Companies often reduce the exercise price of employees’ outstanding stock options to the current stock price to restore the options’ incentive effect and retain talented employees. However, in some cases companies raise the exercise price to provide tax benefits for option holders under certain circumstances.
If a stock option qualifies as an incentive stock option (ISO) under IRC §§ 422 and 409A, the employee receiving the option recognizes no taxable income at the time the employer grants the option or when the employee exercises the option. If the applicable holding requirements are met, any gain upon the sale of the stock received from the exercise of the option is classified as long-term capital gain.
Under section 409A, for an option to be an ISO, its exercise price must at least equal the stock price on the option grant date. For private companies, it must at least equal the fair market value, determined through the reasonable application of a reasonable valuation method within the facts and circumstances as of the valuation date (Treas. Reg. § 1.409A-1(b)(5)(iv)(B)(1)). Stock options granted at an exercise price lower than the stock price on the option grant date are often called “discount stock options” or “section 409-affected options.” However, for these options, the employee must pay ordinary income tax and a 20% penalty tax when the option vests on the difference between the stock price on the vesting date and the exercise price.
Under the rules of Notice 2008-113, outstanding discount stock options that otherwise meet the requirements of section 422 can be converted to ISOs by raising the exercise price for the options to the stock price on the option grant date, thereby satisfying the requirement of section 409A with respect to the options (see, for example, the 2011 prospectus, SEC Form S-1, of Acelrx Pharmaceuticals Inc., Notes to Financial Statements no. 14, page F-35, at tinyurl.com/3hv9wun). However, under Notice 2008-113, the repriced options will be treated as satisfying the requirements of section 409A only if (1) the exercise price was erroneously set below the fair market value of the stock on the date of grant and (2) the repricing occurs before the employee exercises the stock right and not later than the last day of the employee’s tax year in which the employer granted the stock options, or if the employee was not an insider under section 16 of the Securities Exchange Act of 1934 at any time during the year the options were granted, not later than the last day of the employee’s tax year immediately following the employee’s tax year in which the employer granted the stock option.
In addition, affected employees must be allowed to elect whether to accept the repricing offer. If they do not accept the offer, the options remain discount options. While accepting the repricing offer provides the employees the tax benefits accorded to ISOs, it does not necessarily maximize their future payoffs from the options because of the increase in the exercise price.
Employees will likely accept the offer if they expect that their future payoff with upward option repricing is greater than without it. The future payoff with the repricing would equal (projected stock price − stock price on the option grant date) x number of shares, because the new exercise price, after the repricing, is the stock price on the option grant date. However, if employees do not accept the offer and the stock options would be considered discount stock options, their future payoff would be (projected stock price − exercise price) x (1 − (marginal tax rate + 20%)) x number of shares.
The following example describes possible scenarios for an employee’s decision whether to accept an upward repricing. Among all of the factors listed, only the stock price on the option vesting date is not known. Thus, the decision depends on the employee’s projection of the future stock price.
Option grant date: Jan. 1, 2011
Number of shares: 10,000
Exercise price: $5
Stock price on Jan. 1, 2011: $10
Option vesting date: Dec. 31, 2011
Marginal tax rate: 33%
Option repricing date: July 1, 2011
Projected stock price on the option vesting date: Not known
The future payoff with the repricing is (projected stock price − $10) x 10,000. Without upward repricing it is (projected stock price − $5) x (1 − (33% + 20%)) x 10,000.
Scenario 1. If the projected stock price is less than or equal to the exercise price of $5, payoffs both with and without the repricing are zero.
Scenario 2. If the projected stock price is greater than the exercise price of $5 and less than or equal to the price of $10 on the option grant date, employees would reject the offer, because the future payoff without the repricing is positive, but the payoff with it is zero.
Scenario 3. If the projected stock price is greater than the stock price on the option grant date, both payoffs are positive. Generally, if the projected stock price is above the critical value that follows, the payoff with the repricing would be higher than without it.
The critical value is:
In summary, employees would benefit from upward option repricing by accepting the repricing offer when the projected future stock price is high enough that the tax benefit of upward option repricing outweighs future payoff losses due to the raised exercise price.
By Jin Dong Park, Ph.D., (firstname.lastname@example.org) assistant professor of accounting, College of Business and Economics, Towson University, Towson, Md.
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