Probate & Trust Law Section Conference Manual ... - Minnesota CLE

The Well-Prepared Executive: Personal Wealth Preservation Strategies
144, 1974-1 C.B. 105; Rev. Rul. 69-328, 1969-1
C.B. 136.
it is easier to grant ISOs to senior management due
to lower valuations.
8.
Mergers and Acquisitions
e. Lack of transferability by employee.
a. ISOs for ISOs.
Employees of a target corporation may have
their ISOs in the target corporation substituted for
ISOs in the acquiring corporation so long as (i) the
terms of the substitute ISO (expiration date, vesting
provisions, etc.) are not more favorable to the
employee than the terms of the old ISO, (ii) the
difference between the share value and the exercise
price in the substitute ISOs immediately after the
assumption does not exceed the spread in the old
ISOs immediately before the assumption; and (iii)
the fair market value of the substitute ISO shares
immediately after the assumption does not exceed
the fair market value of the old ISO shares
immediately before the assumption. IRC §
424(a)(1); Treas. Reg. § 1.425-1(a)(4)(ii).
b. ISOs for NQOs.
If the IRC § 424(a) requirements for a
substituted ISO are not met, then the substituted
option will be treated as an NQO. As discussed
below, the grant of an NQO is generally not subject
to tax. Instead, the executive will have ordinary
income upon exercising the substituted NQO.
9.
Summary of ISO Advantages
a. Allows executive to defer tax until stock is
sold, and then pay only a 20% capital gains rate on
the full amount of the appreciation in the stock if
they hold the stock for one year; this favorable tax
treatment makes ISOs very popular with employees.
b. Holding period requirements encourage
employee to remain with employer for a longer
term.
10.
Summary of ISO Disadvantages
a. Strict ISO requirements.
b. Available only for employees of
corporations (or a partnership or LLC electing to be
taxed as a corporation).
c. Must be granted “at-the-money.”
d. The $100,000 rule limits the usefulness of
ISOs for senior executives of established companies
and makes them especially popular for “rank and
file” employees. For start-up companies, however,
9
f. Potential AMT issues.
C. Nonqualified Stock Options
1.
Employee’s Tax Consequences
a. Grant.
The grant of an NQO is generally not
subject to tax. IRC § 83(e)(3).
(1) NQOs With Readily Ascertainable Fair
Market
Value.
The grant of an NQO with a readily
ascertainable fair market value is subject to tax.
IRC § 83(e)(4). An NQO will have a readily
ascertainable fair market value if it is actively traded
on an established market. Treas. Reg. § 1.83-
7(b)(1). If the NQO is not actively traded, it will
have a readily ascertainable fair market value only if
(i) the NQO is transferable; (ii) the NQO is
immediately exercisable; (iii) the NQO is not
subject to restrictions that have a significant effect
on value; and (iv) the value of the option privilege
can be readily ascertained. Treas. Reg. § 1.83-
7(b)(2). The practical effect of the regulations is
that the grant of an NQO will not be subject to tax
except in the rare case where it is traded on an
established market.
(2) Deeply Discounted NQOs.
In general, NQOs can be granted with an
exercise price below fair market value. The grant of
an NQO with an exercise price substantially below
the stock’s fair market may be treated as a taxable
grant of the underlying stock. The IRS has
informally raised concerns about deeply discounted
options and has announced that it is going to study
deeply discounted options. Rev. Proc. 89-22, 1989-
1 C.B. 843, as corrected by Announcement 89-42,
1989-13, I.R.B. 53. Unfortunately, the IRS has yet
to issue guidance on what it considers an
excessively low exercise price. The only IRS
authority is in the foreign personal holding company
context where the IRS applied the substance-overform
doctrine and ruled that an option to buy stock
for a price equal to 30% of the stock’s value should
be treated as ownership of the underlying stock.
Rev. Rul. 82-150, 1982-2 C.B. 110. Despite the
IRS’s apparent opposition to deeply discounted
options, case law supports treating discounted
options as options for tax purposes. See