STOCK OPTIONS AND EQUITY COMPENSATION 47 th Annual Texas CPA Tax Institute Houston, Dallas, San Antonio November 14-16, 2000 William H. Hornberger James R. Griffin whornberger@jw.com jgriffin@jw.com 214 953 5857 214 953 5827 Jackson Walker L.L.P. 901 Main Street, Suite 6000 Dallas, Texas 75202 SLIDE 1
An employee stock option is the right or privilege of an individual to purchase stock from an employer by virtue of an offer of the employer in consideration of services performed by the individual for the employer to sell the stock at a price described in the offer SLIDE 2
Topics Covered Section 83 ISOs NSOs Typical plan provisions Stock purchase plans Nontax considerations Legislative developments SLIDE 3
Topics Not Covered Federal and state securities law issues Equity compensation in non-corporate entities Change in control situations (IRC 280G) $1 million deduction limit (IRC 162(m)) Options in not-for-profit organizations Stock option gain deferral strategies Stock options in divorce Accounting for stock options Private and charitable gifting of options Estate planning for options Equity set asides and allocations Types of options & awards SLIDE 4
The Players BigTechs, Inc. ( BTI ) Mr. Idea Nodo ( Nodo ) Employer, a C corporation Employee Hypothetical BTI hires Nodo and grants to him 20% of BTI stock for no consideration other than the performance of services. Issues Choice of entity Type of compensation Income recognition SLIDE 5
Advantages of Equity Compensation Align the interests of employees and shareholders Conserves cash Recruiting, retention & motivation Improve productivity and profitability Promote teamwork Accounting SLIDE 6
Types of Equity Compensation Plans Stock Option Plan Incentive Stock Option (ISOs) Nonqualified Stock Option (NSOs) Stock Purchase Plan Stock Grant Restricted Unrestricted Nonqualified Deferred Compensation Plan ESOP Phantom Stock Plan Stock Appreciation Rights 401(k) Plan SLIDE 7
Compensatory Transfers of Property IRC 83 Property Is transferred to any person By reason of the performance of services Transferrable or substantially vested Not specifically excluded SLIDE 8
Section 83 Tax Consequences Employee Employer Grant Date None None Vesting Date Compensation Compensation Income Deduction Disposition Date Capital Gain N/A Or Loss Compensation = FMV of Property upon Vesting MINUS Amount Paid (if any) SLIDE 9
Property IRC 83 Real and personal property Other than money an unfunded and unsecured promise to pay money or property in the future Includes a beneficial interest in assets (including money) transferred or set aside from the claims of creditors of the transferor SLIDE 10
Transfers IRC 83 A transfer of property occurs when a person acquires a beneficial ownership interest in the property Factors indicating that a transfer may not have occurred requirement to return property upon the occurrence of an event that is certain to occur similarity to an option relationship to fair market value risk of loss SLIDE 11
Substantially Vested IRC 83 Property is substantially vested when it is either transferrable or not subject to a substantial risk of forfeiture Employee s completion of a specified number of years of employment Employee s attainment of a specified age Employer s attaining a specified financial target Occurrence of a specified event, such as the employee s death, disability, retirement or involuntary termination Covenants not to compete Discharge for cause or crimes Consultancy agreement Restrictions imposed by SEC short swing profit rules Risk of decline in value Rule 144 stock Blackout periods Lock up periods SLIDE 12
Example--Substantial Risk of Forfeiture On November 25, 20xx, BTI grants Nodo, in connection with his performance of services, a bonus of 100 shares of BTI stock. Nodo is obligated to return the stock to BTI if he terminates his employment for any reason. For each year after November 25, 20xx, during which Nodo remains employed with BTI, he ceases to be obligated to return 10 shares of the BTI stock. Nodo s rights in 10 shares of the 100 shares cease to be subject to a substantial risk of forfeiture for each year he remains so employed. SLIDE 13
Acceleration of Income Recognition on Restricted Property 83(b) Election Taxpayer s name, address and social security number Description of the property Date the taxpayer received the property and the taxable year for which the election is made Nature of the restriction FMV of the property at the time the taxpayer received the property Amount paid by the taxpayer for the property I have provided copies of this statement as required in the regulation To IRS within 30 days of transfer of stock to Employer to IRS with 1040 SLIDE 14
ISO Requirements IRC 422 Employees only Written plan specifying aggregate number of shares that may be issued employees or class of employees eligible to receive options Shareholder approval Options must be granted within 10 years from the earlier of date of plan adoption or date of plan approval by shareholders Options must not be exercisable after the expiration of 10 years from the date of grant (5 years in the case of 10% shareholders) Option price must be not less than FMV of the stock at the date of grant (110% in the case of 10% shareholders) Options must be nontransferrable $100,000 limit per year on initial exercisability SLIDE 15
ISO Tax Consequences Employee Employer Grant Date None None Exercise Date None None Disposition Date Capital Gain N/A Or Loss Holding period is satisfied upon the later of 2 years after date of grant 1 year after date of exercise If holding period is not satisfied, a disqualifying disposition occurs with the following consequences Compensation Income = Lesser of: FMV of stock on exercise date MINUS exercise price Or Amount received on sale MINUS exercise price Capital gain or loss = Amount received MINUS exercise price plus compensation income SLIDE 16
Alternative Minimum Tax Consequences IRC 55 Nodo exercises an ISO granted to him by BTI to purchase 8,000 shares of BTI stock for $10 per share. BTI stock was valued at $25 per share on the date of exercise. Assumptions: Nodo has regular taxable income of $125,000 Nodo is married Nodo has no other items of preference or adjustment In the year of exercise Regular taxable income 125,000 ISO adjustment 120,000 Alternative minimum taxable income 245,000 AMT exemption 45,000 Exemption phaseout 245,000 Phaseout threshold 150,000 Excess 95,000 Reduction 25% 23,750 Net exemption _21,250 Taxable excess 223,750 AMT @ 26% on first 175,000 45,500 AMT @ 28% on excess 13,650 Total AMT 59,150 Total Regular Tax 30,032 Excess due to AMT 29,118 SLIDE 17
Modification of ISOs The modification, extension or renewal of the terms of an existing ISO is considered as the granting of a new ISO. Modification means any change in the terms of an option that gives the employee additional benefits under the option. Modification does not include a change in the terms of the option attributable to the issuance or assumption of an option in connection with certain corporate transactions to provide accelerated vesting in the case of an option that is not immediately exercisable in full to reflect a change in the number or price of the shares due to a stock dividend or split up SLIDE 18
NSOs IRC 83 Readily ascertainable fair market value on the date of grant Option is actively traded on an established securities market Or Taxpayer demonstrates the following the option is transferrable the option is immediately exercisable the option (or the property subject to the option) is not subject to any restriction or condition that has a significant effect on the fair market value of the option the FMV of the option privilege is readily ascertainable SLIDE 19
Tax Treatment of NSOs IRC 83 Assumptions option does not have a readily ascertainable fair market value stock is transferrable and unrestricted on exercise Employee Employer Grant Date none none Exercise Date Compensation Compensation Income Deduction Disposition Date Capital gain N/A or loss Compensation = FMV of stock on exercise date MINUS exercise price SLIDE 20
Example NSOs & Immediate Exercise BTI grants Nodo an option to purchase 10,000 shares of BTI stock at.50 per share. Nodo must resell the stock to BTI at.50 cents per share if he terminates employment within 5 years. Assume that the stock is currently worth $1 per share and will be worth $5 per share in 5 years and $10 per share in 10 years. Exercise in 5 years $50,000 BTI stock received 5,000 exercise price $45,000 compensation income Exercise immediately $10,000 BTI stock received 5,000 exercise price $ 5,000 compensation income SLIDE 21
Typical Plan Provisions Exercise price Option term Vesting Accelerated vesting FMV on date of grant 10 years 3-5 years Death Normal retirement Early retirement Disability Involuntary termination other than for cause Change in control Time to exercise after termination Time to exercise after disability Time to exercise after death 3 months 12 months 12 months SLIDE 22
Other Stock Option Plan Provisions Vesting based on performance Transferability Reload Repricing Evergreen clause Shareholders agreement Manner of exercise cash note existing shares cashless SLIDE 23
Tax Consequences of Using Existing Shares to Pay Exercise Price Two part transaction Exchange Shares no income carryover basis tacking of holding period Added Shares income equal to value of added shares basis equal to amount of income recognized new holding period Special rule for immature ISO shares NSO ISO exchange shares will be treated as ISO shares use of ISO shares will be treated as a disqualifying disposition SLIDE 24
Example--Using Existing Shares to Pay NSO Purchase Price Assume that Nodo has a vested NSO to purchase 1000 shares of BTI for $5 per share. Nodo would like to use his existing BTI shares to pay the exercise price. BTI shares are currently worth $10 per share. Nodo tenders 500 shares to BTI in payment of the $5,000 exercise price. In return, he receives 1000 shares of BTI stock. 500 of those shares will have a carryover basis equal to the basis of the shares tendered and have the same holding period as the old shares. 500 of those shares will result in taxable compensation income to Nodo in the amount of $5,000. Nodo s basis in the 5,000 added shares will be $5,000 and his holding period will begin on the date of exercise. SLIDE 25
Minimum Wage Considerations Worker Economic Opportunity Act Enacted to amend the Fair Labor Standards Act to specify the conditions under which stock option compensation is excluded from the hourly wage rate for overtime pay purposes. Applies to stock options, stock appreciation rights and stock purchase plans Requirements terms & conditions of the plan must be communicated to the optionee before grant exercise must be voluntary option must not be immediately exercisable exercise price must be at least 85% of FMV of stock on date of grant performance based awards must be based on previously established criteria or past performance Non-complying employers may be liable for additional overtime pay based on the value of the option for up to two years prior to the date of exercise Effective for options granted on or after August 16, 2000 SLIDE 26
Stock Purchase Plan Requirements IRC 423 Employees only Narrow exclusions Uniformity of rights and privileges Shareholder approval Excludes 5% or more owners Exercise price must not be less than 85% of the lesser of the stock s fair market value at date of grant or date of exercise Exercise term may not exceed 5 years Per person stock amount limited to $25,000 per year determined at date of grant Option must not be transferrable SLIDE 27
Stock Purchase Plan Tax Provisions IRC 423 Holding period is satisfied upon the later of 2 years after date of grant 1 year after date of purchase If the holding period is not satisfied, then a disqualifying disposition will occur with the following consequences Compensation income = FMV of stock on purchase date MINUS exercise price Capital gain or loss = Amount received MINUS exercise price PLUS compensation income If the holding period is satisfied, then the following consequences will result Compensation income = Lesser of: Amount received MINUS exercise price Or FMV of stock on grant date MINUS exercise price Capital gain or loss = Amount received MINUS exercise price plus compensation income SLIDE 28
Legislative Developments Stock Option Challenges Identified in Congressional Testimony (10/12/2000) Keep stock options free from ERISA regulation Eliminate alternative minimum tax Eliminate taxation of paper profits on exercise Worker classification Information reporting Withholding rules on disqualifying disposition of employee stock purchase plan stock SLIDE 29
Universal Stock Options Act of 2000 H.R. 4972 Pretax stock purchases up to $10,500 per employee per year Shares held in trust No tax to employees on either payroll deferral or exercise Employers allowed a deduction upon option exercise equal to FMV of the stock Upon disposition of stock, employee recognizes compensation income equal to FMV of the stock on exercise and capital gains for any excess Wealth Through the Workplace Act H.R. 3462 On exercise, employees recognize no compensation income but employers are allowed a compensation deduction On disposition, gain is taxed to employees as capital gain SLIDE 30
Useful Stock Option Websites www.optionwealth.com www.mystockoptions.com www.myoptionvalue.com www.stock-options.com www.stockoptionscentral.com SLIDE 31