This article is reprinted with permission
New York Law Journal.
© 2004 NLP IP Company.
Stock Option Standards and Deferred Compensation Plans
This column will discuss two recent developments. First, the Financial Accounting Standards Board (FASB) has issued a proposed new standard for stock-based compensation which, for the first time, would require a charge against earnings for stock options. Second, the U.S. Senate has passed a bill that would impose significant restrictions on non-qualified deferred compensation plans and other arrangements if deferrals under them are to be recognized for Federal income tax purposes.
On March 31, 2004, the Financial Account Standards Board circulated an exposure draft of its “Proposed Statement of Financial Accounting Standards for Share-Based Payment.” For many U.S. companies the most significant feature of the proposed new standard is the requirement that stock options be charged against earnings. Remarks in this column on the Standard Board’s proposals will be limited to proposals affecting options. When the new rules are finalized a more complete discussion of the Standard Board’s new statement will be provided.
Under the proposal, stock options and other forms of stock-based compensation would be valued as of the date of grant using a “fair value” method of valuation and that “fair value” would be charged against earnings. This was true under FAS 123, if a company chose to charge earnings).
The exposure draft proposes an effective date for fiscal years commencing on or after December 15, 2004. Comments on the proposals are invited for the period ending June 30, 2004.
Under the proposal “fair value” means the theoretical price at which the option, if it were transferable, might be sold to a third party at the time of grant. Fair value can take into account the specific characteristics of the option, such as its term and its exercise price and characteristics of the underlying stock, such as volatility and dividend yield.
The exposure draft, like FAS 123, would permit employers to use a lattice type of valuation method, such as the binomial model which takes into account projections as to future events including changes in stock price at different points in time or, alternatively, a Black-Scholes or similar “closed-form” static model which predicts values based on historical data determined at a fixed point in time. For many years, uses of formulaic valuation methods often used in proxy statements and footnotes to financial statements, have favored the Black-Scholes model. The exposure draft would encourage use of the more flexible binomial method.
The exposure draft does not, in the author’s opinion, provide adequately for adjustment in fair value to reflect a basic feature of an employee stock option: it is not transferable for value.
The proposed statement does provide that the contractual term may be shortened, and thus option value reduced based on factors such as expected employee behavior or departures by employees before they become entitled to exercise the option. Unfortunately, merely shortening the estimated option term in order to take into account such circumstances would not appear to take into account fully the impact on value of an options not being transferable.
The exposure draft mentions a number of factors that may be taken into account under a binomial valuation method. These include employees’ past exercise practices, post-vesting employment termination behavior and black-out periods.
The draft would require that a stock option vesting over a period of years, for example, 25 percent on each anniversary date, be charged over the vesting period. Unlike FAS 123, however, it would not permit a straight-line charge in such a case. Instead, each vesting tranche would be treated as a separate grant up front. In year one, for example, there would be a charge of 100 percent of the first 25 percent tranche, 50 percent of the second tranche, 33-1/3 percent of the third tranche and 25 percent of the fourth tranche. If, instead, the option did not vest until the end of year 4 (“cliff vesting”) a straight-line charge against earnings would be permitted.
Under the proposed new rule, as under FAS 123, an employer may reverse a charge if an employee forfeits an award due to failure to meet a service requirement or failure of the company to meet performance criteria. No reversal of a charge is permitted for failure to meet a stock price target because the likelihood of attaining the stock price should be factored into the valuation of the option at the grant date.
Legislation (H.R. 3574 and S. 1890) is pending in Congress that would limit any mandatory charge against earnings to options granted to “named executive officers.” Generally this includes the five executive officers included in the proxy statement’s summary compensation table. The legislation would also require that the Secretaries of Commerce and Labor conduct a joint study regarding the economic impact of the Standard Board’s proposals if implemented in full. Once such study is completed, the legislation which differs somewhat in the House and Senate, would permit charges against earnings on account of stock options for all employees, subject to certain limitations. At the time this column was written neither bill had been reported out of committee.
On May 11, 2004, the U.S. Senate passed an international tax bill, S. 1637, entitled “Jumpstart Our Business Strength (JOBS) Act,” containing new rules for deferring compensation under nonqualified deferred compensation arrangements. S. 1637’s counterpart H.R. 2896, is under consideration in the U.S. House of Representatives.
The bill provides that it “shall apply to amounts deferred in taxable years beginning after December 31, 2004.” The intent appears to be that amounts earned prior to January 1, 2005 as to which an election to defer was made prior to 2005 are grandfathered under the new provisions.
The bill also provides that any exchanges in 2005 or thereafter by an employee of (a) an option to purchase the employer’s securities, (b) the employer’s securities, such as restricted stock, or (c) any other property based on employer securities for the right to receive a future payment shall be taxable in the year of the exchange in an amount equal to the present value of the right received in the exchange.
Following is a brief overview of the provisions of S. 1637 relating to deferrals under nonqualified deferred compensation plans.
1. Arrangements and Individuals Affected: S. 1637 defines a “nonqualified deferred compensation plan” as
any plan that provides for the deferral of compensation, other than (A) a qualified employer plan, and (B) any bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plan.
Thus, the only plans exempt from these rules would be tax-qualified plans, including certain plans for government employees. The term “plan” is broadly defined to include any agreement or arrangement, even if for only one person.
2. Requirements for Compensation Deferred After December 31, 2004.
In its current form, S. 1637 will require that a covered “plan” satisfy certain requirements in order to qualify as an effective vehicle for the deferral of income tax.
A. Timing of Distributions. Compensation deferred under the plan cannot be distributed before the earlier of (a) separation from service or, in the case of “key employees” of public companies, six months after separation from service, (b) the date a participant becomes disabled or dies, (c) a time specified in the plan for amounts to be distributed, (d) a change of control or, in the case of an executive covered by Section 16(a) of the Securities Exchange Act of 1934, one year after the change of control, or (e) upon the occurrence of an unforeseeable emergency. The legislation defines “disabled” and an “unforeseeable emergency.” It leaves to the Treasury to define what constitutes a separation from service and a change of control for this purpose.
B. Investment Options. Investment options must be comparable to the investment options under the employer’s tax-qualified defined contribution plan with the fewest investment options or, if the employer does not have a defined contribution plan, the plan will need to meet requirements as to investment options specified by the Treasury.
C. Limitation on Acceleration of Distributions. Except as specifically provided in the legislation or by Treasury regulation as contemplated by the legislation, there can be no acceleration of the time or schedule of any payment.
D. Timing of Elections to Defer. An initial election to defer compensation “for services performed during a taxable year” must be made “during the preceding taxable year or at such other time as provided in regulations.” There is a limited exception for newly eligible participants to elect to defer within the first 30 days after becoming eligible to participate in the plan.
A second election is permitted to delay payment or to change the form of payment if the plan permits and the deferral following the second election is for at least five years. Exceptions exist, however, in the case of disability, death or an unforeseeable emergency. In a case in which the initial deferral was based on a scheduled payment date the election must be made at least 12 months before the first scheduled payment date. In no event can an election to defer or to change the form of payment take effect sooner than 12 months after the date the election is made.
3. Consequences of Failure to Satisfy These Requirements. Failure to satisfy these requirements or to operate the plan in accordance with these requirements during a taxable year will result in taxation of all compensation deferred under the plan for that taxable year, as well as all preceding taxable years, unless such compensation is subject to a substantial risk of forfeiture has previously been included in gross income or is grandfathered (that is, compensation earned prior to January 1, 2005 as to which the election was made prior to 2005).
Deferred amounts will be deemed to be subject to a “substantial risk of forfeiture” if the right to receive such compensation is conditioned upon the future performance of substantial services. Amounts subject to taxation will also be subject to an interest charge with respect to the underpayment of taxes in prior years and a 10 percent penalty.
In the case of an executive who is subject to Section 16(a) of the Exchange Act, payments within one year of a change in control, other than upon the executive’s death or disability as defined in the legislation, will also be treated as excess parachute payments subject to the 20 percent Federal excise tax under Section 280G of the Internal Revenue Code. This is so whether or not such payments otherwise would be treated as excess parachute payments under Code Section 280G.
The proposed legislation also appears to impose the 20 percent excise tax on the deferred compensation distribution even if the same payment also is subject to a 20 percent excise tax under Code Section 280G without reference to the new provision described in the preceding sentence, resulting in a possible 40 percent excise tax. The bill does provide, however, that no such payment shall be disallowed more than once as a deduction by the employer.
4. Transition Rules.
Within 90 days after the enactment of the legislation, the Treasury must issue guidance providing a limited period during which an individual participating in a plan adopted on or before December 31, 2004 may terminate participation or cancel any outstanding deferral election with regard to amounts earned after December 31, 2004.
5. Funding Arrangements.
An employee would become subject to current taxation of deferred amounts, including interest and a 10 percent penalty, to the extent assets in a rabbi trust are restricted from the reach of creditors upon a change in the employer’s financial health or are set aside, or transferred, outside the United States. No taxation occurs, however, if all of the services to which the deferred compensation relates are performed in the foreign jurisdiction in which the assets are located.
 Under the proposed new rule, representing a change from FAS 123, non-public companies no longer will be permitted to use the “minimum value” method. Either the company must determine the option’s fair value under the methods noted in the text or else the option will be treated as a variable price option, resulting in mark-to-market charges each year over the life of the option.
 FASB explains its position on non-transferability as follows:
Employee share options generally differ from transferable (or traded) share options in that employees cannot sell their share options – they can only exercise them. To reflect the effect of employees’ inability to sell their vested options, this Statement requires that the fair value of an employee share option be based on its expected term rather than its contractual term.
FASB Proposed Statement of Financial Accounting Standards (Mar. 31, 2004) at 45, n.9.
 The exposure draft also provides that fair value “should not reflect the effects of vesting conditions or other restrictions that apply only during the vesting period. Those effects are reflected by recognizing compensation cost only for awards that actually vest because the requisite service is provided.” Id. at 41. The exposure draft also excludes “reload features” and “clawback features” from consideration in determining the value of the option.
“Qualified employer plan” is defined as a tax qualified plan within the meaning of section 219(g)(5)(A) or (B) of the Internal Revenue Code (the “Code”) and “any eligible deferred compensation plan (within the meaning of [Code] section 457(b)) of an employer described in [Code] section 457(e)(1)(A).”
 For this purpose, a “key employee” of a public company means a key employee within the meaning of Code section 416(i) (which contains provisions for determining whether a plan is “top heavy”).
 In the case of an annual bonus, the election will need to be made in the year prior to the year in which the services are performed. In the case of a long-term incentive plan, this would appear to mean that the election must be made prior to the commencement of the period (usually covering multiple years) in which the services are to be rendered.
 As noted earlier in the text, the evident intent of the provision contained in Section 671(e) of S. 1637 is to exclude from coverage amounts earned prior to January 1, 2005 as to which an election to defer was made prior to 2005. Such amounts would appear to be grandfathered by Section 671(e)(2) notwithstanding that the funding arrangement fails to comply with the new regulations as described in paragraph 5 of the text. It would be helpful, however, if the final version of the legislation provides specific clarification as to this point.