Get The Most Out Of Employee Stock Options
Many small, closely held companies, especially start-up companies, like to issue stock options to key executives and employees as both an incentive to help grow the company and as a substitute for cash compensation when they need the cash to invest in the business. In both instances, the tax consequences for executives and employees can be disastrous. IRC section A provides comprehensive rules regulating the taxation of nonqualified deferred compensation.
While section A does not explicitly define a "deferral of compensation," the IRS has been consistent in its position that discounted stock options are deferred compensation subject to section A throughout its notices, proposed regulations, and the final regulations. Specifically, IRS Notice states that if a stock option is granted with an exercise price that is less than the fair market value of the underlying stock on the date of the grant, the option will be treated as a deferral of compensation and will be subject to the requirements of section A.
Tax Topics - Topic Stock Options
The attraction of stock options to executives and employees is that they themselves control the timing of income recognition by timing the exercise of the option. If section A applies to the option, this flexibility is lost, substantially eliminating the value of the stock option.
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To avoid taxation under section A, the option must either be specifically exempted from section A or meet certain requirements as outlined below. Incentive stock options issued pursuant to IRC section and stock options issued under an employee stock purchase plan pursuant to IRC section are specifically exempted under the regulations from section A provided that they continue to meet the applicable qualification requirements of those sections of the IRC.
If any of the requirements of section A outlined above are violated, the nonqualified stock options or SARs are immediately taxable or, if later, upon vesting when the stock option is no longer subject to a substantial risk of forfeiture. The amount recognized as ordinary income by the grantee is the excess of the fair market value of the stock at December 31 less the exercise price and any amount paid for the option at grant.
Further, any appreciation in the value of the option in subsequent years is also taxed under section A including the year the option is exercised [Treas.
In conducting field audits, the IRS is clearly looking at stock option grants with respect to whether the option was granted at fair market value. The case, Sutardja v. United States, is not yet settled; however, in an initial ruling the Court of Federal Claims confirmed that section A applies to stock options.
Still to be decided in the case is whether, based on the facts, the options granted were in fact granted at a discount to fair market value. With confirmation that section A applies to stock options, the IRS will continue to scrutinize option grants. All businesses need to be aware of the rules applicable to the granting of stock options and SARs to their employees.
Closely held businesses need to be acutely aware of the valuation requirements related to stock and appreciation right grants under section A to avoid the extremely harsh tax consequences imposed on the employee for failure to comply with these rules.
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As companies grow we help them reach their goals every step of the way. By Peter Alwardt, CPA. Background IRC section A provides comprehensive rules regulating the taxation of nonqualified deferred compensation. Application of Section A to Stock Options and Stock Appreciation Rights The attraction of stock options to executives and employees is that they themselves control the timing of income recognition by timing the exercise of the option.
For nonqualified stock options, the exercise price must be at least equal to the fair market value of the underlying shares as of the grant date. For this purpose, if the grantee is entitled to dividend equivalents at exercise, they will be treated as a reduction to the exercise price; i.
A public company must base fair market value on a reasonable method using actual sales of its common stock such as the last sale, closing price or average price on the day before or the day of the option grant. Further, a company may use an average over a specified period in certain circumstances typically related to grants to employees in foreign jurisdictions in order to comply with local tax law.
However, the terms of the grant and the averaging period must be specified in advance of the grant date of the option.
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Under the section A regulations, three safe harbor valuation methods are presumed to be a reasonable valuation shifting the burden of proving unreasonableness to the IRS for this purpose, as follows: The stock subject to the nonqualified option grant must be solely stock of the entity receiving the services of the service provider or any corporation that owns a controlling interest in the service recipient or that is included in a chain of companies each of which is controlled by another company ending with the ultimate parent company.
Only stock that qualifies as eligible common stock may be subject to a stock option granted to the service provider.
For this purpose, section A allows the use of any class of common stock as defined under IRC section of any eligible service recipient as discussed in 2 above.
The stock may be subject to restrictions, but may not have any dividend preferences of any kind. Liquidation preferences are permitted, but the stock may not be subject to a non-lapse mandatory repurchase obligation or put or call right at a price other than fair market value.
The stock option may not provide for a deferral feature i. Material modifications to an existing grant are treated as a new grant subject to the requirements of section A and will likely require re-pricing.
Extensions of the right to exercise are permitted up to the lesser of the original exercise period as specified under the option grant or 10 years. Underwater options may be extended without restrictions.
For this purpose, they are treated as a new grant with an exercise price that exceeds the current fair market value of the stock. Tax Consequences of Failure to Comply If any of the requirements of section A outlined above are violated, the nonqualified stock options or SARs are immediately taxable or, if later, upon vesting when the stock option is no longer subject to a substantial risk of forfeiture. IRS Audit Activity and Federal Claims Court Ruling In conducting field audits, the IRS is clearly looking at stock option grants with respect to whether the option was granted at fair market value.
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