Page 455 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 8. Long-Term Incentives 441

625 shares of company stock and decides to exercise an option for 1,000 shares at $100 a
share. The cost to exercise is therefore $100,000. Assume, further, the fair market value is
$160 a share at time of exercise. By transferring to the company the 625 shares already
owned (purchased at $30 per share), the executive meets the exercise requirement. Or, it
the company permits, formally declaring the requiste number of shares are owned. This is
called attestation.
The executive would receive two certificates, one for 625 (replacing the one transferred
to the company) and another for 375. Since the first was a tax-free exchange, the 375-share
certification is considered compensation in the amount of $60,000 (375 shares $160 FMV).
This amount is the same as if the executive simply exercised the option with a check for the
amount of $100,000—in other words, the difference between option price of $100 and FMV
of $160 multiplied by 1,000 shares, or $60,000. The cost basis for the 625 shares remains $30
a share; the cost basis for the 375 shares is $160 per share (after paying the taxes).
Had the individual sold the 625 shares in order to obtain funds to exercise the option,
the taxable income would have been $81,250 [i.e., ($160 30) 625]. Had the sale quali-
fied for long-term capital gains, and if that tax were 20 percent, the tax could have been
as high as $16,250 (i.e., 20 percent of $81,250). Therefore, the additional cash needed to
exercise the option would have been $35,000 since the net proceeds from stock sale would be
only $65,000 (i.e., $81,250 $16,250). Individuals may also wish to have sufficient shares
withheld to meet the tax-withholding requirements of the exercise.
The IRS stated in Revenue Ruling 80-244 that an employee could deliver stock owned
as payment for exercising a nonqualified stock option without incurring a taxable event on
the unrealized appreciation of shares delivered. It separated the exercise into two actions.
First was the delivery of owned shares in a tax-free exchange. The second was receipt of new
shares at a cost basis of zero, representing the spread between exercise cost and the FMV of
delivered shares owned. Since tax withholding is required on this spread, many choose to
satisfy the withholding requirement by reducing the number of new shares. In 1999, the
FASB stated that companies that withheld in excess of the minimum required must take a
compensation expense for the amount of the excess.
At about the same time, the SEC amended Rule 16b-3, enabling insiders to engage in
such transactions and also stated that shareholder approval of such a feature was not neces-
sary. As a result, a number of companies not only incorporated this method of exercising
stock options in their subsequent grants but also amended outstanding options to permit pay-
ment with company stock. However, companies had to be careful to ensure that such stock
received was not “tainted” in the eyes of the SEC, as this would preclude pooling-of-interest
accounting—a concern that disappeared in 2001 when FASB eliminated pooling.
Tendering stock to exercise an outstanding stock option and then immediately retender-
ing the shares received, continuing this virtual simultaneous exchange of shares received
in ever-increasing amounts to exercise remaining shares, is called pyramiding. It would be
possible to exercise the option by tendering one share and then engage in the rapid-fire
pyramid until the entire option was exercised. Since the tendered stock has not been owned
for at least six months, the company is subject to recognize a charge to earnings on appreci-
ation. Furthermore, such an action would be precluded for 16(b) executives.
Shown in Table 8-26 is an example of a stock-for-stock exercise combined with a reload
grant. The two disadvantages shown in Table 8-25 have been negated, namely, “shares at
work” and ownership issues. However, two new potential disadvantages have been added,
namely, proxy disclosure and shares available for use.