Why Bother With ISO's?

Joseph Bartlett and Colleen M. McIntosh

The news stories about employees, including but not limited to key executives, who have taken a bath in the stock of their own companies have been plentiful since the NASDAQ meltdown. Take one example (not the Enron case).[1]

An executive is granted a non-qualified stock option to acquire 1,000 shares of the company stock in 2002, the exercise price and fair market value being $20 a share. Assume the executive exercises the non-qualified option when the company shares have appreciated to $100 a share, recognizing $80 per share, or a total of $80,000, of ordinary income taxable to her. After exercise, but before sale, the company?s shares decline in price to $5 a share. The executive is out the $20 a share, or the $20,000 she paid to purchase the option shares, plus the tax on $80,000 of income... somewhere around $55,000 net out-of-pocket. All she has to set off against that bad news is shares worth $5,000. Alternately, let?s assume, instead of a non-qualified option, the company transfers 1,000 shares of restricted stock to the executive; she pays $5 a share, the stock being then worth $10 a share. Assume she files a Section 83(b) election and elects to be taxed on the current spread because the shares are subject to vesting (in I.R.C. language, a ?substantial risk of forfeiture?) and she wants to avoid a more significant tax if the shares appreciate in value when the substantial risk of forfeiture lapses. She is now out the $5,000 she paid, plus the tax on the $5 spread, and she hasn?t sold a share.

There are a variety of ways creative planners can deal with these situations so as to avoid some of the horror stories appearing in the trade press and, indeed, in the public journals. One such palliative gambit depends on timing. If the meltdown in the stock price occurs in the same tax year in which the options were granted or the restricted stock transferred, the company and the executive can call off the trade. The executive gets her money back and no tax is owed. As in most tax situations, the rules governing the parties? tax outcomes are complex and those interested should review Mr. Mooney?s article (see footnote) with some care for this and other potential solutions to the problem. But a simple lesson pops out from the foregoing narrative, namely: if one is going to employ a program for awarding key executives with options or restricted stock in a fluid economy such as we have experienced in the recent past, the best day to implement the trades is on January 2nd of each year, giving the executive and the company a full 12 months to review the situation and take advantage of a recission opportunity if the tide has turned against the executive... and if the company feels it is equitable under the circumstances to return to Square One.

In connection with the grant and exercise of non-qualified options, the hypothetical set out above is not realistic, at least for anyone with a modicum of good advice. If one reaches the conclusion that a non-qualified stock option should be exercised because the stock is a good buy, it still does not make sense to exercise and hold; this strategy, in all likelihood, gives the executive the worst of both possible worlds. First, she pays the exercise price and is long the stock, with the attendant risks. Secondly, she pays tax on the spread as if the gain had already been realized. Exercise and immediate sale is the obvious way to go about one?s business. The thought is that, even if one is convinced the stock will subsequently appreciate, nonetheless one should exercise and sell, pay the tax out of the proceeds of the sale and use the balance of the gain to invest in the stock. If you put a gain that is equal to the exercise price back in your pocket, then the worst that can happen is a zero result... no gain and no loss.

Interestingly enough, it looks as if the same formula (exercise and immediate sale) will be strongly recommended under almost any circumstance for holders of incentive stock options, as well. The attractiveness of an incentive stock option lessens the fact that the gain is taxed at capital gains rates. The bad news, however, is that the option stock must be held for 12 months following exercise and 24 months from the date of grant. The difference between capital gains and ordinary income tax being significant, on the surface there is an argument for the ?exercise and hold? strategy (in a rising market, anyway). However, the straw might have just broken the camel?s back and rendered incentive stock options essentially worthless, compared to non-qualified options. The points against incentive stock options include the following:

  • The exercise price of the option, when granted, must be set at an existing fair market value. A non-qualified option may, within limits, set the exercise price at some number below fair market value, meaning that, without paying any immediate tax, the holder is ?in the money? from the beginning of the transaction.

  • The fact that the non-qualified stock option is taxable at ordinary income rates means that the corporation gets a tax deduction in the amount of the gain, it being treated as taxable compensation. In the case of the incentive stock option, there is no tax benefit to the issuer.

  • Since the tax on what otherwise would be compensation to the holder of an incentive stock option is reduced to the capital gain rate, this implies a tax shelter of a sort and, therefore, alternative minimum taxable income is calculated on the basis of the gain, meaning the holder is all the more likely to encounter alternative minimum tax... a big issue these days.

  • Finally, the straw that breaks the camel?s back is the position just announced by the Internal Revenue Service that, starting in 2003, the government plans to collect Social Security and unemployment taxes when an incentive stock option is exercised. And, in the case of the Social Security tax, this means collecting the tax from the exercising holder and, at a date when the cash, if any, is 12 months away.

In a word, why bother with ISOs?

[1] This example is taken from an article by Michael Mooney, ?Mitigating the Pain of Equity Compensation in the Down Market,? 93 Tax Notes, 1099 (Nov. 19, 2001).

Colleen M. McIntosh is a partner in the New York office of Morrison & Foerster LLP.

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