Page 462 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

448 The Complete Guide to Executive Compensation

still subject to a 25 percent rate. Thus, the tax spread between salary and bonus versus stock
option was reduced from a difference of 45 percentage points (70 percent versus 25 percent)
to a difference of 15 percentage points (50 percent versus 35 percent).
Third, it introduced a new form of tax—an alternative minimum tax (AMT) that would
apply to certain items (i.e., preference income). This tax preference income (TPI) would be
taxed at the rate of 10 percent above a $30,000 exclusion. However, this exclusion was
further increased by the amount of tax liability for the current and up to seven prior years.
The spread between market value and option price on the date a qualified option was
exercised met the definition of tax preference income (unless sold within the same tax year),
as did one-half of the long-term capital gains at time of sale.
Assume the executive exercised the option, and the “spread” equaled $50,000. Further,
assume that the individual paid $22,000 in federal taxes. Since the $30,000 exclusion plus the
tax liability exceeded the TPI, there was no tax liability. However, any TPI over the $30,000
exclusion reduced dollar for dollar earned income subject to the 50 percent maximum tax,
thus making it subject to a possible 20-point increase in taxes.
In spite of prophecies that the qualified option was dead, it continued to be a viable part
of the compensation program—especially for those under the 50 percent maximum tax
bracket—primarily because the stock market continued to produce profits.
However, a later downturn in the stock market was coupled with the 1976 Tax Reform
Act, which legislated the qualified stock option out of existence on May 20, 1981. Any
qualified stock options that were not exercised by that date were taxed as nonqualified stock
options. Furthermore, it made use of such options less attractive during their remaining life
by (1) eliminating the $30,000 annual TPI exemption, (2) increasing the AMT to 15 percent,
and (3) lowering the overall TPI exemption to the greater of $10,000 or one-half of
the regular income tax for the current year (the carryover of unused previous year’s credit
was eliminated).
The conference report accompanying the 1976 Tax Reform Act requested the IRS to
develop and promulgate rules that would govern an individual’s election to have the option
valued at time of grant rather than exercise and sale. In addition to the option price
and length of the option, some estimation of future earnings of the company was to be con-
sidered. To date, the IRS has been reluctant to take this action, perhaps since the future
aspects of the company’s success make it unlikely that the value will be “readily ascertainable”
as required in Section 83(3). Some have argued that FAS 123R provides the needed “fair
value.” Stay tuned!
The 1978 Revenue Act reduced the portion of long-term gains subject to taxes from half
to 40 percent, thus effectively lowering the maximum capital gains tax from 35 percent
(i.e., 50 percent of income 70 percent tax rate) to 28 percent (i.e., 40 percent of income
70 percent tax rate). Also, the untaxed portion of capital gains income was no longer subject
to the 15 percent preference tax. In addition, the reclassification of $1 of personal service
income as ordinary income for every $1 of untaxed capital gain income was eliminated.
However, these two tax features still applied to the difference between fair market value and
option price at time of exercise for TPI purposes.
Each of these legislated changes made nonqualified stock options comparatively more
attractive. In the eyes of many, the official death of the qualified option on May 21, 1981, was
more a “mercy killing” than a vicious act. The period of mourning was brief, as the the 1981
Economic Recovery Tax Act (ERTA) restored the statutory stock option, now called the
incentive stock option (ISO). The features of these options include the following: