New Strategies for Employee Stock Options

From Employee Benefits Alert

July 1997

Stock options have become a very popular method of providing additional compensation to employees and motivating employees to increase shareholder value. Recently, some new strategies have been developed for enhancing the benefits that may be obtained from stock options.

Transferable Options

Recent IRS rulings have provided guidance on the use of transferable stock options in estate and gift planning for executives. The basic technique is for the employee to transfer options to a family member or an irrevocable trust for the benefit of family members shortly after receiving the grant. The transfer of the options would be a taxable gift, but the transfer will occur at a time when the options have a low value, thereby minimizing the amount of the gift. If the gift is made directly to a family member (or if the trust is properly structured), it will qualify for the $10,000 annual gift tax exclusion.

Upon exercise of the options, the employee would remain subject to the income tax that is triggered when a nonqualified option is exercised and the employer would receive a corresponding deduction (this technique cannot be used with incentive stock options, which, by their terms must be nontransferable in order to qualify under the Code). The employee's payment of the income tax results in an added benefit in that it avoids reduction of the amount of the gift to the family member that would occur if the family member or trustee had to pay the income tax.

In order for employees to utilize this technique, employers must provide in their stock option plans and agreements that the nonqualified stock options may be transferred to family members or trusts for the benefit of family members. The IRS has ruled that existing plans or outstanding option agreements can be amended in this regard without the amendment constituting a material modification of the plan for purposes of complying with the section 162(m) transition rule regarding the performance based compensation exception to the $1 million limit on deductible executive compensation.

Employers also must consider the need to comply with securities law with respect to transferable options. At present, the exercise of a stock option by a family member will not be covered by a Form S-8 registration statement. Stock received by the family member would be subject to Rule 144, and thus could not be sold publicly for one year, except in certain small transactions, unless the employer files a Form S-3 registration statement.

Deferral of Income on Exercise of Stock Options

Another technique that has become popular recently is the stock option deferral, by which an executive defers the gain that would ordinarily be recognized upon exercise of a nonqualified stock option. The gain is credited to a nonqualified deferred compensation plan maintained for executives, with future payment of the benefit from that plan being made in stock or cash in an amount measured by the value of the stock or by some other hypothetical investment. The executive is subject to tax at ordinary income rates when the payments are made from the deferred compensation plan.

The stock option deferral can benefit the executive in a number of ways. If the executive has options that are about to expire, he can exercise the options and obtain additional deferral of the tax consequences of exercising the options. An executive who wishes to reduce his exposure to the stock of the employer can exercise the options and diversify by selecting a different hypothetical investment under the deferred compensation plan without paying the tax that would be imposed on exercise of the option and sale of the shares. Care should be taken in permitting executives to control investment alternatives for the deferred compensation, however, or the IRS may treat the executive as taxable on the amounts subject to his control. Executives who would be subject to trading restrictions can avoid the "phantom income" that would result if they had to exercise expiring options at a time when they could not sell the shares to obtain funds with which to pay their income tax.

In order to make the stock option deferral available, the employer must have a nonqualified deferred compensation plan for executives that permits deferral of stock option gains or must provide for such deferral under its stock option plan. The executive must make an advance election (usually at least six months) to defer the gain that will be recognized upon the future exercise of the stock option. The executive also should exercise the stock option by paying the exercise price with employer stock; the deferral technique relies in part on an IRS Revenue Ruling that applied the stock-for-stock exchange exemption to the receipt of option shares when the exercise price was paid with stock. Under the ruling, if the employee tenders 20 shares to pay the exercise price for the purchase of 100 shares, the first 20 shares received would be a tax-free exchange of the original shares for the new shares. The stock option deferral would defer the receipt of the remaining 80 taxable shares. The payment of the exercise price in shares can be accomplished through attestation, a process whereby the executive attests that he owns shares with sufficient value to pay the exercise price, and the employer credits the executive with the net number of shares upon exercise.

Employers should note that the deferral will not apply for FUTA, FICA and Medicare tax purposes. In addition, depending on how the deferral is structured and on the terms of the stock option and deferred compensation plans, the employer may be required to take a compensation charge for accounting purposes. Finally, employers must observe securities law requirements in reporting the deferral election and exercise of the option.

Funding a 401(k) Plan With Options

Recently, an employer obtained a private ruling from the IRS permitting the transfer of stock options to a 401(k) plan. The ruling permitted the employer to claim a deduction for the fair market value of the stock options contributed to the plan and treated that value as an annual addition to the plan. Although the IRS subsequently announced that it was reconsidering this ruling, this technique could be quite useful if the IRS does not change its position. A Department of Labor ruling is expected to be issued shortly approving a prohibited transaction exemption with respect to the loan from the employer to the plan that enables the plan to exercise the stock options. Future issues of the Employee Benefits Alert will provide additional information on this stock option strategy.

For additional information regarding transferable stock options, stock option deferrals, or other employee benefits, please contact Paul J. Powers, Jr. or Kirk H. O'Ferrall.