Page 474 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)
P. 474
460 The Complete Guide to Executive Compensation
Company
Advantages Statutory (ISOs) Nonstatutory (All Others)
Positive cash flow from exercise proceeds True True
Positive cash flow from tax at exercise False True
Positive cash flow from tax at sale
if not LTCG True True
No outlay of cash True True
Fixed accounting at time of grant True True
Disadvantages
Increased dilution with shares purchased True True
Fair-value expense over vesting period
reduces profits True True
No tax deduction if optionee meets
holding requirements True False
Executive may leave if stock price does not
exceed option price True True
Table 8-41. Stock option advantages and disadvantages to the company
parachute (either single or double trigger). When activated, it would immediately convert all
of the stock option gains to cash SAR payouts.
SARs can also be freestanding, namely, not connected in any way to a stock option. Self-
standing, or freestanding, SARs are really phantom awards, since there is no accompanying
stock option. Such a plan must be designed carefully to avoid an IRS ruling of constructive
receipt due to lack of alternative right. An important point to remember in structuring a
plan to avoid constructive receipt is the basic principle that if income is available only if the
individual forfeits a valuable right, then income is subject to a substantial limitation and not
constructively received. In Revenue Ruling 80-300, the IRS, applying this logic, indicated
that since the exercise of the SAR would mean the loss of valuable right (namely, the chance
for further appreciation in the market price), the gain should not be recognized as income
until the rights are exercised. Thus, the normal tax treatment of a SAR is to tax when
exercised, and the company has a tax deduction in the same amount.
As for the SEC, the grant of a SAR, like that of a stock option, is considered the
acquisition date for purposes of the six-months rule. Initially, the SEC viewed the receipt
of cash in lieu of stock as a simultaneous purchase and sale and therefore a prohibited
transaction with all gains forfeitable to the company. After further reflection, the SEC
agreed to permit the payment in cash provided certain rules were met. These include
the following:
1. The SAR must be administered by a disinterested board of directors or by a committee
of three or more disinterested persons.
2. The SAR cannot be exercisable for the first six months.
3. The SAR can be exercisable only between the third and twelfth business days following
the release of quarterly company earnings data.