THE WACKY WORLD OF STOCK OPTIONS
By Walter Copeland and Kara Keyes
Over the last several years, companies (especially public
companies) have expanded their use of stock options, warrants and other
stock based instruments to provide creative compensation to employees,
consultants and other product and service providers as well as for complex
financing. Many of these situations apply to smaller public companies and
adequate information may not be available to the recipients and issuers to
guide them in their handling of tax aspects.
Financing transactions can involve conversion features, detachable warrants
and equity investments structured as debt. Option plans can provide for
reloads, net settlement alternatives and various contingencies and formulas
for underlying stock price changes.
The accounting world has tried to keep up with this whirlwind of activity by
issuing somewhat complex pronouncements to identify, value and account for
them. SFAS 25,133,150 and EITFs 98-5, 00-19, 00-27 and ASR 268 are a few of
the more important accounting releases dealing with options, warrants,
embedded conversion features and those that are categorized as derivatives.
In addition, new SFAS 133a, 123 R and 15X have been proposed that further
impact the accounting treatment of options and warrants and those treated as
derivatives.
As a result, the practitioner is faced with not only the daunting task of
understanding the accounting treatment, but also the tax effect of the
myriad variations to both the recipient and issuer.
This article will identify some of the basic areas that the practitioner may
come in contact with as to such instruments and provide an outline of tax
treatment for the issuer and the recipient. The comments will be directed at
public company options and warrants, so the reader is cautioned to do
additional research when dealing with private company options or warrants.
The research and resultant comments is not an exhaustive study of this ever
changing area and should not be relied on to be all inclusive. Since changes
are on going, any work in this area should be coupled with checking current
activity and tax rules that apply at that time. The article will not attempt
to identify all the variations in accounting for such instruments. At best,
the paragraphs that follow will alert the reader of possible problem areas
and possible solutions or paths for further research.
OPTIONS AND WARRANTS FOR SERVICES
As previously mentioned, options (and warrants) can be provided to
employees, outside consultants and board members as compensation or in
exchange for other goods and services. In addition, creative financing can
include convertible debt or preferred stock that includes detachable
warrants as additional inducements to attract investors. While there is a
fairly long history of rules for the tax and accounting treatment of options
issued to employees, the use of options and warrants for other service
providers and as part of financing transactions is more recent and has
increased over the past several years.
Companies that issue stock options need written plans describing their
features and terms. Stock options are typically Incentive Stock Options (ISOs)
or Nonqualified Stock Options (NQSOs). Under IRC Section 422(b), a stock
option plan must meet several specific requirements in order to be
classified as an ISO plan. In addition, ISOs can only be issued to
employees, so options granted to service providers will not qualify as this
type of option. Due to the greater restrictions on this type of plan, many
options are issued as NQSOs. Another alternative used by companies is to
issue options under Employee Stock Purchase Plans. These options are used
less frequently by companies than ISOs or NQSOs due to the fact that these
plans require virtually all employees (and only employees) to be included in
the plan and that all employees have similar rights and privileges under the
plan.
Recipients may prefer ISOs because ISOs allow for favorable income tax
treatment if a specified holding period is met. ISOs are issued with an
exercise restriction providing that at exercise, the employee is not subject
to income tax on the spread between the exercise price and market price at
exercise if the stock acquired is not sold within two years after issue of
the option or one year after obtaining the stock. If the stock is sold
within either of those periods, the employee will recognize ordinary income
and the corporation will obtain a corresponding tax deduction for the income
element. Otherwise, the corporation does not obtain a tax deduction for ISOs.
In addition, the ISO cannot be transferred except by will or the laws of
descent without triggering ordinary income. When the stock from the
exercised option is later sold, the gain on the sale is taxed at capital
gain tax rates. For dispositions that occur prior to the holding period
explained above, the ordinary income element is added to the basis of the
stock for the capital gain determination. Alternative minimum tax should be
considered at the time of ISO exercise because the amount of unrealized gain
(i.e. exercise price versus market price at exercise) is considered an
adjustment for minimum tax purposes. This adjustment becomes part of the
alternative minimum tax basis of the stock, decreasing alternative minimum
taxable income when the stock is disposed of. The corporation is not
required to withhold tax, pay payroll tax, or provide notification to the
IRS in the event of early disposition or transfer of an ISO. However, when
the stock’s legal title is transferred to a recipient (whether early
disposition occurs or not), a corporation is required to furnish a statement
to the stock recipient by January 31 of the following calendar year.
NQSOs are issued and are taxed to the recipient at ordinary income tax rates
when the option is exercised, based upon the difference between the strike
price (exercise price) and the market price of the stock at the exercise
date. Upon subsequent disposition, capital gain tax rates will apply to
future increases in the value of the stock acquired if it is held for at
least one year. The holding period is deemed to start with the date of
exercise and does not include the period that the option was held.
Corporations issuing NQSOs will deduct the income element of the exercise
transaction for tax purposes and include the amount as compensation on Form
W-2 issued to employees or on Form 1099 issued to service providers. When
employees exercise NQSOs, the corporation is required to withhold federal
income tax and FICA tax on the income element. Withholding is accomplished
either by payment from the employee to the employer or netted out of the
proceeds if the stock is simultaneously sold when acquired.
Section 83(b) Election
When the underlying stock subject to NQSO is restricted (subject to
forfeiture), an individual can make an election under IRC Section 83(b)
within 30 days after exercising an option (or warrant) to recognize in
taxable income the value of the option at that time rather than when the
stock restrictions lapse. This election is available if there is a readily
ascertainable market value for the stock (generally meaning the stock is
traded on an exchange). The market value determination is made without
regard to the restrictions. If 83(b) applies, future appreciation in value
would then be subject to capital gain treatment.
OPTIONS AND WARRANTS IN FINANCING
Warrants can be included as part of financing arrangements along with other
instruments including common stock, debt or preferred stock. However,
warrants are also issued for services to employees and outside service
providers and even as payment for products and equipment. Warrants can be
detachable from the other instrument involved in the transaction and can be
included together with convertible features. The convertible feature allows
for the debt to be converted into stock of the issuer. The other instrument
is often referred to as the “host” instrument. The accounting for host
instruments with detachable warrants can be complex. Particularly in the
case of warrants treated as derivatives, the accounting borders on the
bizarre.
For tax purposes, the debt instrument and warrants are treated as an
“investment unit” for determining the value of the warrants. The valuation
falls under the IRC Section 1273 original issue discount rules, which
mandates that the time of valuation is upon issuance of the warrant that is
connected with the debt. In effect, the warrant value is compensating the
creditor for additional risk, thereby raising the effective interest rate of
the loan. The issuer of the debt instrument performs this allocation and the
treatment is binding on the creditor unless a disclosure is made on the
federal income tax return of the creditor that an alternative allocation has
been made. The OID warrant value is deductible by the debtor for tax
purposes over the life of the loan and includible as taxable OID income to
the creditor. The U.S. Tax Court in Custom Chrome, Inc. and Subsidiaries v.
Commissioner (September 2, 1998) held that warrants did qualify as OID
interest. The Court did not allow an interest deduction for the warrants,
however since the Court determined the warrants had no ascertainable value
at the time of the transaction.
The issuance of warrants as part of a financing arrangement should be
distinguished from convertible debt financing arrangements in addition to
warrants. Although the valuation of the conversion feature of convertible
debt for financial statement reporting purposes may be similar to the
valuation for warrants described above in that the conversion feature will
have a separate value assignment, the treatment is generally not similar for
tax purposes. For tax purposes, convertible debt is not bifurcated and
treated as an investment unit, so the issue price of the debt is not reduced
for the conversion feature. In addition, the American Jobs Creation Act of
2004 (Title VIII, Subtitle B, Section 845) amended IRC section 163 and
generally provides for the disallowance of any interest deduction for debt
that is substantially based upon the value of equity. Thus, if a financing
really represents an equity investment that is in the form of debt and if
the debt or a substantial amount of the interest is payable in stock of the
issuer or a related party, the interest is not deductible.
If there are features to the above convertible debt with detachable warrants
such that the conversion right or warrants are deemed to be derivatives for
accounting purposes, the company is required to value the derivative at
“fair value” at each reporting period and recognize corresponding expense or
income. This expense or income would be subject to the above described rules
relating to the equity based payments and is generally not deductible or
taxable for tax reporting purposes.
The derivative treatment can also result in a reclassification of preferred
stock to a liability that then is subject to the valuation rules. If
convertible preferred stock is the instrument, dividends versus interest
will generally be the result of the accounting treatment as a derivative.
VALUATION ISSUES
Stock options and warrants can be valued in different ways for accounting
purposes depending on who they are issued to, the arrangement’s terms and
what the recipient does with the options. Similarly, they can have the same
or different treatment for tax purposes. Usually, options are issued at or
above the current market price of the stock so that there is no immediate
positive spread between exercise and market price.
In the case of NQSOs, through 2005 the company will be able to not take an
expense for the issuance or exercise. of the options. After 2005, new rules
under FAS 123 R will have different results. Prior to 2006, footnote
disclosure of NQSOs issued to employees can be accounted for under FAS 25
and result in footnote disclosure only.
When warrants or options are issued to other than employees, valuation is
accounted for using a fair value method. Generally, companies use the Black-Scholes
Option Pricing Model (Black-Scholes) to determine the booking of the
options. If there is a vesting schedule to the options or warrants, they are
generally expensed over the vesting period. The recipient on the other hand
may take another approach to the value and would not necessarily follow the
book treatment. Fair value for book purposes using Black-Scholes is not
generally followed for tax purposes. For tax purposes, the value to the
recipient will depend on their specific circumstances. If there are
restrictions beyond the vesting, or forfeitability features, each recipient
may want to evaluate the economic value for tax purposes. In most cases,
options are issued with the strike price (exercise price) above the price of
the stock. As such, there may not be a tax value at that point and no income
to report.
In the event that options or warrants are issued in exchange for products or
outside services, if there is a bona fide value for the product or services
established between the parties, the warrants or options would usually take
that value. If there is no bona fide value established, then the value to
the recipient would depend on the facts and circumstances as mentioned above
considering price of the stock and restrictions.
If the options or warrants are part of the accounting for derivatives or are
considered a derivative themselves, the value for financial statement
purposes will change over time using a fair value approach. Such changes in
fair value can create income or expense to the company but would not result
in a corresponding taxable income or expense.
In conclusion, there are many uses of options and warrants by public
companies that create different timing and amounts of income to the
recipient and the issuer. When a company is subject to the discount
provisions of EITF 00-27 and 98-5, there typically will be book expense that
is going to be treated much differently for tax purposes. Similarly,
derivatives of the kind described previously will provide different book and
tax results. Other types of derivatives may cause yet other tax results
different from the items in this article. If you are working with an
individual or corporation concerning options, warrants or other stock based
instruments, you should be wary of relying on information being provided in
the normal course. There may be tax effects that otherwise would not be
obvious and easily overlooked. Therefore, you should investigate the
particular facts of the situation and review all pertinent tax rules before
advising your client or preparing a tax return.
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