You are probably aware of the new stock option expensing rules under FASB, and the final IRS regulations requiring amendments to most incentive stock option plans. However, little attention has been given to the negative tax treatment afforded discounted stock options under the American Jobs Creation Act of 2004 (“JOBS”). Due to JOBS, stock options should be carefully monitored to avoid inadvertently triggering adverse tax consequences.
Discounted Stock Options Are No Longer Feasible. As background, a non-qualified stock option (“NQSO”) award is typically not exercisable until the passing of a specified period of time or the occurrence of a specific event. This is known as a vesting schedule. Once the vesting schedule is satisfied, the recipient may exercise the NQSO by paying the exercise price and receiving the underlying share. The recipient is typically taxed on the date of exercise.
A discounted stock option is a NQSO that is granted with an exercise price below the fair market value (“FMV”) of its underlying share on the date of grant. For example, a company with a FMV of $10.00 per share has a discounted NQSO if it grants the NQSO with an exercise price of $2.00. Prior to JOBS, this discount of $8.00 was not taxed until the recipient exercised.
JOBS changes the taxation of discounted NQSOs. JOBS requires the recipient to elect, around the time of receiving the NQSO, the exact date he or she will exercise in the future. If the recipient complies with this election requirement, taxation will continue to occur at the time of exercise. However, if the new election requirement is not satisfied, taxation will occur at the time of vesting (not exercise); plus, noncompliance can trigger a 20% tax penalty.
ISO Modifications Should Be Monitored. Due to JOBS, incentive stock options (“ISOs”) should be monitored to ensure any modifications do not result in adverse taxes to the employee. As background, one of the rules to obtain ISO treatment is that it must be issued at an exercise price equal to the FMV of the option’s underlying share on the date the ISO is granted. Another rule is an ISO cannot be modified or else it is considered the granting of a new option on the date it is modified. Thus, the exercise price must equal FMV on the date of modification or it fails to qualify as an ISO.
If the modified ISO fails to retain ISO status because, for example, the exercise price remains the same both prior to and after the modification, the option automatically converts to a discounted NQSO if the underlying share’s FMV had increased since the date of the initial grant. For example, assume a company issues an ISO with an exercise price of $10.00 (representing the company’s then FMV per share). Further assume that two years later this ISO is modified when the FMV of the underlying share rose to $11.00. In this example both the company and the employee would probably want to retain the exercise price of $10.00 post-modification. However, since an ISO modification is considered the granting of a new option on the date the ISO is modified, the modified ISO will convert to a discounted NQSO because the exercise price of $10.00 falls short of the underlying share’s FMV ($11.00) at the time of modification. Therefore, the employee will have to comply with the election requirements of JOBS or face taxation at the time of vesting (along with a possible 20% penalty).
Anthony J. Eppert is a benefits and compensation attorney in Luce Forward, Hamilton & Scripps, LLP’s San Diego office. He can be reached at (619) 699-2506 or aeppert[at]luce.com. Founded in 1873, Luce Forward is a full service law firm serving all of California with offices in San Diego, Carmel Valley/Del Mar, Los Angeles, and San Francisco.