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
The IRS reckoned that basing the grant date on the date certain corporate actions are completed and verifiable is an administrable standard for both the government and taxpayers. Therefore, taxpayers, in ascertaining grant date, should apply the standards in the regulations under Section 421 or the very similar standards under the Section 409A regulations.
In addition, APB Opinion No. 25, “Accounting for Stock Issued to Employees,” provides guidance for determining the “measurement date” (i.e., the grant date) for grants made before 2002. Under APB No. 25, the measurement date is “the first date on which are known both the number of shares that an individual employee is entitled to receive and the option price.”
When the backdating crisis became well understood, the staff of the Securities and Exchange Commission advised its constituents that “completion of all required corporate granting actions” is generally necessary for there to be a grant of options. But the staff noted that a grant may occur at an earlier date, depending on when the facts and circumstances establish that the terms and recipients “were determined with finality” on an earlier date.
Further, the IRS concludes that, although the accounting standards are “less stringent” than existing tax standards, it is reasonable to use the measurement date determined by taxpayers for purposes of their accounting restatements as the grant date for purposes of Section 162(m). However, the IRS warns that “in future cases” the agency reserves the right to insist on determining grant date in accordance with the standards under the Section 421 and Section 409A regulations.
Whether a stock option satisfies the requirements of Regulation Section 1.162-27(e)(2)(vi)(A) is determined as of the date of grant of the option. 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. Because the compensation arising from the option grants in this case was not based solely on an increase in the price of the stock after the grant date, none of the compensation attributable to the options in question was qualified performance-based compensation.
Therefore, it does not seem to matter whether a company determines at the time of grant that a stock option is qualified performance-based compensation. That’s because subsequent actions, such as a repayment by an employee, cannot change the fact that the option was issued at a discount. Moreover, the grant and exercise of an option, and a later voluntary repayment of a compensatory amount, are separate transactions for tax purposes.
Also, the July legal memorandum released by the IRS states that in some cases, employers repriced options before the options were exercised. However, whether an option satisfies the requirements is determined as of the date of grant. Once again, the actions to reprice the options did not change the fact that the options were issued at a discount.
Accordingly, the IRS memorandum concludes that the remuneration resulting from the exercise of “discounted” stock options that may have been repriced before exercise is not qualified performance-based compensation. Thus, as most observers suspected would be the case, once it is ascertained that a stock option was issued at a discount, the resulting remuneration cannot constitute qualified performance-based compensation. Moreover, there are no “curative” steps the corporation can take, ex post facto, to alleviate the problem. It is the situation existing on the grant date that controls the outcome, and steps taken thereafter will not, under any circumstances, relate back to such grant date.
Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.