Even with backdating backlash, classic stock option still in vogue

07 Dec Even with backdating backlash, classic stock option still in vogue

Madison, Wis. – In my last column, I outlined the basic types of stock options that you might encounter in the market. This column will take a closer look at one of those types: the good, old-fashioned version known as the nonqualified or non-statutory stock option, usually referred to as an “NSO.”
The NSO typically is a benefit afforded executives in companies and is the prime subject of the recent backdating scandals faced by a number of high-profile companies, including notable tech companies like Apple, Broadcom, Dell, Comverse, and others. Despite these high-profile disasters, the NSO still is a widely used arrangement, particularly for directors, executives and other consultants, principally because of its flexibility.
What is an NSO?
An NSO is any stock option that is not a qualified stock option! I’ll cover the qualified stock option in the next column, where you will see some of the myriad rules affecting those types of options. Suffice it to say that the NSO is the classic way to issue an option to purchase a company’s stock.
It is subject to fewer rules, but it is generally less tax advantageous for the recipient. That is, an NSO recipient will typically pay income tax on the difference between the option exercise price and the fair market value of the stock at the time the option is exercised. In other words, if you paid $1,000 when you exercised an option that was worth $100,000 when you did so, you would owe income tax on $99,000. Thus, the drawbacks are that you generally must pay income tax when you EXERCISE the option (not when you later sell it) and you have to pay tax at regular INCOME TAX RATES.
So, given the drawbacks to these types of options, why might they get used?
First and foremost, NSOs are generally more flexible and easier to administer for the employer. Instead of a full-blown plan that must comply with a litany of IRS rules, the NSO can simply be a contract between the employer and one employee. NSOs also can, in certain circumstances, be transferable by the recipient of the option.
More importantly, while statutory options can be awarded only to employees, NSOs can also be granted to independent contractors (such as outside consultants) and, importantly, directors.
Employers may like the NSO, too, because the employer can deduct the amount included in the employee’s income as an expense at the time the option is exercised, a feature that is not available in the case of a qualified option.
While NSOs are quite flexible compared to statutory options, care must be taken in a few key areas. For example, you must make sure you do not run afoul of securities laws because the stock option can be subject to regulation under both state blue sky laws and federal securities laws. And, the relatively recent enactment of the Sarbanes-Oxley Act has imposed new limitations on the flexibility of stock options, along with some new reporting requirements.
Another area of concern is the potential that the option will be treated as deferred compensation to the recipient. While compliance concerns may have eased somewhat with the issuance of the final 409A rules, employers need to be very careful about how they value their stock options —failure to fairly value the options on the date of the grant can lead to some nasty surprises for both the employer and the recipient (including a 20 percent penalty tax).
Employers and option recipients should also heed the provisions of Section 83 of the Internal Revenue Code. While the details are beyond the scope of this column, the general rule about the timing of the taxation of NSOs does not apply in each and every case, which can cause adverse tax consequences. The “83(b) Election” can solve these issues, but is not without its own potentially adverse consequences. Suffice it to say that you should work with experienced counsel to make sure that you abide by the Section 83 rules on NSOs.
Rules of disengagement
Finally, new accounting rules may make NSOs less attractive for companies. So, not only must a company work with good attorneys to put these plans together; it also must work with its accountants to accurately report the options in the company’s financials.
Next time, we will explore the ISO, which is more widely used for plans to grant options to employees because of the very beneficial tax consequences for the recipient.
Some links of interest until then:
For an FAQ on some recent woes facing the tech industry, check out this link, and if you’d like to see a discussion of the tax consequences of these schemes, see this link.
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