Assignment 9 Flashcards
Summarize the history of stautory stock options.
The first stock option form receving favorable tax treatment was the restricted option as defined in Section 424 of the IRC. The Revenue Act of 1964 terminated the restricted form of option and introduced a new form of statutory option- the qualified option.
Like the resticted option, the qualified option imposed no tax liability on the holder either at time of grant or time of exercise. Thus, while the qualified option was not as attractive as its predecessor, it was still more palatable than anything else, given:
- a rather favorable growth in stock procies
- marginal tax rates as high as 70% before the 1964 Revenue Act
The 1969 Tax Reform Act took three further swings at the attractiveness of the qualified option. First, it lowered the maximum marginal tax rate from 70% to 50% on earned income. Second, the long-term capital gains tax maximum of 25% was increased to one-half the ordinary income tax rate for the first $50,000, which was still subject to a 25% rate. Third, it introduced a new form of tax called an alternative minimum tax (AMT), that would apply to certain items. This tax preference income (TPI) would be taxed at the rate of 10% above a $30,000 exclusion.
The 1978 Revenue Act reduced the portion of long-term gains subject to taxes from half to 40%, thus effectively lowering the maximum capital gains tax rate from 35% to 28%. In addition, the untaxed portion of capital gains income was no longer subject to the 15% preference tax.
Each of these legislated changes made nonqualified stock options comparitvely more attractive. The 1981 Economy Recovery Tax Act restored statutory stock options, now called the incentive stock option (ISO), with the following requirements:
- The optionee must not sell the acquired shares sooner than 2 years from the date grant nor within one year after exercise
- The optionee must be an employee and exercise the option not later than 3 months after leaving employment, one year for disability or to term for death.
- The optionee incurs no ordinary income upon grant or exercise of an ISO but may be subject to AMT
- The plan must specify the employees or class eligible, the number of share available for grant and be approved by shareholders within 12 months of the date the plan is adopted.
- Grants under the plan may not be later than ten years from the date of grant
- The exercise period may not exceed ten years from the date of the grant
- The grant price may not be less than FMV on the date of grant
- The value of the grant may not exceed $100,000 per person with limited carryover to subsequent years
- ISOs are not subject to discrimination requirements
The 1997 Taxpayer Relief Act lowered the long-term capital gains rate to 20% for those assets held 18 months of longer, while retaining a 28% rate for those hled more than 12 months but less than 18 months. A year later, the 20% applied to assets held more than 12 months.
Explain what a nonstatutory stock option is.
By definition, this is a stock option that fails to meet the requirements of a statutory option and therefore is more flexible in terms of grant size, ability to exercise, lenght of grant and holding period. As with a statutory option, there is no tax liabilty at time of grant. However, at time of exercise, the spread between market value and option price is taxed income. Since it is taxed as income, the TPI does not apply at time of exercise although the gain at time of sale will be subject to the alternative minimum tax without adverse maxium tax consequences. The holding period to achieve long-term capital gains is the same as for other holdings
The most common form on nonstautory stock options is a nondiscounted, ten-year grant, probably due to a carryover of the former SEC rules that an option for insiders could neither be discounted nor exceed ten years in duration in order to be an exempt transacation at time of grant.
Why have stock options been one of the most acceptable forms of incentive compensation to shareholders?
For years, stock options have been one of the most acceptable forms of incentive compensation to shareholders because:
- The executive must put up some of his or her own money
- The value, like the shareholders’, is at risk with the price of company stock
- Assuming no discount, there is no charge to corporate earnings
Options are a form of profit-sharing that link the professional manager’s financial success to that of the shareholder.
For those who are about to make an IPO, moving the company from a privately held to a publicly traded company, there is a high degree of interest in large stock option grants. Historically, stock prices increase dramatically in the days and weeks preceding an IPO.
What are stock appreciation rights? (SARS)
The stock appreciation right is another feature many companies used in conjuction with a nonstatuory option. The stock appreciation right permits the optionee to receive the appreciation of fair market value over option price in stock and/or cash without providing funds to pay the option price.
Describe different types of stock appreciation rights.
Stock appreciation rights may be granted in parallel, in tandem, or on top of a stock option. A tandem grant would mean the exercise of one would proportionately reduce the other. A parallel grant would mean the two are independent of each other.
Stock appreciation rights can also be freestadning,
