IRS Proposed Regulations on Incentive Stock Options Can Have an Adverse Impact on Corporate Transactions

Article

Corporate & Finance Alert

October 14, 2003

On June 6, 2003, the Internal Revenue Service issued comprehensive proposed regulations on incentive stock options (“ISOs”). This Alert discusses ISOs in general, and how the proposed regulations can adversely affect ISOs in corporate transactions.

TAX TREATMENT OF ISOS

The Internal Revenue Code of 1986, as amended (the “Code”) provides the following tax treatment for ISOs. An employee does not recognize income on either the grant of an ISO, or the exercise of an ISO. Once the employee exercises the ISO and holds the stock for the required holding period, on a subsequent sale of the stock the employee recognizes capital gain equal to the difference between the sale proceeds and the exercise price. The required holding period is two years from the date of grant, and one year from the date of acquisition of the stock. The employer is not allowed any compensation deduction. Finally, the spread between exercise price and the fair market value of the stock at exercise is an item of tax preference in computing the alternative minimum tax.

The tax treatment of ISOs is advantageous to the employee. First, since the capital gain rate is now 15%, this rate is much lower than ordinary income rates. Second, the tax treatment has a practical benefit to the employee because he or she recognizes the gain at the date of sale when he or she receives cash sale proceeds that can be used to pay the tax. Third, if the employee has capital losses, he or she can use these losses to offset the capital gain.

The tax treatment of ISOs is more advantageous to the employee than the tax treatment of nonqualified options. With a nonqualified option, the employee recognizes ordinary income on the date of exercise equal to the difference between the fair market value of the stock and the exercise price. Thus, the employee recognizes income before he or she has sold the stock and received the cash sale proceeds. Unlike an ISO, an employer can take a compensation deduction when the employee recognizes income.

REQUIREMENTS FOR ISOS

An ISO must satisfy the following requirements:

  1. The option must be granted pursuant to a plan that sets forth the maximum aggregate number of shares that may be issued on exercise of the ISOs, and the employees or class of employees eligible to receive ISOs.
  2. The plan must be approved by the shareholders of the granting corporation within twelve months before or after the date of the plan’s adoption. The shareholders must approve the maximum aggregate number of shares that may be issued on exercise of the ISOs, and the employees or class of employees eligible to receive ISOs.
  3. The option must be granted within ten years after the earlier of the date of the plan’s adoption, and the date of shareholder approval. The option, by its terms, must not be exercisable after ten years from the date of grant.
  4. The exercise price must not be less than the fair market value of the stock on the date of grant.
  5. The option, by its terms, must not be transferable by the employee other than by will or the laws of descent and distribution, and the option must be exercisable only by the employee during his or her lifetime.
  6. If the employee owns more than 10% of the total combined voting power of all classes of stock of the employer corporation or its parent or subsidiary, the exercise price must be at least 110% of the fair market value of the stock on the date of grant, and the option must not be exercisable after five years from the date of grant.
  7. The aggregate fair market value of stock subject to an ISO, determined as of the date of grant, that is exercisable by the employee for the first time in a calendar year cannot exceed $100,000.

THE EFFECT OF THE PROPOSED REGULATIONS ON ISOS IN CORPORATE TRANSACTIONS

The proposed regulations, if adopted as final in their current form, can have an adverse effect on corporate transactions. With respect to the $100,000 limitation, the proposed regulations state that the limitation applies to an option subject to acceleration as of the date the acceleration is triggered. Thus, the limitation applies to ISOs for which vesting is accelerated because the option contains a change of control provision. Options for stock that exceed the $100,000 limitation become nonqualified options, with the result that an employee recognizes large amounts of ordinary income on exercise, rather than the nonrecognition treatment of an ISO. It is important to note that the employee recognizes ordinary income regardless of whether the acquiror assumes the options.

The proposed regulations can also wreak havoc with the shareholder approval requirement. The prior regulations required new shareholder approval on a change in the aggregate number of shares to be issued under the plan, and on a change in the class of eligible employees. The proposed regulations require new shareholder approval not only for these changes, but also on a change in the identity of the granting corporation, and a change in the shares issued. These new requirements can be problematic. In many corporate transactions, the acquiror will assume the target’s outstanding awards into a preexisting plan of the acquiror. In this manner, the acquiror and target preserve outstanding awards. If the acquiror’s plan continues to issue shares in the target, this arrangement will be a change in the shares issued that requires new shareholder approval. If the acquiror substitutes its shares, often the plan will exceed the number of shares authorized. Another approach is for the acquiror to assume the target plan, but if the target stock has been cancelled or is otherwise unavailable for issuance, the substitution of acquiror stock also requires new shareholder approval.

The best approach to avoid this dilemma created by the proposed regulations is for the acquiror to assume or substitute the target’s outstanding awards as a contractual obligation outside the acquiror’s plan. Unfortunately, other provisions in the proposed regulations can prevent this approach from being a workable solution. Under Code Section 424, a modification of an ISO is treated as the grant of a new option at a new option price. An important exception to modification treatment is an assumption or substitution by a reason of a corporate transaction. Under this exception, the aggregate spread of the award must not be greater than the aggregate spread before the transaction, and the assumption or substitution must not give the employee additional benefits that the employee did not have under the old option. The proposed regulations require that the options contain the same terms that they had prior to the transaction, and that the new arrangement must satisfy all the requirements for ISOs. This means that any assumed or substituted ISOs must be part of a shareholder approved plan that contains all the material terms of the plan under which ISOs were granted.

Thus, when an acquiror does not wish to assume a target plan, does not want to take the time or bear the expense of obtaining a new shareholder approval, and does not want to cash out the old ISOs, the acquiror is left without a meaningful way of handling ISOs in corporate transactions. Hopefully, the IRS will recognize the deleterious effect that the proposed regulations can have on corporate transactions, and will make the appropriate revisions in the final regulations.