• The Death of the Discount Non-Qualified Stock Option
  • January 15, 2005 | Authors: Andrew J. Rudolph; David M. Kaplan
  • Law Firm: Pepper Hamilton LLP - Philadelphia Office
  • A frequent planning technique for management compensation has been the issuance of non-qualified stock options (NQOs) where the option exercise price is less than the fair market value of the option stock on the date of grant. This planning technique is no longer tax effective under the American Jobs Creation Act of 2004, which was enacted on October 22, 2004.

    Under prior law, if a company issued NQOs with an option exercise price that was less than the fair market value of the option stock on the date of grant, the issue was whether the discount was so deep that for tax purposes it was tantamount to the direct issuance of the stock. For example, if the stock was worth $10 a share, and the option exercise price was $0.01, for tax purposes we would have concluded that the transaction was properly characterized as the direct grant of stock, and we would have disregarded the option feature for tax purposes. By contrast, if the same option for stock worth $10 had an exercise price of $8 a share, we would have concluded that the option feature should be recognized, and that the taxable event would occur only on the exercise of the option.

    Under the new and currently applicable law, the traditional discount stock option model, in which optionees have the discretion following the vesting date to time the exercise of their discount stock options, is no longer viable. Here's why:

    • Assume stock is worth $10 on grant, exercise price is $8 and the option is vested at grant. Under the new rules, on the grant date the employee has $2 current taxable income and a 20 percent penalty is tax imposed on the employee.
    • Assume stock is worth $10 on grant, exercise price is $8 and the option vests next year. Under the new rules, at the time of vesting the stock is worth $15. The employee has taxable income of $7 and a 20 percent penalty tax.

    The new law does provide for a mechanism to defer the income recognition date (and the corresponding stock delivery date), but the mechanism generally requires a minimum five-year deferral, and does not give the optionee the discretion to pick any date following vesting for exercise. Accordingly, we do not believe that discount options, as we have known them, continue as a viable planning technique.

    Generally, bona fide discount options that were exercisable before January 1, 2005 are grandfathered, and are not subject to the new rules.

    Temporary guidance issued by the IRS recognizes that the valuation of privately held stock is not an exact science, so that for purposes of determining fair market value of stock at the date of grant, "any reasonable method may be used." This latitude is welcome, given the renewed importance of issuing stock options at fair market value at the grant date to avoid the challenges presented by the law change.

    Note also that the new rules apply to discount compensatory options. They have no impact on warrants that are issued as part of investment unit, and they do not impact the compensatory options that are issued at fair market value.