This article is reprinted with permission from the
June 30, 1993
edition of

New York Law Journal.

1993 NLP IP Company.

 


Incentive Plans After Proposed Tax, Accounting Changes

By Joseph E. Bachelder.

 

THE MARCH 29 column discussed proposed tax and accounting changes that, if adopted, will significantly affect executive compensation. The purpose of this column is to consider modifications of executive compensation programs that might be considered in response to such changes. First, a brief summary of the tax and accounting proposals:

Proposed Tax Rules

The proposed tax legislation (H.R. 2264 as passed by the House of Representatives on May 27; S. 1134 as passed by the Senate on June 25), if enacted, will

(i) increase the marginal individual income tax rate to 39.6 percent (as a result of an increase in the marginal income tax rate to 36 percent and the imposition of a 10 percent surtax on the income tax),

(ii) lift the ceiling on earnings subject to the Medicare tax thus increasing the "true" marginal rates to 41.05 percent and

(iii) put a cap on the deduction for certain executive compensation in excess of $1 million in any one taxable year.

Although the tax rate changes noted in (i) are effective Jan. 1, 1993, in the legislation as passed by the House, the Senate version of the legislation would put into effect only half of the increase for the taxable year 1993. The elimination of the Medicare cap noted in (ii) would take effect commencing with the 1994 calendar year. The cap on the deductibility of certain executive compensation noted in (iii) would take effect for taxable years commencing after 1993.

While the House bill did not change the long-term capital gains rate for individuals, currently 28 percent, the Senate would extend the 10 percent surtax to long-term capital gains, thus increasing the rate to 30.8 percent. Even if the Senate version were enacted, there still would be a meaningful difference in tax rates between ordinary income and long-term capital gains rates. Without the 10 percent surtax on capital gains just noted, the difference is 11.6 percentage points. With the change, the difference is 8.8 percentage points.

It also is noted that under both the House and Senate versions of the legislation the corporate income tax rate would increase from 34 percent to 35 percent.

Proposed Accounting Rules

The Financial Accounting Standards Board exposure draft containing changes in the rules governing the accounting treatment of stock compensation is expected by the end of June. For purposes of this column, the most important change anticipated is the change in accounting for stock options. Stock option grants, for the first time, generally will result in a charge against earnings. That charge will be based upon the value of the option at the time of grant, such value to be based on "fair value" of the grant as determined under the new rule1.

It is expected that a note will be required to the financial statements disclosing the effect of net income and earnings per share of recognizing a charge for stock option grants. Footnote disclosure probably will be required for grants made after 1993. It is expected that actual recognition of a charge against earnings will be required for grants made after 1996.

The following discussion considers certain aspects of executive compensation that may be affected by (i) the tax proposals and (ii) the accounting proposals.

1. Ideas -- Tax Rules

Deferring compensation

The deferral of compensation provides the opportunity to "grow" the deferred amounts without reduction by the taxes that would be imposed if the amounts involved were distributed. Of course, there will be a tax on the deferred amounts when they are finally distributed to the executive. If the tax rates when the deferred amounts are paid out are higher than the rates in effect at the time of deferral, deferral could be detrimental from an after-tax standpoint.

Following is an example of the difference on an after-tax basis in the amount to which a $100,000 bonus might be "grown" (i) if it were first paid out and the net amount remaining after taxes were invested at an annual rate of 4.17 percent aftertax (8 percent pretax) for five years and (ii) if such amount were deferred for five years, credited with an 8 percent pretax annual rate and then paid out and taxed. An aggregate effective tax rate on the executive (federal, state and local) of 47.86 percent is assumed throughout the period.

________________________________________________________________________________________

End
of
Year
$100,000 taxed today
($52,140 after taxes)
growing at 4.17%
aftertax rate
$ 100,000 deferred today
growing at 10% pretax rate
(taxed 5 years from today)
1 $ 54,315 $ 108,000
2 $56,580 $ 116,640
3 $58,941 $ 125,971
4 $61,399 $ 136,049
5 $63,960 $ 76,611

________________________________________________________________________________

The above difference may be increased if the rate of growth on the $100,000 is increased and/or the tax rate at time of payment is lower than the rate at time of deferral. Conversely, the difference may be decreased if the rate of growth is decreased and/or the tax rate at time of payment is higher than the rate at the time of deferral.

It should be noted that there may be an economic loss to an employer in allowing deferral of compensation as just described. This economic loss results from the fact that the employer will be crediting the executive with interest on the full $100,000 for the five-year deferral period even though the net after-tax cost to the employer of paying the bonus would have been $60,000 (assuming a 40 percent aggregate effective corporate tax rate). This additional interest cost will be only partially offset by the deduction obtained by the employer upon payment of the deferred amount including interest. To the extent the interest credited on the deferred amount exceeds the interest the employer would normally pay to borrow money, this economic loss would be even greater.

Stock-for-Stock Option Exercise

Another example of deferral of taxation is a so-called "stock-for-stock option exercise." If an executive owns stock in the employer, under many stock option plans he can use that stock to exercise any stock options that he holds. The potential taxable gain (excess of current value over his tax cost) in the stock that he turns in to exercise the option will not be taxed at the time of the exchange. 2 Thus the executive is able to realize the economic benefit of purchasing additional shares with the economic gain in such stock on a pre-tax basis. If, in addition, the employer provides a reload option opportunity to the executive (by granting the executive a new option covering shares equal to the number of shares turned in upon exercise of the option), the executive will be able to continue his option leverage to the extent of the shares subject to the reload option.

Waiving Compensation to Invest in an Option

Assume an executive is given the opportunity to waive $500,000 of his salary over the next five years ($100,000 per year) and to invest that amount in the "purchase" of an option on the stock of the employer. The employer places a value on the stock option equal to, say, 25 percent of the fair market value of the underlying stock. The employer might arrive at such a valuation by the use of one of a variety of stock option valuation models available (such as Black-Scholes).

Assume the price of the employer's stock to be $40 per share. Thus, the value of a stock option, on a per-share basis, would be $10. Since the executive waived $500,000 in compensation (and ignoring reduction by a factor reflecting present value), the executive would be granted a stock option for 50,000 shares.

If the stock doubles in value over the next five years, the executive will have a spread in the option of $2 million ($4 million total value of the underlying shares less the exercise price of $2 million). At the end of the five-year period, after taking into account the $500,000 "paid" for the option by waiver of salary, the executive will have a net economic gain of $1.5 million before taxes. If the executive sells the stock at that point, and if he is taxed at an aggregate effective rate of 47.86 percent, the executive will have left after tax $1,042,800. 3

A very interesting feature of this arrangement is that, with the assumed aggregate effective tax rate of 47.86 percent, if the executive had simply received the five $100,000 salary payments, instead of waiving them, and reinvested the aftertax proceeds as received, he would have had to earn an internal rate of return of about 60 percent on those investments to end up with $1,042,800 after tax at the end of Year 5.

If the executive is a Named Officer under the SEC proxy statement definition, 4 there are two other potential advantages to a salary waiver program as just described. The annual compensation to the executive is reduced by $100,000 for purposes of the calculation of the $1 million limit on deductible compensation under the proposed new tax rule. Since that $100,000 has been waived, it will never be included in the calculation of that limit. A second benefit if the executive is a Named Officer is that under the proxy statement disclosure rules the $100,000 per year waived will not appear in the salary column of the Summary Compensation Table. 5

Creating Capital Gains Opportunities

The most obvious long-term capital gains opportunity is the tax-qualified incentive stock option (ISO), provided for in 422 of the Internal Revenue Code of 1986. 6 The so-called ISO permits the holder to exercise the option without tax and, if the provisions of 422 are complied with, the holder will realize long-term capital gains on sale of the stock. There are rather stringent limits set forth in 422 on the amount of such stock that can be granted under an ISO. A particular disadvantage of an ISO to the employer is the loss of tax deduction combined with the charge against earnings that would be incurred under the proposed accounting rules as discussed further below.

Another program that may provide long-term capital opportunities involves the sale of stock to the executive in exchange for recourse unsecured notes with, say, a five-year maturity date (subject to acceleration as noted below). Concurrently, a five-year incentive program could be adopted with a target payout, based upon corporate and/or individual performance targets, equal to the amount of the note plus interest for the period to maturity date.

Under such a program, the stock would be fully vested and freely transferable (subject to the insider requirements of 16 of the Securities Exchange Act of 1934). The long-term incentive award would be forfeited under various terminations (e.g., a voluntary termination or a termination for cause) but would not be forfeited in the event of other terminations (e.g., death, disability or termination without cause).

If, for example, the executive left voluntarily before the end of the five-year period, the note would become due immediately and the executive would forfeit any entitlement to the bonus. The same would occur if the executive transferred the stock. In no event, however, would the stock itself be subject to any restriction.

On this basis the executive should be eligible for long-term capital gains treatment on the stock whenever it is sold (provided it is held for more than one year as required by 1222 of the Code). To the extent there is an issue as to whether there has been an unrestricted transfer under Code 83 an election under 83(b) would eliminate the transfer issue.

Upon satisfaction of the long-term incentive award conditions, the executive would receive a bonus payment, equal to the amount due on the note. This amount would be ordinary income to the executive and a tax deduction to the employer.

Special Class of Stock

The program just described could be carried out with a special class of stock based on performance of a subsidiary. An example of a major U.S. corporation with special stock tied to the performance of a subsidiary is General Motors with one class of stock tied to the performance of Electronic Data Systems Corp. (GM class E) and another class of stock tied to the performance of GM Hughes Electronics Corp. (GM class H). Thus a corporation could tailor a stock purchase/note/bonus plan to the performance of one or more of its units. That suggestion raises corporate and securities law considerations beyond the scope of this discussion.

Convertible Debentures

Another method to create a long-term capital gains opportunity would be the sale of a convertible debenture to an executive. Financing of the purchase might be done by a combination of cash and notes. The debenture would provide that, subject to the satisfaction of certain conditions, it would be convertible into common stock of the employer. Risk on the downside could be limited by giving the debenture holder a right to have the debenture redeemed, again under specified circumstances. The conversion of the debenture into stock of the employer should be possible on a tax-free basis. If the holding period requirements have been met, sale of the underlying stock should result in long-term capital gains.

Tax Consequences to Employer of Program Providing Capital Gains Opportunities to Executives

A structure that permits capital gains on a particular item to the participants will prevent an ordinary deduction as to that item to the employer. Accordingly, if the employer and the executive are looked at as a "tax unit," a program that delivers capital gains to the executive will not be tax efficient. Generally speaking, the tax benefit to the executive of a reduced tax in the form of long-term capital gains will be less than the tax cost to the employer of losing an ordinary deduction.

2. Ideas -- Accounting

A frequently raised question in anticipation of the proposed new accounting rules is -- what will happen to stock options?

Perhaps the most vulnerable form of stock option will be the ISO. From the employer's standpoint it already carries with it the disadvantage of its nondeductibility for tax purposes. (Under current tax rules a non-qualified stock option gives rise to an ordinary deduction equal to the amount of the spread in the option at the time of option exercise; an ISO, under Code 422, does not permit a deduction to the employer, assuming there is not a disqualifying act subsequent to its grant.) If the proposed accounting rules are adopted, an ISO will carry with it a double disadvantage. Not only will it be nondeductible for tax purposes, but it also will be a charge against earnings.

Stock options have been a preferred long-term incentive for many companies in large part because there has been no charge against earnings. If the proposals take effect, stock options will undergo scrutiny as to their competitiveness with other forms of long-term incentive compensation.

Exercisability of options may become more performance based. For example, the right to exercise an option may be made contingent upon attainment of corporate performance targets. If there is to be a charge against earnings for a stock option in any event, employer corporations may decide they are better off tying exercisability to achievement of performance targets rather than making an option grant that is simply earned out over time.

Other forms of performance-based awards also may become more popular under the proposed new rules. Performance shares (whether in the form of deferred share awards or restricted shares) are an example. Such awards are tied to the achievement of corporate performance targets such as return on assets or growth in earnings per share.

Finally, stock options may undergo redesign in features other than performance-based criteria. For example, stock option grants may provide an exercise price with a premium over market value at time of option grant. Another example, already noted, may be the sale of stock options to executives rather than outright grants. This latter approach may not be widely accepted because of the inherent risk in a stock option, unless the "sale" is accomplished by a particularly favorable arrangement. An example of such an arrangement, involving waiver of future compensation, was discussed earlier in the column. The attractiveness of that arrangement from the executive's standpoint lies in the use of future compensation to finance, on a pre-tax basis, the "purchase" of the option.


FOOTNOTES:

1 25 Sec. Reg. & L. Rep. (BNA) 515-16 (April 9, 1993).

2 Rev. Rul. 80-244, 1980-2, C.B. 234.

3 Under present tax rules, a grant of a stock option does not result in taxable income at time of grant. This is based upon the principle that except in very unusual circumstances a stock option does not have a readily ascertainable value and therefore should not be treated as a taxable transfer of property. IRC 83(e)(3). It is not known whether a final adoption by the Financial Accounting Standards Board of the rule requiring a charge against earnings based on date of grant value of a stock option will lead to an alteration of the IRS position as to the circumstances under which a stock option will be deemed not to have an ascertainable value.

4 See 17 CFR 229.402(a)(3) (1992).

5 Instruction 3 to Item 403(b)(2)(iii)(A) and (B) of Regulation S-K provided that such waived amounts need not appear in the salary column. 17 CFR 229.402(b) (1992). Under that instruction salary waived in consideration for an option grant, in lieu of being reported in the salary column, must be represented by disclosure in the stock option column of the number of shares granted under the option. Moreover, any amount waived at the election of a Named Officer is still used to determine whether the executive is a Named Officer for that fiscal year. See 17 CFR 229.402(a)(3) (1992) (Instruction 1 to Item 402(a)(3) of Regulation S-K).

6 Code 422A was redesignated as Code 422 by the Omnibus Budget Reconciliation Act of 1990, Pub. L. No. 101-508, Title XI, 11801(c)(9)(A)(i), 104 Stat. 1388-524, 1388-525 (Nov. 5, 1990). Former Code 422, Qualified Stock Options, was repealed by the same legislation.