Page 466 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

452 The Complete Guide to Executive Compensation

However, in accord with FAS 123R, the company must take a charge to its earnings
statement equal to the fair value at time of grant spread over the vesting period in this case,
one year). Assuming the option pricing model chosen came up with $30, this is the amount
that would be charged.
Executives must be careful not to trigger a wash-sale transaction. This would occur if
the individual acquired stock through the exercise of an option within 30 days before or after
selling any stock of the same company at a loss. The IRS would deny recognition of the loss
but would include the amount of the loss in determining the FMV of the stock acquired
under exercise. However, the SEC ruled that the grant date, not the exercise date, is the
purchase date, making it easier to avoid wash-sale problems.

Nonstatutory Stock Option. By definition, this is a stock option that fails to meet all the
requirements of a statutory option and therefore is more flexible on grant size, ability to exer-
cise, length of grant, and holding period. Like the statutory option, there is no tax liability at
time of grant; however, at time of exercise, the spread between market value and option price
is taxed income. Since it is taxed as income, the TPI does not apply at time of exercise,
although the gain at time of sale (assuming long-term capital gains treatment) will be subject
to the alternative minimum tax without adverse maximum tax consequences. The holding
period to achieve long-term capital gains is the same as for other holdings (i.e., currently
more than one year).
Companies find the nonstatutory option more tax effective since they have a deduction
at the time of the optionee’s exercise. The only way for a company to receive a similar deduc-
tion under the statutory option is if the optionee sells the stock short of the holding require-
ment. This premature sale is called a disqualifying disposition and allows the company to take
a tax deduction equal to the spread between market value at date of exercise and option price.

Price-per-Share-Determined Stock Options. The most common form of nonstatutory
options is a nondiscounted 10-year grant, probably due to a carryover of the former SEC
rules that an option for insiders could neither be discounted nor exceed 10 years in duration
in order to be an exempt transaction at time of grant (i.e., neither a purchase nor a sale). With
the lifting of the SEC no-discount rules, some nonqualified options were discounted. Using
the same format shown in the previous section for statutory plans, let’s review what happens
with a nonstatutory grant. We’ll start with a nondiscounted stock option with the same price and
action dates used for the statutory grant. These are shown in Table 8-32. The only differ-
ence, albeit a significant one, is that at time of exercise, the optionee has an ordinary income
tax liability on $60. Using the same methodology as with the ISO, there would be a $30
charge to the earnings statement. The company has a $60 tax deduction.
A discounted, nonstatutory stock option is illustrated in Table 8-33. Everything is the same as
the example in Table 8-33 except the option price is set at $10 below the fair market value of
$100 at time of grant. Section 409A of the IRC requires that the $10 be taxed as ordinary
income at time of grant (plus a 20% penalty on that amount for a total of $12). The tax basis
having been stepped up to $100 the individual has ordinary income of $60 ($160 $100)
and the company a like tax deduction at time of exercise. In this example, assume the option
pricing model determines the fair value to be $33; it is this amount that will be spread
equally over the three years (i.e., 12 quarters) of vesting.
A variation would be an option whose price is discounted each year (e.g., $95 after one
year, $90 after two years, etc.). The rationale is to encourage the individual to stay for the