In 2006 the Internal Revenue Service became aware of instances in which stock options were granted with exercise prices that were less than the fair market value of the stock on the date of grant. In many cases, this discount resulted from a discrepancy between the purported grant date (on which date the strike price of the option and the stock price were identical) and the actual grant date (on which date the strike price of the option was below the applicable stock price).
In some cases in which the executive had already exercised the option, the employer attempted to “reprice” the option by obtaining a “voluntary” repayment from the executive in the amount of the discount. In cases where the executive had not yet exercised the option, the executive agreed to an increased share price based upon the value of the stock on the actual grant date. The IRS legal memorandum, AM 2009-006, released on July 6, 2009, addresses the issue of whether the compensation emanating from these discounted options constitutes “qualified performance based compensation.” The answer is an unequivocal no.
Applicable Employee Remuneration
The tax code, specifically Section 162(m)(1), states that for any publicly held corporation, no deduction is allowed for applicable employee remuneration with respect to any covered employee to the extent that the amount of such remuneration for the taxable year exceeds $1 million. However, under Section 162(m)(4)(C), applicable employee remuneration does not include remuneration payable solely on account of the attainment of one or more “performance goals.”
Looking at tax rules more carefully, practitioners will find that under Regulation Section 1.162-27(e)(2)(vi)(A), compensation attributable to a stock option is deemed to satisfy the performance goal requirement if, under the terms of the option, the amount of compensation the employee could receive is based solely on an increase in the value of the stock after the date of the grant. Conversely, in the case of an option that is granted with an exercise price that is less than the value of the stock as of the date of grant, none of the compensation is qualified performance-based compensation.
However, there is something else to consider. Section 162(m) does not define the term grant date, nor do the regulations provide a standard for determining grant date. Nevertheless, the IRS concludes that the standard for determining the grant date in the regulations addressing incentive stock options and deferred compensation is a reasonable standard for purposes of Section 162(m). To be clear, the options and deferred compensation are based on the date the corporation completes the corporate action constituting an offer of sale of a certain number of shares of stock to a designated individual at a set price.
“The regulations do not provide a mechanism to retroactively reprice an option to transform compensation resulting from the exercise of the option into performance-based compensation.” — Robert Willens