Page 343 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 6. Employee Benefits and Perquisites 329

the stock may be purchased. A stock option has five key dates: grant, vest, grant termination,
exercise, and sale.
While more will be said about stock options in Chapter 8 (“Long-Term Incentives”), the
focus there will be on executive stock options, which is a major portion of senior executive
pay. Broad-based stock option plans are more of an employee benefit than an incentive. Like
stock purchase plans, they are a way of supplementing retirement income from other sources
through capital accumulation of the company’s stock.
A stock option that complies with the requirements of Section 422 of the IRC is called a
statutory option and is eligible for preferential tax treatment.
Section 422 requires the following:

1. The optionee may not sell within two years from date of grant nor within one year after
exercise.
2. The optionee must exercise the option not later than three months after leaving
employment.
3. The plan must specify the number of shares available for grant and be approved within
12 months of date plan is adopted.
4. Grants under the plan may not be later than 10 years from adoption or approval date
(whichever is sooner) of the plan.
5. The exercise period may not exceed 10 years from date of grant.
6. The grant price may not be less than the fair market value on date of grant.
7. The aggregate fair market value of the grant (i.e., grant price times number of shares
exercisable in a year) may not exceed $100,000.
8. The option is not transferable by the optionee other than by will or the laws of descent
and distribution, and is exercisable only by the optionee during his or her lifetime.
9. The optionee does not own more than 10 percent of the voting power of all stock
outstanding.
Because of these limitations, statutory stock options have little appeal to executives. Rather,
they grant nonstatutory stock options, as will be discussed in Chapter 8.
Stock options are typically thought of as something reserved for executives; however, they
can be a broad-based method for getting stock into employees’ hands. Pfizer Inc. began grant-
ing such broad-based stock options to its employees in 1951. In 1999 the SEC defined a broad-
based stock option plan as one that granted a majority of the shares to other than officers and
directors and in which a majority of U.S. exempt full-time employees are eligible to participate.
Except for possible tax preferential income, statutory stock options are not taxed until
sold. The 2004 American Jobs Creation Act exempts purchases and sales of such options
from FUTA and FICA taxation. Under FAS 123R, companies are required to use an option
pricing model to determine the charge to earnings. The company has no tax deduction if
income is taxed as a long-term gain.
The number of shares granted to employees is either a constant number or a share for
every prescribed increment of salary. The two are contrasted in Table 6-34, using an option
price of $100 a share. Determining the number of shares based on salary increments provides
a constant percentage benefit. The same number of shares regardless of salary level provides
the greatest benefit to the lowest paid. However, it also means the percentage cost of exer-
cise is the highest at the pay level least able to afford the exercise cost. Admittedly, this
becomes easier to accomplish if the exercise cost is spread over the full 10 years. However,