Page 461 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 8. Long-Term Incentives 447

but the company has no tax deduction. However, if the statutory holding period has not been
met, the sale is a disqualifying disposition. The gain is taxed as ordinary income, and the
company has a tax deduction of like amount.
Obviously, if the form of exercise is a cashless exercise, the disposition occurred at time
of exercise.
Companies wanting the executive to retain stock acquired may either motivate them to
hold on to the stock or put restrictions in place that must be met before the stock can be sold.
An example of an incentive to hold would be to award restricted shares in some formula (e.g.,
one for every 10 shares acquired). Restrictions would lapse after a stated number of years or
after a stated number of shares had been acquired. Restrictions on sale without company
approval could be attached either to time requirements or stated level of share ownership.

History of Statutory Stock Options

The first stock option form receiving favorable tax treatment was the “restricted” option as
defined in Section 424 of the Internal Revenue Code. It came into being with the Revenue
Act of 1950 and lasted until the Revenue Act of 1964, when it was replaced by the “qualified”
option. The “qualified” option lasted until the Tax Reform Act of 1976 legislated it out of
existence (the burial was on May 21, 1981). However, it also was subjected to heavy attack by
changes in the 1969 Tax Reform Act. Like Lazarus, the qualified stock option returned to the
world of the living in the form of the “incentive stock option” with the 1981 Economic
Recovery Tax Act, as described in Section 422 of the IRC.
The essential features of the early restricted option in the Revenue Act of 1950 included
(1) an option price as low as 85 percent of market value at time of grant, (2) capital gains
treatment on the difference between market value at time of sale and option price for stock
held more than six months after exercise and more than two years after date of grant, (3) a
period as long as 10 years during which the grant could be exercised, and (4) no restriction as
to which sequence options needed to be exercised in.
The Revenue Act of 1964 introduced a new form of statutory option (i.e., “qualified”),
while terminating the restricted form. Like the restricted option, the qualified imposed no
tax liability on the holder at either time of grant or time of exercise. However, (1) the grant
could not be for less than 100 percent of market value at time of grant, (2) the option period
could not exceed five years, (3) an option could not be exercised while the holder had an
earlier-granted qualified option outstanding at a higher price, and (4) capital gains treatment
was available only if the stock was held for more than three years. If the stock was not held for
more than three years, the executive was considered to have made a disqualifying disposition
and the spread at exercise was taxable in the year of sale. At that point, the company took a
like amount of deduction for tax purposes.
Thus, while the qualified option was not as attractive as its predecessor, it was still
more palatable than anything else, given (1) a rather favorable growth in stock prices and
(2) marginal tax rates as high as 77 percent (91 percent before the 1964 Revenue Act).
The 1969 Tax Reform Act took three further swings at the attractiveness of the qualified
option. First, it lowered the maximum marginal tax rate from 70 percent to 50 percent on
earned income (namely, payment arising out of employment), thereby making cash more
attractive.
Second, the long-term capital gains tax maximum of 25 percent was increased to one-half
the ordinary income tax rate (maximum 70 percent) except for the first $50,000, which was