Incentive Stock Options (ISOs) vs. Nonstatutory Stock Options (NSOs) Quick Comparison: Tax treatment of ISOs vs. NSOs

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1 Incentive Stock Options (ISOs) vs. Nonstatutory Stock Options (NSOs) Quick Comparison: Tax treatment of ISOs vs. NSOs ISOs NSOs Employees don t have to report any income when they exercise the option, unless it s later sold in a disqualifying disposition A qualifying disposition allows the profit to be treated as longterm capital gains, meaning the seller can qualify for the 15% maximum rate ISOs must conform to IRC s.422 and it s rules/guidelines ISOs may trigger the AMT Only employees may be granted ISOs Employees must report their taxable income upon exercise Gain at the date of exercise is treated as income (taxed at a higher rate than capital gains); further gains between the date of exercise and sale may be treated as capital gains NSOs have fewer regulations and restrictions than ISOs ISOs Incentive Stock Options are regulated by IRC section 422 which lays out the requirements for an equity instrument to qualify as an ISO. Incentive stock options are only available for employees and must be granted pursuant to a shareholder plan. The exercise price of an ISO may not be lower than 100% of the fair market value of the underlying stock at the time of the grant. Section 422 provides that an attempt, made in good faith, to value the Common Stock is sufficient for this purpose, even if the valuation later turns out to be incorrect. The broader IRS regulations interpreting the good faith rule create a safe harbour if the valuation is based upon an average of the fair market values set forth in the opinions of completely independent and well-qualified experts. 1 1 The opinions may take into consideration the option holder s status as a majority or minority stakeholder. 2 Notice, s. H, Substitutions of Non- discounted Options for Discounted Options.

2 The significant difference between ISOs and NSOs lay primarily in their tax treatment. The basic tax treatment of an ISO is quite different than the treatment of a non-qualified stock option (NSO). ISOs uniquely offer the possibility of being taxed under long-term capital gains, while NSOs are taxed under both ordinary income and capital gains. Upon the exercise of an ISO, the employee does not recognize ordinary compensation income, and the employer is not required to report or withhold income or employment taxes (although the option spread at exercise is included in calculating the option holder s alternative minimum taxable income ( AMT ). The employee recognizes income only upon the sale of ISO shares, with tax treatment dependent upon whether or not it was a qualifying or non-qualifying disposition. To represent a qualifying disposition, the sale of shares must have occurred: more than two years after the option-grant date; AND more than one year after the exercise date of the option Where both conditions are met, the gains on the sale would be subject to long-term capital gains (e.g. 15%), and where they were not met the gains on the sale would be subject to short-term capital gains. Example On April 19, 2009 you receive an ISO giving you the right to purchase 1,000 shares of stock for $2 per share. You then exercise the option on May 10, 2010 when the fair market value is $5 per share. Your per-share basis is $2 (the exercise price). You then sell on June 20, 2011 for $10 per share. The sale date is more than two years after the grant date and more than one year after the exercise date. Thus, your entire $8,000 profit is treated as a long-term capital gain qualifying for the maximum federal rate (15%). However, if you don t follow the holding rules, then the favourable tax treatment of ISOs no longer stands. If you make a disqualifying disposition, some or all of your gain will now be taxed as ordinary income rather than at the lower capital-gains rate. The tax rate on the spread from the exercise price to the price at which you sell the stock will depend on your holding period (which begins on the day after the exercise date). Example If you make a disqualifying disposition by selling less than one year after the grant date, but you owned the share for more than a year after the exercise date, you would owe income tax on the spread from the exercise to the fair market value on date of exercise, and then capital gains on the gain (difference between fair market value on date of exercise and the sale price) after you exercised. The employer does not have an obligation to withhold income or employment taxes on a premature disposition of ISO shares, but is required to report the ordinary compensation income recognized. NSOs

3 With NSOs, the employee must pay income tax on the spread between the exercise price and fair market value in the year of exercise. Then, when the stock is sold, there is a separate tax payable on the spread between the fair market value at time of exercise and the ultimate sale price. Upon the exercise of an NSO, the employee recognizes ordinary compensation income equal to the excess of the fair market value of the stock on the date of exercise over the exercise price. The employer is required to report the income and withhold applicable income and employment (FICA/FUTA) taxes.

4 Appendix II Elections under Section 83(b) Under Section 83(a) of the Internal Revenue Code, a taxpayer who receives property in connection with the performance of services must generally recognize as ordinary income the difference between the value of the property and the amount paid in exchange therefor at the first time the property is either transferable or not subject to a substantial risk of forfeiture. Section 83(b) allows a taxpayer who receives property in connection with the performance of services that is subject to such restrictions (e.g., nonvested property) to elect to recognize this income at the time of transfer. The principal benefit of a Section 83(b) election is that the taxpayer can lock in appreciation which is generally taxable at capital gains rates upon later disposition. This reflects the tenets of the economic benefit doctrine, which denotes that if an individual receives any economic or financial benefit or property as compensation for services, the value of the benefit or property is currently includible in the individual's gross income. More specifically, the doctrine requires an employee to include in current gross income, the value of assets that have been unconditionally and irrevocably transferred as compensation into a fund for the employee's sole benefit, if the employee has a nonforfeitable interest in the fund. Section 83 codifies the economic benefit doctrine in the employment context by providing that if property is transferred to a person as compensation for services, the service provider will be taxed at the time of receipt of the property if the property is either transferable or not subject to a substantial risk of forfeiture. If the property is not transferable and subject to a substantial risk of forfeiture, no income tax is incurred until it is not subject to a substantial risk of forfeiture or the property becomes transferable. For purposes of section 83, the term "property" includes real and personal property other than money or an unfunded and unsecured promise to pay money in the future. However, the term also includes a beneficial interest in assets, including money, that are transferred or set aside from claims of the creditors of the transferor, for example, in a trust or escrow account. Property is subject to a substantial risk of forfeiture if the individual's right to the property is conditioned on the future performance of substantial services or on the nonperformance of services. In addition, a substantial risk of forfeiture exists if the right to the property is subject to a condition other than the performance of services and there is a substantial possibility that the property will be forfeited if the condition does not occur. Property is considered transferable if a person can transfer his or her interest in the property to anyone other than the transferor from whom the property was received. However, property is not considered transferable if the transferee's rights in the property are subject to a substantial risk of forfeiture. NOTE: The cash equivalency doctrine must also be considered when looking at arrangements in this context. Under the cash equivalency doctrine, if a promise to pay of a solvent obligor is unconditional and assignable, not subject to set-offs, and is of a kind that is frequently transferred to lenders or investors at a discount not substantially greater than the generally prevailing premium for the use of

5 money, such promise is the equivalent of cash and taxable in like manner as cash would have been taxable had it been received by the taxpayer rather than the obligation. More simply, the cash equivalency doctrine provides that, if the right to receive a payment in the future is reduced to writing and is transferable, such as in the case of a note or a bond, the right is considered to be the equivalent of cash and the value of the right is includible in gross income. For example, suppose a startup company founder is issued founders' stock that is subject to a company repurchase at the stock's cost, but the repurchase right lapses over a service based lapsing period. This founder has received stock, but because the stock is subject to a substantial risk of forfeiture (the at-cost repurchase right lapsing over the service based vesting period), the founder does not have to pay tax on his receipt of the stock until it vests. However, the founder may prefer to make a Section 83(b) election to pay tax on the value of the stock today because its value is lower than it is expected to be when it vests--or because the founder paid full value for it today, so the Section 83(b) election costs him no additional tax today. The making of the Section 83(b) election also starts the founder's capital gains holding period. It is a common misconception, but a Section 83(b) election generally cannot be made with respect to the receipt of a private company stock option. You must exercise the option first and acquire the stock before you can make a Section 83(b) election, and you would only make a Section 83(b) election in that instance if you exercised the option and acquired unvested stock (if the stock acquired on exercise of the stock option was vested, there would be no reason to make a Section 83(b) election). Another common misconception is that Section 83 does not apply to restricted stock that is purchased at fair market value. This is not true. Section 83 applies even to stock that has been purchased at fair market value, if the stock is subject to a substantial risk of forfeiture and received in connection with the performance of services. An 83(b) election has to be filed with the IRS within 30 days of receipt of the property, a copy has to be filed with the tax return of the person making the election, and a copy must be provided to the company.

6 Appendix II Effective Dates of Option Rules The effective date and transition rules articulated in the IRS guidance are exceedingly complex and, in most cases, do not directly deal with options. But we feel reasonably confident that these rules may be applied to options as follows: Section 409A does not apply to an option if it (a) was granted on or before October 3, 2004, and (b) vested on or before December 31, 2004 Unless an exemption applies, Section 409A applies to options that vest on or after January 1, If an option vests in installments, Section 409A would apply only to those installments that vest on or after January 1, In certain circumstances, an option may be amended so that it either (a) qualifies for an exemption from Section 409A, or (b) complies with Section 409A. for example, if an options provides for an exercise price below 100% of fair market value at the time of the grant, it may be possible to increase the exercise price. The optionee s written consent would generally be required, but the optionee would probably prefer the higher exercise price over the tax consequences engendered by s. 409A. However, the IRS has severely limited the availability of this relief in years after Under IRS Notice , NSOs granted before 2005 will be deemed to satisfy the 100% of fair market value requirement of s. 409A if the good faith standard applicable to ISOs is met. [For NSOs granted after 2005 but before 2008, the 100% of fair market value requirement will be deemed to be satisfied as long as a reasonable method was used to value the stock. What is considered reasonable presumably depends on the amount of IRS guidance that was available at the time of the grant.] If an option is grandfathered under the rules above, the option could nevertheless lose its exempt status if it is modified after that date. How to Fix Options Issued with a Valuation If outstanding stock options are priced below FMV, the IRS will allow cancellation and reissuance of existing (including arrangements to make up the lost discount ) until December 31, 2005, so long as the new arrangements are at FMV. 2 The IRS is moving aggressively to implement these rules and has issued Audit Guidelines for its staff. 3 However, even if a discounted option would be subject to section 409A under the above effective date rules, there are a few ways in which a company may still remedy the section 409A problem with respect to such discounted options. On October 4, 2006, the Internal Revenue Service issued a notice extending the period during which discounted options may be corrected until December 31, However, this extension does not apply to options granted to Section 16 officers of public companies which expect to report a financial expense in connection with the discount that was not timely reported. For those officers, action will still be required by December 31, Notice, s. H, Substitutions of Non- discounted Options for Discounted Options. 3 Nonqualified Deferred Compensation Audit Techniques Guide ( )

7 Some companies are offering to replace the discounted options with options having an exercise price equal to the fair market value of the stock on the legal date of the grant. Companies may provide employees with some kind of compensation for the value of the lost discount. Under the applicable guidance, any compensation to employees in consideration of the increase in the exercise price of stock options cannot vest or be paid in the same year as the cancellation and reissuance. It should also be noted that there will be employment tax withholding whenever the additional consideration is paid. Some companies are offering to cancel the old options and pay the employees an amount equal to the Black-Scholes value of the cancelled options. Again, this amount may not be paid until a year subsequent to the cancellation of the option, and is subject to employment tax withholding. Some companies have offered to amend the discounted options to require that they be exercised at fixed times in the future. The fixed exercise time may generally be any date or year in the future (prior to the expiration of the option), such as the year in which the option vests; but if the employee chooses not to exercise an option at the designated time, it would have to be forfeited. While this solution may avoid the application of section 409A, it may not be an attractive solution for the employee, because the stock price may fall and the fixed period chosen for exercise may turn out to be an unfavorable time for exercising the options. It must be noted that offers to amend options may be subject to federal securities law tender offer rules (requiring filing of Schedule TO by public companies and provision of disclosure documents and 20 business days to consider the offer). Pending further guidance from the Treasury, it may be too late to correct discounted options exercised after 2005 and prior to correction. The Treasury Department has announced that it plans to issue final section 409A regulations later this year. [FIXING 409A OPERATIONAL ERRORS: IRS Notice outlines correction procedures to be followed for certain inadvertent operational violations of Section 409A and offers the possibility of obtaining either complete or partial relief from its adverse tax consequences. The relief provided and the correction procedures required depend upon when the operational failure is corrected and whether the affected individual is a Section 16 insider. The earlier that an eligible operational error is discovered and corrected, the more likely that the error will be eligible for correction and that additional Section 409A taxes and interest payments can be avoided or at least minimized. Relief generally is not available under the Notice if an operational error is corrected any later than the second taxable year following the taxable year of the failure. However, the Notice provides special transition relief for the following types of operational errors involving non-section 16 insiders that are corrected on or before December 31, 2009, regardless of the taxable year of the failure: Failure to delay separation payments to specified employees for at least six months. Premature or late payments. Deferrals of more or less than the correct amount.[4] Under the transition relief, even if the operational error occurred in 2007 or an earlier year, if it corrected no later than December 31, 2009, it will be treated as having been corrected in the year following the

8 taxable year in which the failure occurred, so that no additional Section 409A taxes will apply to the non-section 16 insider.[5] BUT Note that [4] Note that correction of discounted option grants is not included as one of the operational errors eligible for correction under the transition relief. The Notice provides that for non- Section 16 insiders, discounted option grants may be corrected not later than the earlier of (i) exercise of the option or (ii) the year following the year of grant.

9 Appendix III History of the Enactment of section 409A Brief History Section 409a was enacted in response to perceived widespread tax avoidance through nonqualified deferred compensation arrangements. These arrangements were heavily favoured by staff who wanted to maximize their potential compensation while at the same time deferring income tax payments on that compensation. These arrangements allowed directors, consultants, staff and other service providers to enjoy a contractually enforceable right of future compensation without paying tax on those amounts until they were actually or constructively received. In the context of tax provisions, compensation is not constructively received until it no longer is subject to a substantial risk of forfeiture (generally speaking this means until it vests). Not surprisingly, these deferred compensation arrangements also are attractive to many firms as key elements of recruitment and retention strategies for staff with the benefit of not requiring any immediate cash outlay. While the nonqualified deferred compensation schemes do not afford the firm the immediate tax advantages of a qualified deferred compensation plan (e.g. a plan established under s.401), the nonqualified arrangement is not subject to the vesting, nondiscrimination, funding and other requirements imposed on a qualified plan. Consequently, nonqualified deferred compensation arrangements are popular and frequently used as part of staff pay packages. Firms have for many years tried to push the enveloped of deferred tax payments by designing schemes that increased the beneficiaries ability to influence the timing and nature of compensation payments (and therefore tax liability). A number of different techniques and vehicles were developed over the years including rabbi trusts, foreign trusts, secular trusts, and split-dollar life insurance arrangements. One approach that was generally permitted by the IRS was the haircut provision. This allowed for early partial withdrawals from deferred compensation arrangements without triggering constructive receipt of the entire amount. 4 The beneficiary was allowed to make a withdrawal from the arrangement if she forfeited a portion of the amount deferred. This forfeiture was considered by the IRS as a substantial deterrent and limit on the beneficiary s ability to receive early distributions. Consequently, the constructive receipt rule, which would otherwise have resulted in immediate taxation of the entire amount deferred, was not triggered in a properly executed partial withdrawal under a plan s haircut provisions. In late 2002 Enron collapsed amidst, among other things, a significant amount of accounting fraud resulting in the loss of deferred compensation benefits for thousands of employees. Among many other abuses, Enron executives made extensive use of the haircut provisions in the final weeks before the company declared bankruptcy. Senior executions arranged for over $53M in accelerated distributions to 4 Under the constructive receipt doctrine income although not actually reduced to a taxpayer s possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available to him so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. This doctrine is now codified in IRC s. 451(a).

10 themselves from the company s nonqualified deferred compensation plans under the plan s haircut provisions. The public outcry over Enron s collapse led Congress to begin an effort to plug the many holes in the tax code that had been exploited by Enron (and other company) executives. The focus of these changes were primarily around heavily regulating the means by which beneficiaries of deferred compensation arrangements could exercise control over timing of payments and other aspects of the amounts deferred. Specifically, the staff of the Congressional Joint Committee on Taxation recommended rules requiring current income inclusion where nonqualified deferred compensation arrangements allow participants to maintain security and control over amounts deferred. 5 It is these recommendations, in content and spirit, that eventually evolved into s.409a. After s.409a came into force, many of the old tax deferral techniques are no longer usable, and it is increasingly difficult to enact new strategies to secure promised compensation while deferring income tax on that compensation. Section 409A greatly limits the conditions under which promised compensation may be treated as tax-deferred. 5 Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues and Policy Recommendations, February 2003.

11 Appendix IV Salary Deferrals and Severance Salary Deferrals Often the founder of a start-up company will voluntarily accept a below-market salary until the company obtains outside financing. The founder may want to create a legal obligation on behalf of the company to pay the missed salary at a specified future date. This obligation can take a variety of forms, including a salary deferral or a performance bonus (payable, say, when a financing closes). Salary deferrals are subject to extremely complex rules regarding the time when a deferral election must be made and the time(s) when the deferred salary must be paid. In addition, if a deferral election is made, the deferred salary may not be paid sooner than the time provided the election. Any change in the election to further delay the payment date is subject to additional rules, which generally mandate at least a five-year delay. If a deferral election is not properly structured or payment of a deferred amount is improperly accelerated or further deferred, it will result in the immediate inclusion of the supposedly deferred amounts in income plus a 20% excise tax. Severance Benefits Section 409A generally covers all plans and agreements under which compensation vests and becomes taxable in two different calendar years. Under this principle, s. 409A applies to severance benefits, if the payments vest in one year but the actual distributions stretch into subsequent years. For this purpose, vesting is deemed to occur when employment terminates, or even earlier if the employee may qualify for the payments by resigning (as opposed to being actually or constructively discharged). The IRS regulations confirm that severance benefits may be subject to s.409a. Fortunately, the regulations also offer a safe harbor for severance pay. If each of the following requirements is satisfied, the severance pay generally is exempt from s. 409A: The employment termination that triggers the severance pay must be involuntary. This includes a resignation for good reason if certain requirements spelled out in the regulations are satisfied. (Typically good reason means a material pay cut, a material demotion or a material involuntary relocation) The employee cannot provide substantial consulting services to the company after the employment termination. All severance payments must be completed by the end of the second full calendar year after the year of termination The exemption is available only for amounts up to the smaller of (a) $490,000 or (b) two times the employee s total compensation for the calendar year preceding the year of the termination. (The $490,000 amount is indexed for inflation).

12 The implications of s.409a must be considered when offer letters and employment agreements with severance pay provisions are prepared. They also must be considered whenever separation agreements and releases are negotiated with departing employees. 6 6 The regulations make it clear that s.409a cannot be avoided by disguising severance pay as a fee for minimal consulting services.