Unlocking The Handcuffs

 

A stock option is the right to purchase a certain amount of shares of the granting company's common stock at a given price for a specified period of time. To the manager, engineer, marketer, or other key employee who is granted them, options are a riskless opportunity to earn more income -- often considerably more in the case of a start-up -- and to become an equity owner of the corporation. Typically, a stock option is vested over four or five years -- the "handcuffs" -- and may either expire at a certain date, be renewable on a year-to-year basis, or be exercised. Another stock option may or may not follow.

Ever since the bull market's startling beginning last summer, pushing growth-company equities to four or five times their August 1982 market values, the stock option as a form of deferred compensation has made an equally dramatic resurgence as a perquisite. The idea of granting motivational stock options to employees of a corporation has been around for several decades, but it wasn't until 1981's Economic Recovery Tax Act (ERTA) that the gradually waning tax advantages of stock options were shored up and formally turned into incentives. Regulations for a qualified incentive stock option (ISO) allow a stock option to be granted to a select group within the company. Unlike a nondiscriminatory employee stock ownership plan (ESOP) with regulations defined by the Employee Retirement Income Security Act, a company may grant an option to anyone at will, in only one year or over a period of years.

Another large difference between an ESOP and an ISO is that the former is an outright grant of stock, whereas the latter requires the employee to come up with payment to purchase the option's underlying stock. Another difference is that with an ISO, it is the employee -- not the company -- who realizes tax advantages. However, if a corporation elects not to qualify for ISO treatment, it can gain deductions on the appreciation of the stock's value at the sacrifice of the employee's advantages. (Usually it would not choose to do so, since the concept is to inspire the employee, not burden him with a tax problem.) The major advantage established by ERTA is that the recipient of an ISO is not deemed to have received taxable income either when the option is granted or exercised. The taxable event occurs only when the shares are sold, at which time the income is viewed as a long-term capital gain. (This substantial kindness by the Internal Revenue Service was Indian-given to some extent by 1982's Tax Equity and Fiscal Responsibility Act, which imposes an alternative minimum tax on ISOs in certain income situations.)

To receive favorable tax treatment, the grantee of an option must not dispose of the underlying stock within two years of the date the option is granted and must hold the acquired stock for the long-term period of a year and a day. Among other qualifying strictures are that not more than $100,000 worth of options can be issued to an individual each year, that the recipient must exercise the option within three months of termination of employment, that no other previously issued ISO is outstanding, and that the price of the stock underlying the option must be the prevailing value (either as determined by the open market or an independent appraiser) at the date of issue. If these requirements are met, the executive gains both postponement and reduction of taxation -- an appealing shelter and powerful income enhancement. On the other hand, certain executives are willing to waive favored ISO treatment in favor of the grant of more than $100,000 worth of stock or for such variation of the option as a discounted price for the underlying stock. At its discretion, a company may issue both qualified and nonqualified options and may give the grantee further consideration, such as a cash payment to help him or her with taxes, guided only by IRS "reasonable compensation" principles.

A company may allow -- or may take firm steps to prevent -- an increasingly popular practice called "pyramiding." This is the tactic of paying for the exercise of an option with stock acquired from any source except the ISO -- thus presumably avoiding a taxable event by the practitioner's never having "sold" the acquired stock. So far, a one-time exchange has been tolerated by both the Securities and Exchange Commission and the IRS, but accountants uneasily predict that the maneuver won't long be tolerated by either as a tax-avoidance technique.

The handcuffing benefits of stock options presume that the corporation's stock rises during the years involved. If it doesn't, the now-worthless piece of paper can become a decided disincentive. In such a case, a corporation might rewrite the option for the lower prevailing price, but in so doing it forfeits ISO qualification. This or any other modified plan must be approved by shareholders within 12 months, if the new setup entails activating authorized stock. Because of many similar constraints and pitfalls, it is a wise company that seeks financial and legal guidance before embarking on a stock option program.