issued and vested before the new law) with a cashless exercise feature might be acceptable, if the feature use does not require the exercise of post-2004 discretion. To the extent that ESPPs meet the requirements of Section 423 of the Code, the employer does not have any Federal income, FICA or FUTA tax withholding obligations when compensation is recognized in connection with the ESPP discount. ESPPs meeting the tax code requirements are also exempt from the Section 409A requirements. ACCOUNTING FOR STOCK OPTIONS. The FASB issued FAS 123R on December 15, 2004, which sets forth its new rules for accounting for equity-based compensation. The new rules are effective for reporting periods beginning after June 15, 2005 for public companies, and for the first fiscal year beginning after December 15, 2005 for private companies. The new rules generally require companies to expense stock options and other equity-based compensation based on a valuation model (e.g., Black-Scholes or a lattice model) the company chooses. The expense is determined at the grant date and accrued over the vesting period for awards settled in stock, but awards settled in cash are subject to variable accounting. The rules do not require that prior financial statements be adjusted, but companies that earlier reported expense or included it in footnote disclosures can restate prior financials if they wish, so that year to year comparisons are more meaningful. Companies that maintain ESPPs that meet the tax code requirements may also have to record an expense for stock that is purchased pursuant to such plans if the purchase price is discounted more than 5% below the fair market value. There are design and administrative features available to avoid having to recognize this expense. ACTION NEEDED: All stock option plans should be reviewed in early 2005, and before any options are granted or exercised, for compliance with these rules. Most plans will need amendment to remain compliant; at a minimum, new grants will need careful scrutiny. * * * * * -5-

6 The primary authors of this FBT Client Advisory are Alison Stemler and Brian Zoeller. Contact FBT for more information or advice about your specific situation. The Employee Benefits and Executive Compensation Practice Group members are listed below: Name: Direct Dial Phone No. John Appel (513) Bill Strangfeld (513) Jim Berry (615) Debbie Reiss (502) Debbie Tudor (859) Alison Stemler (502) Jill Perry (502) Brian Zoeller (502) Brett Smith (513)