Page 465 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 8. Long-Term Incentives 451

Each of these 18 possibilities will be reviewed individually, but recognize that 196
combinations can be constructed, excluding variations on the length of the option. Later in
the chapter, combinations will be examined further.
While the construction of the grant might be complicated, the accounting and tax treat-
ment is not. As an equity award plan, the accounting is fixed at time of grant using a fair-value
expense model, either closed (such as Black-Scholes) or open (such as the binomial lattice
formula). The latter may be more useful when there is more than one variable. The expense
charge is spread equally over the period of vesting. Reversals are not permitted if the option is
not exercised. The recipient is taxed at time of exercising the stock option on the difference
between fair market value and option price. The individual is also taxed at time of grant if the
option price is less than fair market value on that date (see Section 409A of the Internal Revenue
Code). The company has a tax deduction at time of income recognition in the same amount as
the individual’s ordinary income. If the company tax deduction and expense charge are not the
same, an adjustment must be made to the deferred tax accounting the balance sheet.

Statutory Option. The various actions of grant, vest, exercise, and sale of a statutory stock
option are examined in Table 8-31. In this example, the three-year vesting requirement
combined with retaining the purchased stock for an additional year meets the “two years
from date of grant and one year after exercise” requirement described as an earlier require-
ment of Section 422 stock options. However, the $60 paper profit at time of exercise, while
not considered ordinary income, is subject to the alternative minimum tax described earlier.
Since the sale occurred three years after the purchase date, the $110 gain is all treated as
long-term capital gains. The company has no tax deduction (there was no ordinary income)
and it does have positive cash flow ($100 in this example). Had the optionee not met the more
than two years from grant and more than one year after exercise requirements at time of sale,
the optionee would have lost qualified status. The optionee would have had ordinary income
on the spread between FMV and option price and the company a like tax deduction. This is
the previously described disqualifying disposition.

Grant Vest Exercise Sell
Time Lapse Today Three years Five years Eight years

Stock price
• Fair market value $100 $130 $160 $210
• Option price $100 $100 $100 $100
Individual
• Ordinary income — — — —
• Long-term capital gains — — — $110
Company
• Tax deduction — — — —
• Expense* — $30 — —

* Accrued over vesting period
Table 8-31. Statutory stock option