The following article is adapted and reprinted from the M&A Tax Report, Vol. 11, No. 2, September 2002, Panel Publishers, New York, NY.

STOCK OPTION RUMINATIONS

By Robert W. Wood

We at The M&A Tax Report have learned (the hard way) that commenting on proposed legislation is often a no win proposition. After all, tax trends wax and wane, and only a small percentage of the stuff (dare we call it drivel?) that is discussed actually gets introduced in a bill. Even then, only a small percentage of the tax proposals that get introduced as proposed legislation eventually become law.

Nevertheless, occasionally there is a frenzy of activity about a certain subject that we can't help noticing. Such is the case with the stock option frenzy currently embroiling Congress and the public. There is a kind of frenetic activity out there, one that in another era might have made us cry out for Ritalin.

Options, Which Options?

Just a couple observations to add to all those floating around these days. The aptly named "Ending the Double Standard for Stock Options Act" (S-1940) that was introduced in February 2002 by Senators Jon McCain (R-AZ) and Carl Levin (D-MI) would supposedly end what the bill's sponsors view as a double standard for stock options. It would limit the corporate tax deduction arising from the exercise of nonstatutory options. In the case of non-incentive stock options, this bill would limit a corporation's deductions to the amount the corporation treats as an expense in computing its earnings. Thus, tax and accounting treatment would be harmonized.

There are probably lots of observations one could make about this. However, we are struck by something arising in a quite different field, but one riven with examples suggesting taxpayer behavior. Taxpayer reaction to tax legislation seems like a kind of Pavlov's dog response. Or, as a tax-modified Hollywood might put it: "Build it, and they will deduct it."

In a recent article, David Walker (an associate law professor at Boston University) suggests that if nonstatutory options are restricted as to deductibility by the issuing corporation, then corporations will be likely to forego corporate tax deductions for the options in an effort to keep the share price high. See Walker, "Tax Incentives Will Not Close Option Accounting Gap," Tax Notes, August 5, 2002, p. 85. Earnings statements, after all, are critical, as everyone in this post-Enron, post-WorldCom milieu knows. Indeed, Professor Walker points out that even though ISOs are quite popular with employees, there is a statutory limit ($100,000) on ISOs held by any individual. As a result, the large majority of options granted, particularly to CEOs and other senior executives who receive the largest grants of options, are generally nonstatutory options. Practitioners all know this.

Taxpayer Diversion

It seems questionable whether S-1940 would be even remotely effective. The big question would be whether companies would choose to deduct nonstatutory options (the price tag for the deduction being a charge to earnings for financial statement purposes). To try to answer this question, Professor Walker turns to the golden parachute rules, something that has been with us now since the mid-1980s.

The golden parachute rules are embodied in the dual tax regime of Sections 280G and 4999. The former section eliminates a corporate tax deduction for so-called "excess parachute payments." The latter section levies an excise tax on the executives who receive such pejorative payments. There is a safe harbor, though, that is clear. As long as payments arising from a change in control are less than three times an executive's average compensation over the previous five years, they miss out on the dreaded parachute payment classification altogether.

The idea is not to exceed this threshold. If payments do exceed the safe harbor amount, every dollar above the executive's base amount will be considered an excess parachute payment, will not be deductible by the company, and will be subject to a nondeductible 20% excise tax. Thus, the consequences of exceeding the safe harbor amount are severe.

What, Me Worry?

When this set of rules was enacted back in 1984, one would have thought that everyone would stay away from the dual-pronged hot poker of excess parachute payments. As we noted in these pages a number of times, that is exactly what happened. See Wood, "Holes in Golden Parachutes," Vol. 9, No. 6, The M&A Tax Report (January 2001), p. 1. Initially, companies responded to the unenviable golden parachute classification by inserting contractual caps in the maximum safe harbor payment. As Professor Walker points out, though, the more recent experience has been more troubling, at least if one hopes to modify behavior with respect to stock options.

Today, Walker notes a trend in favor of gross-up arrangements, at least for top executives. (On this topic, see also Wolk, "The Golden Parachute Provisions: Time for Repeal?" 21 Virginia Tax Review 125 (2001).) As its name would suggest, a gross-up arrangement involves just that. A company agrees to gross-up payments to an executive to make up for the golden parachute tax. The idea is to put the executive in the position he would have been in had Sections 280G and 4999 never been enacted.

Of course, this triggers the old (and appropriately circular) notion of a tax on a tax (on a tax — you get the idea). Because a gross-up payment is subject to income taxes and excise taxes, the gross-up payment itself is also considered a parachute payment. Thus, the gross-up payment is also nondeductible by the paying corporation. Consequently, the actual cost of grossing up payments to an executive for excise taxes can be an order of magnitude greater than the benefit to the executive. See Walker, "Tax Incentives Will Not Close Stock Option Accounting Gap," Tax Notes, August 5, 2002, p. 851, 855. Considering cost benefit analysis may sound anachronistic — especially when you are an executive and it is your benefit but not your cost!.

Clearly, there is a huge cost to the paying entity to these gross-up arrangements. Still, Professor Walker reveals one study reporting that 55% of CEO contracts included a gross-up provision. See Bowie and Fischer, "Have Parachutes Become More Than Security Blankets?" Mergers & Acquisitions (Nov.-Dec. 1996), p. 17.

Nail in the Coffin?

The debate about stock options and their appropriate treatment isn't likely to be over anytime soon. Even so, Professor Walker's analysis is darned interesting. Even more fundamentally, shouldn't any analysis of the treatment of options encompass both ISOs and nonqualified options?

Stock Option Ruminations, Vol. 11, No. 2, The M&A Tax Report (September 2002), p. 1.