This article is reprinted with permission from the
May 30, 1997 edition of
New York Law Journal.
1997 NLP IP Company.


Deferral of Stock Option Gains

By Joseph E. Bachelder.


MANY U.S. CORPORATIONS are considering programs that would give executives the opportunity to defer the gain, and hence the taxes, on the exercise of non-qualified stock options. 1 Typically, such a transaction involves a stock-for-stock exercise of the option. 2 This means the executive uses stock already owned to pay the exercise price. Based on a prior election, the gain (the spread in the option at the time of exercise) is deferred through a deferred compensation plan of the employer. The arrangement may involve the use of a rabbi trust. The executive receives payment (whether in the form of employer stock or otherwise) at a date, such as retirement, he previously selected.

There are various reasons why an executive may want to exercise an option at a particular time. Some of these are consistent with the idea of deferral of the gain.

1. The option is about to expire, and the executive is forced to exercise or lose the benefit of any spread in the option. (Exercisability also may be lost, or the period of exercisability may be shortened, in the event of a termination of employment.)

2. The employer may require its senior executives to hold shares of employer stock equal to a specified ratio of stock to salary (two or three times salary is not an unusual requirement). Exercising an option, even on a stock-option-gain deferral basis, should assist the executive in meeting this requirement.

3. The executive may want to convert the option gain into actual shares in order to "capture" the spread. Even though the executive continues to hold the gain in the form of deferred employer shares, he has "captured" that gain and put it at less risk. 3 Another advantage, in many cases, will be that the executive, as holder of the deferred stock, will become entitled to dividends declared on employer shares, which dividends themselves can be subject to deferral.

4. The executive may want to convert the option gain into diversified investments.

5. The executive may want to use the option gain for immediate cash needs.

The first four purposes may be achieved through option exercise in which the gain, and the income tax on the gain, is deferred until later when the proceeds are paid out. 4

It appears that from a technical standpoint -- tax securities and accounting -- stock-option-gain deferral arrangements are workable. The most sensitive point at this time appears to be the accounting treatment -- especially on the issue of diversification. The Financial Accounting Standards Board (FASB) Emerging Issues Task Force (EITF) held a meeting on this point May 22, 1997, as discussed below.

Tax Considerations

How can the executive defer taxes on the option spread at the time of option exercise? In Revenue Ruling 80-244, 1980-2 C.B. 234, the Internal Revenue Service ruled that an exercise of a non-qualified stock option, with payment of the exercise price in the form of stock held by the executive, resulted in two "sub-transactions"; (i) under 1036 of the Internal Revenue Code, a tax-free exchange of shares equal to the number of shares transferred in exercise of the option occurred and (ii) the transfer of the remaining shares to the executive resulted in ordinary income tax on those shares.

How can the gain as described in Clause (ii) of the preceding sentence be deferred? This depends on the effectiveness of a prior election to defer that gain pursuant to a deferred compensation arrangement. The principles on which deferral of compensation is recognized have long been part of the tax law. Code 451 deals with general rules for the taxable year of inclusion. Treasury Regulation 1.451-2 deals with the principles of constructive receipt of income. Under the constructive receipt principles, income is taxable to a cash-basis taxpayer when it becomes available to the taxpayer without being subject to substantial limitations or restrictions upon its receipt.

In light of applicable cases and rulings, one method used to defer compensation income has been an election by the executive to defer an item of compensation that is made significantly earlier than the compensation becomes available to the executive. 5 Many practitioners are comfortable with an election to defer if it is made at least six months before the item of compensation becomes available to the executive, notwithstanding that the IRS has never given an official blessing to six months as being a generally acceptable "insulation" period.

Thus, if an election to defer the gain is made at least six months before an option exercise, "current wisdom" would suggest that such election should defer the gain. This assumes the election is made pursuant to an arrangement that otherwise meets appliable requirements for effective deferral arrangements in light of the authorities cited in footnote 5.

Diversification of Investment

Can the executive having elected to defer the gain attributable to the exercise of the option, take the next step and diversify the investment of the gain? This might be accomplished by the employer's setting up alternative investment accounts to which the deferred amounts might be credited. It also might include the use of a rabbi trust to which deferred amounts would be transferred by the employer. 6 Future investments of the gains would be held in the rabbi trust and then paid out to the executive at the designated future date. There are important accounting considerations involved in diversification that are discussed below.

Beyond the scope of this column is the extent to which an executive deferring compensation may direct the investments of the deferred amounts. Care must be taken to avoid challenge by the IRS on the ground that control over the investment of the deferred amounts confers on the executive an economic benefit equivalent to ownership of the deferred amounts resulting in current tax on those amounts. 7

From the standpoint of an employer that is a public corporation, an important tax consideration is the risk of loss of deduction under Code 162(m) for the stock option spread in a case in which the exercise and deferral is effected by a senior officer. For the top officers of a public corporation (usually five, described as "named executive officers"), compensation paid currently in excess of $1 million is not deductible unless it enjoys an exemption under 162(m). If the deferred amounts are paid out after the year in which such an executive ceases to be a named executive officer, there will be no loss of deduction by the employer under 162(m).

A stock option, granted pursuant to a plan approved by shareholders, generally enjoys an exemption from the non-deductibility rule of 162(m). However, if the option confers an economic benefit beyond the right to benefit from growth in value of the stock over the market value on date of option grant, the exemption under Code 162(m) would be lost. Under Treasury Regulation 1.162-27, the addition of the right to defer would not seem to cause loss of the exemption. The consequence of adding the right to diversify the investments on the deferred amounts is not so clear. 8

Accounting Issues

The first accounting issue is whether the status of an option as a non-expense item would be put in jeopardy by the addition of a right to defer gain on option exercise. The applicable accounting principles are set forth in APB Opinion No. 25 (1972). 9 Before addressing a second and more complicated issue in this connection -- the diversification of the deferred gains -- we will address two questions relating to deferral.

1. Does the addition to an already outstanding option of the right to defer option-exercise gain result in a new measurement date under APB Opinion No. 25? If the addition of the deferral right were deemed to be a regrant of the option, a new measurement date would apply. At its meeting May 22, 1997, the EITF apparently concluded (at least tentatively) that the addition to an already outstanding option of the right to defer does not result in a deemed re-grant of the option. Accordingly, addition of the deferral right to an already existing option does not appear to jeopardize the non-expense accounting treatment for the option.

2. Does this arrangement somehow convert the option into a stock appreciation right (SAR) that results in a charge against earnings (based on the so-called "mark to market" accounting treatment for SARs generally)? It appears that the EITF does not have a problem if the ultimate payout is in shares of stock. In other words, if the arrangement merely allows the executive to defer the option spread in the form of shares of deferred stock, or stock units, that ultimately are paid out in stock, there should not be any adverse consequence to the non-expense status of the option. If the ultimate payout is in cash, the answer is not so clear. 10

The issue becomes more complex when the subject of diversification of the deferred amounts is introduced. As noted above, a diversification program allows the executive upon exercise to direct that the proceeds be invested in one or more investment accounts maintained by the employer. If a rabbi trust is involved, presumably the investments would be made by the trust from funds attributable to transfers from the employer.

The Consequences

At this stage, accountants differ as to the consequences of giving the option holder the right to diversify. For example, does an entitlement to diversify mean that the executive has been given something other than a mere option right to receive a fixed number of shares upon exercise of the option? From another perspective, the question is whether a right to diversify is the equivalent of giving the option holder the immediate right to cash out and use the proceeds to diversify. In either case, APB Opinion No. 25 would appear to require a charge against earnings.

In the view of some accountants, the problems described in the preceding paragraph may be avoided if the executive is required to keep the deferred amounts invested in employer stock, or stock units, for at least six months following exercise and deferral. A prior ruling of the EITF has indicated that if at least six months go by after a stock-for-stock option exercise non-deferred basis) the executive may have the right to sell back to the employer the shares exchanged without jeopardizing the status of the option. 11 (If the executive could sell back to the employer the shares exchanged immediately after exercising [non-deferred basis], the arrangement, in effect, would be like a SAR, which does result in a charge against earnings.)

Yet another group of accountants is of the view that the executive should be free to diversify immediately after deferral without any adverse impact on the expense-free status of the option. This definitely appears to be a minority view.

Thus, the May 22 meeting of the EITF resulted in lack of consensus on whether diversification:

* should in all events result in a charge against earnings;

* should not result in a charge against earnings provided the deferred stock is "held" for at least six months following exercise of the option before diversification;

* in all events should be permitted without resulting in a charge against earnings, or

* should be subject to some other rule.

The staff of the FASB apparently will be reviewing issues including those involving diversification, for the purpose of holding further discussion at a future EITF meeting. (Such meetings are generally held about six times a year.) Given the diversity of views, it may be some months before the EITF is able to adopt a position on stock-option-gain deferrals, including the diversification issue.

Stock-option-gain deferral does not appear to raise significant issues under 16 of the Securities Exchange Act of 1934 (Exchange Act). Under Rule 16b-3, with limited steps required of the employer, stock option-related transactions can be exempted from the profit recapture provisions of 16 of the Exchange Act. An exception may apply to so-called "discretionary transactions." 12 A right to convert deferred stock option gains into a diversified account may be viewed as a "discretionary transaction." In addition, the right to elect out of a diversified account and back into employer stock may give rise to another "discretionary transaction." 13

Assuming that the stock-option-gain deferral arrangement contemplates a stock-for-stock exercise (as most such arrangements will, as noted above), care also should be taken that appropriate approval for such an exercise has been obtained in order to comply with Rule 16b-3. Beyond the scope of this column are any reporting requirements under Exchange Act 16(a).

For proxy statement reporting purposes, questions may arise as to the appropriate reporting of stock-option-gain deferral. Careful attention should be given to whether the arrangements require reporting in the Beneficial Ownership Table. Deferral of option gain should be described in footnotes to the Stock Option Tables, and Compensation Committees may want to describe such a program in the Compensation Committee Report. 14


1 The concept of deferring stock option gain generally does not apply to "incentive stock options (ISOs)" qualifying under 442 of the Internal Revenue Code of 1986 since there is no tax upon the exercise of an ISO. There are, however, conceivable applications of the deferral technique to an ISO. For example, it might be applicable in the event of a disqualification following an exercise of an ISO.

2 Provision for stock-for-stock exercises in non-qualified stock options has been common practice since Rev. Rul. 80-244, 1980-2 C.B. 235. That ruling is discussed later in this column.

3 For example, if an executive has a stock option entitlement to 1,000 shares with a current market price of $40 and an exercise price of $20, the exercise of the option obviously changes the investment risk. Instead of the "play" on 1,000 shares, with a risk of total loss if the price drops back to $20, the executive has a net enhancement of 500 shares worth $20,000 with less upside opportunity but with one less risk in the sense that if the stock drops to $20 the executive will have a value of $10,000 represented by 500 shares rather than zero represented by an option on 1,000 shares.

4 Notwithstanding deferral for federal income tax purposes, the deferred amounts may be taxed sooner for purposes of FUTA and FICA including Medicare taxes.

5 The grandfather ruling on the subject of deferral and constructive receipt is Rev. Rul. 60-31, 1960-1 C.B. 174 modified by Rev. Rul. 64-279, 1964-2 C.B. 121 and Rev. Rul. 70-435, 1970-2 C.B. 100. Other rulings pertinent to the subject include Rev. Proc. 71-19, 1971-1 C.B. 698 as amplified by Rev. Proc. 92-65, 1992-2 C.B. 428. Among tax cases relevant to this issue, see Martin v. Commissioner, 96 TC 814 (1991).

6 For prior discussion of deferred compensation and the role of rabbi trusts, including discussion of the IRS matter rabbi trust ruling, Rev. Proc. 92-64, 1992-2 C.B. 422, see this column, Aug. 29, 1992.

7 For discussion of consequences of employee investment discretion in connection with (i) deferred compensation arrangements and (ii) rabbi trusts, see this column, April 7, 1994.

8 Treas. Reg. 1.162-27(e)(2)(iii)(B) provides that "If compensation is payable upon or after the attainment of a performance goal, and a change is made to defer the payment of compensation to a later date, any amount paid in excess of the amount that was originally owed to the employee will not be treated as an increase in the amount of compensation if the additional amount is based either on a reasonable rate of interest or on one or more predetermined actual investments (whether or not assets associated with the amount originally owed are actually invested therein) such that the amount payable by the employer at the later date will be based on the actual rate of return of a specific investment (including any decrease as well as any increase in the value of an investment)." (Emphasis added.) There is no similiar provision in Treas. Reg. 1.162-27 regarding diversification of deferred amounts and the reasoning of the quoted excerpt suggests that continuing discretion to choose among investments would not be within its rationale.

9 In 1995 the Financial Accounting Standards Board adopted FASB Statement No. 123, which essentially provides that employers can continue to treat stock options under the non-expense rules of APB Opinion No. 25 (1972), subject to footnote disclosure to the financial statements of the pro forma charge to earnings if one were required.

10 If the exercise of a stock option results in an immediate payout of cash, there would be a charge against earnings under APB Opinion No. 25, para. 11(g). The EITF did not reach a conclusion at its May 22 meeting as to whether an exercise on a deferred gain basis with ultimate payout in cash would result in a charge against earnings. This issue obviously is tied in with the diversification issue as discussed subsequently in the text.

11 EITF Issue No. 84-18.

12 A "discretionary transaction" is defined in Rule 16 b-3(b)(1) as "a transaction pursuant to an employee benefit plan" that is "at the volition of a plan participant" (other than one made in connection with certain specified terminations of employment or one required by the Internal Revenue Code) and that results in either
* "an intra-plan transfer involving an issuer equity securities fund" or
* "a cash distribution funded by a volitional disposition of an issuer equity security."

13 Under Rule 16 b-3(f), a "discretionary transaction" is exempt if effected pursuant to an election made at least six months following the most recent election that effected a discretionary transaction that was (i) an acquisition, if the transaction to be exempted is a disposition, or (ii) a disposition if the transaction to be exempted is an acquisition.

14 Not included in the column's discussion are any registration implications of a deferral/diversification program.