THE NEW OPTIONS REGULATIONS - AN OVERVIEW Robert B. Webb III, Esq.
S Q U I R E , S A N D E R S & D E M P S E Y L .L .P. Introduction An international law firm with more than 700 lawyers in 26 offices worldwide Squire, Sanders & Dempsey L.L.P.
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THE NEW OPTIONS REGULATIONS - AN OVERVIEW • August 3, 2004 – IRS Issued New “Final Regulations” regarding stock options and IRC 423 Stock Purchase Plans • Available from IRS website at http://www.irs.gov/pub/irs-regs/td9144.pdf or • www.esop.us/irsoptionregulations.pdf Squire, Sanders & Dempsey L.L.P.
THE NEW OPTIONS REGULATIONS – What these regulations are not • These are not related to option expensing for financial accounting • These regulations are not related to employer payroll and FICA/FUTA withholding obligations Squire, Sanders & Dempsey L.L.P.
THE NEW OPTIONS REGULATIONS - • The Regulations address Sections 421, 422 and 423 of the Internal Revenue Code. • IRC 421 – General provision which provides that there is no taxable income upon exercise of a “statutory stock option.” • A “Statutory Stock Option is an option to purchase stock of a corporation that is either (a) an incentive stock option under Section 422 of the Code, or (b) the right to purchase stock pursuant to a stock purchase plan under Section 423 of the Code Squire, Sanders & Dempsey L.L.P.
THE NEW OPTIONS REGULATIONS - • The Regulations reflect a comprehensive set of regulations for statutory stock options – finalizing an IRS regulatory project first begun with the 1984 publication of proposed regulations. • In 2003 the IRS issued new proposed regulations • The Regulation do not affect the tax treatment for nonqualified stock options • The Regulations do not change the Alternative Minimum Tax treatment of gain upon exercise of an incentive stock option Squire, Sanders & Dempsey L.L.P.
THE NEW OPTIONS REGULATIONS - In large part, the Regulations reflect much of the substance of the 1984 proposed regulations, but attempt to provide greater clarity in certain areas. Squire, Sanders & Dempsey L.L.P.
THE NEW OPTIONS REGULATIONS – Specific Points Employment Relationship • IRC 422 and 423 provide that Statutory Stock Options may only be granted to employees of the granting corporation, a parent or subsidiary of the granting corporation, or a corporation issuing or assuming the option in a merger within the scope of IRC 424. . Squire, Sanders & Dempsey L.L.P.
THE NEW OPTIONS REGULATIONS – Specific Points Employment Relationship • The regulations provide that in the case of an assumption or substitution under IRC 424(a), the period of during which options may be granted includes the period up to 3 months after employment termination. . Squire, Sanders & Dempsey L.L.P.
THE NEW OPTIONS REGULATIONS – Specific Points Employment Relationship • The regulations also provide, that in the case of employees with a contractual or statutory right to return (sick leave, family medical leave, military leave) the period includes 3 months (or longer as in the case of Family medical leave or military leave re-employment rights). . Squire, Sanders & Dempsey L.L.P.
THE NEW OPTIONS REGULATIONS – Specific Points Disqualifying Dispositions • A disqualifying disposition occurs when an optionee purchase and then disposes of stock before 2 years from the date of grant or one year from exercise. • The regulations clarify the calculation of these periods. • Most notably – when options are “early exercised” prior to vesting, if a disqualifying disposition occurs, holding period is calculated from the date of exercise, but ordinary income is calculated based upon the date of vesting, not the date of exercise . Squire, Sanders & Dempsey L.L.P.
THE NEW OPTIONS REGULATIONS - – Specific Points Shareholder Approval Requirements • Statutory Stock Option Plans must be approved by shareholders within 12 months before or after a plan is adopted. The regulations do not vary this basic rule. • The Regulations do clarify, that when a merger occurs, an assumed plan must be approved, but that this approval requirement is met if the merger is approved by shareholder vote and the plan of merger expressly describes the plan and provides that it will be continued after the consolidation. Squire, Sanders & Dempsey L.L.P.
THE NEW OPTIONS REGULATIONS - – Specific Points Maximum Aggregate Number of Shares • The Code expressly requires that the shareholder approval must include a maximum number (not percentage or formula) of shares that may be issued under the plan. • The regulations clarify that this must be a specific number for the statutory plan, not a global number for both statutory and non-statutory options • The regulations also clarify that this number may be calculated as a “net” number – i.e. if netting is permitted, only the net number counts against the total. Squire, Sanders & Dempsey L.L.P.
THE NEW OPTIONS REGULATIONS - – Specific Points Fair Market Value • Statutory Options must be granted at Fair market Value ( or a set percentage thereof in certain cases) • The Regulations repeat the Code provisions that a reasonable effort will suffice, but in reference to non-public corporations, refer to determination by “an average of appraisals by qualified appraisers” – thus suggesting that one appraisal may not be enough. The IRS specifically commented that they were rejection suggestions that a single appraisal should suffice. • Minority/Discounts/Control Premiums may be used Squire, Sanders & Dempsey L.L.P.
THE NEW OPTIONS REGULATIONS - – Specific Points $100,000 Limitation • As to any individual, the number which qualify as Incentive stock options is limited to $100,000 which “first become exercisable at any time during the year. • The Regulations clarify that this is calculated throughout the year but applied in the order granted. Thus options granted 5 years ago but which “vest” in December will, “pre-empt” ISO status and use the $100,000 limit ahead of options granted 1 year ago but which vest in February. Squire, Sanders & Dempsey L.L.P.
THE NEW OPTIONS REGULATIONS - – Specific Points $100,000 Limitation • If an option grant exceeds the limit, a corporation may designate or “bifurcate” the grant by separate certificate or designation in plan records. • Absent such designation, any shares purchase are first deemed exercised under the $100,000 limit, then treated as Non-qualified options. Squire, Sanders & Dempsey L.L.P.
THE NEW OPTIONS REGULATIONS - – Specific Points Substitution, Modification or Assumption • In a statutory option is modified, extended or renewed, that is generally treated as a new option • A modification is any change which gives the optionee additional benefits. • Corporate Transactions such as mergers, stock dividends, or similar are not treated as modifications Squire, Sanders & Dempsey L.L.P.
THE NEW OPTIONS REGULATIONS - – Specific Points Substitution, Modification or Assumption • A change to an option to give a corporation the discretion to provide an additional benefit upon exercise is considered a modification. • The exercise of discretion to grant that additional benefit is also a modification. • If the right to exercise discretion to pay a bonus, provide a loan, or permit exercise with shares is in the original plan, the exercise of that discretion is not a modification. The exercise of discretion to pay taxes is not a modification if reserved under the original plan. Squire, Sanders & Dempsey L.L.P.
THE NEW OPTIONS REGULATIONS - – Specific Points Substitution, Modification or Assumption • A change which is offered but not accepted is not a modification if the optionee must exercise it within 30 days or less (but a greater period is considered a modification even if not taken). Squire, Sanders & Dempsey L.L.P.
THE NEW OPTIONS REGULATIONS - – Specific Points Mergers • The Regulations confirm that in the case of a merger, options previously granted under the plan are not subject to a second shareholder approval requirement. • The Regulations contains detailed provisions for proper adjustment to terms in a merger to avoid the transaction resulting in a “modification.” Squire, Sanders & Dempsey L.L.P.
THE NEW OPTIONS REGULATIONS - – Specific Points Effective Dates • The Regulations are effective August 3, 2004 • Transition Rules Apply: • For options granted before June 9, 2003, optionees may rely upon either the 1984 Proposed Regulations, the 2003 Proposed Regulations, or the Regulations until January 1, 2006 or the first regularly scheduled shareholder meeting after March 2, 2005. Squire, Sanders & Dempsey L.L.P.
THE NEW OPTIONS REGULATIONS - – Specific Points Effective Dates • For options granted after June 9, 2003 until the earlier of (a) January 1, 2006 or (b) the first regularly scheduled shareholder meeting after March 2, 2005, optionees may rely upon either the 2003 Proposed Regulations, or the Regulations until January 1, 2006. • Taxpayers must rely consistently and entirely • After January 1, 2006, the Regulations apply in all cases. Squire, Sanders & Dempsey L.L.P.
THE NEW OPTIONS REGULATIONS - – Strategies for Corporations • Review Plans for consistency and compliance (or variance from the regulations. • Consider new plans and suspension of old plans (no new grants) • In issues exist-consider advising optionees to exercise during transition period to insure old rules apply. Squire, Sanders & Dempsey L.L.P.
THE NEW OPTIONS REGULATIONS - – Strategies for Optionees • Consider early exercise Squire, Sanders & Dempsey L.L.P.
Post Event Archive www.esop.us (within 1-2 weeks) Contact Info Bob Webb Squire, Sanders & Dempsey L.L.P. firstname.lastname@example.org +1 703.720.7855 Squire, Sanders & Dempsey L.L.P.