This article is
reprinted with permission from the
March 01, 1997 edition of
New York Law Journal.
© 1997 NLP IP Company.
Opportunities for Capital Gains
By Joseph E. Bachelder.
AS A RESULT of the passage of the Taxpayer Relief Act of 1997, the gap between ordinary income tax rates and long-term capital gains rates has substantially widened, making it more advantageous than it has been in a long time for executives to shift income subject to ordinary income tax rates under compensation arrangements to income subject to long-term capital gains rates. The federal ordinary income tax marginal rate is 39.6 percent (which, when the Medicare tax rate of 1.45 percent is added, brings the total rate to 41.05 percent). Under the Taxpayer Relief Act, the long-term capital gains rate is now reduced to a marginal rate of 20 percent (for property held more than 18 months). 1
Following are several executive compensation arrangements that provide opportunity for long-term capital gains treatment:
1. Incentive stock option grants,
2. Stock purchases through employer loans,
3. Purchases of convertible securities such as debentures and
4. Reload options.
Incentive Stock Options
Under § 422 of the Internal Revenue Code of 1986, as amended, an executive may receive rights to a limited number of shares, based on dollar value, under a stock option grant which, provided other requirements are met, will qualify as an Incentive Stock Option (ISO). The dollar-value limitation provides that no more than $100,000 of ISO grants may become exercisable for the first time in any one calendar year. 2
Other ISO requirements include the period a share acquired upon exercise of the option must be held before it is sold (two years after option grant, one year after exercise), the exercise price (no less than fair market value of the underlying stock on date of grant) and post-termination exercise limits (exercise must occur within three months following termination of employment). For specific language on these and other requirements, see Code § 422.
Presumably because of these requirements and the loss of deduction to the employer, there has not been widespread interest in ISOs, at least in recent years. The new capital gains tax rates may reawaken such interest. Unless the alternative minimum tax applies, a circumstance not applicable to most executives, there is no tax to the executive on exercise, and provided the stock is held by the executive for the requisite holding periods, the sale of the stock acquired on exercise of the option should qualify for long-term capital gains.
As noted, under the ISO rules the stock must be held at least two years from option grant and one year from option exercise; under the new Taxpayer Relief Act, to qualify for long-term capital gains, the stock must be held at least 18 months from option exercise before sale. For those who are subject to the alternative minimum tax, gain on exercise of an ISO generally is included in alternative minimum taxable income.
The principal criticism of ISOs, from a compensation consultant's standpoint, has been that they are not a tax-efficient way to provide executives with stock options: the employer loses its tax deduction and may be better off being more generous with non-qualified options that provide it with a tax deduction.
This "tax inefficiency" (measuring the tax cost to the employer against the tax benefit to the executive) is reduced as a result of the capital gains rate reduction. The same "tax inefficiency" criticism, of course, can be directed to the other arrangements discussed in this column for delivering a long-term capital gains opportunity to the executive: the employer must forgo a deduction it otherwise would have against its ordinary income.
Loan and Stock Purchase Program
Under a loan and stock purchase program, the executive purchases stock in exchange for a recourse note to the employer, which is not secured by the stock. The reason for not securing the loan with stock is to avoid subjecting the transaction to the margin rules of the Federal Reserve Board. The note is forgiven on a specified date, such as five years following purchase of the stock and may be forgiven on an accelerated basis if performance targets are met. If the executive leaves before the specified date, the unpaid loan becomes due immediately.
Since the executive owns the shares outright, they will qualify for long-term capital gains treatment if held for 18 months. Assuming there is not a margin-rule problem, the arrangement may provide that the executive cannot sell the shares before the associated loan is forgiven without triggering repayment of the loan. 3 If the arrangement provides for pro-rata forgiveness of the loan, the sale of a corresponding number of shares could occur without triggering repayment, as described in the preceding sentence, of the remaining amount of the loan.
To the employer, this program may offer a potential "golden handcuff" on the executive. If the executive leaves employment before the end of the specified period, the loan becomes due immediately. If the stock has dropped in value, the executive may not realize enough cash from a sale of the stock to pay off the loan and will have to dip into other resources to make such payment.
Purchase of a Convertible Debenture
Under this arrangement, the executive purchases a debenture that, after certain conditions are satisfied, becomes convertible into stock of the employer. To qualify this arrangement for a long-term capital gains opportunity, the executive must make a "true" investment in the debenture. This means the executive must use cash, or a combination of cash and recourse borrowing (not secured by the debenture). An example of such an investment might involve a combination of cash, recourse borrowing (from the employer) and non-recourse borrowing (from a bank which takes the debenture as collateral).
Assuming a sufficient percentage of the investment is in the form of cash and recourse borrowing the arrangement should qualify as a "true" investment (and not merely the grant of a stock option) for federal income tax purposes.
The next step in such an arrangement is for the executive to elect, under Code § 83(b), to be taxed at the time of purchase. A concern for the executive would be the possibility of tax at such time if the value of the debenture exceeds the cost of purchase. However, it should be possible to avoid the executive's incurring tax by designing the debenture in such a way as to "equalize" its value with the purchase price.
This may include, among other features, a premium attached to conversion of the debenture. On this basis, the executive can elect under § 83(b), without current income tax, to have any future gains treated as long-term capital gains (provided he satisfies the 18-month holding period requirement).
Once the debenture becomes convertible, the executive can convert it into stock in a transaction that is tax-free. 4 The executive also is entitled to include the period the debenture has been held as part of the holding period. Code § 1223. In this way, the executive can achieve long-term capital gains on the stock acquired through conversion of the debenture, even if the stock is sold immediately, provided the debenture has been held for more than 18 months.
As in the other arrangements discussed in the column, it is important to note that the employer is giving up an important tax benefit whenever it permits the executive to receive compensation in a transaction that is eligible for long-term capital gains treatment. In the case of the convertible debenture, the employer is giving up the deduction it otherwise would have for federal income tax purposes on any growth in value of the stock between the date of purchase of the debenture, as to which the § 83(b) election is made, and the date the executive exercises the debenture.
A reload option gives the executive the opportunity to exercise an existing option and to receive a new one covering the same number of shares less the number of shares the executive "nets" on exercise of the original option. For this purpose, "nets" refers to that number of shares representing the "spread" in the original option at the time of exercise. With the grant of the reload option, the executive is in the same position to participate in the future growth of the employer's shares as before the exercise. However, after exercise he owns some of the shares, with a reload option covering the remainder.
Following is an example of how such an arrangement works.
An employer grants an executive an option for 1,000 shares of its stock. Well before the end of the option term, the executive exercises the option in order to acquire stock ownership to qualify for long-term capital gains.
The current price is $50 per share. The exercise price of the option is $40 per share. For this example, we will assume the executive exercises the option by turning in 800 shares already owned (he also could exercise by payment in cash) which, at the current price of $50 per share, equals in value the aggregate exercise price of $40,000. The executive receives back 800 shares -- equal to the number turned in on the exercise, plus 200 shares more (representing the spread in the option on its exercise). The executive must pay an ordinary income tax on the $10,000 spread in the option, represented by the value of the 200 shares. (The turning in and receiving back of 800 shares on exercise of the option is tax-free.)
The employer next grants the executive a new "reload" option for 800 shares. The executive thus continues with a growth opportunity on 1,000 shares attributable to the original option grant: 200 shares now owned outright and 800 subject to the new option. As noted, through this program, the executive has put himself in a position to realize long-term capital gains on any future growth in the 200 shares, provided they are held for more than 18 months.
The executive, of course, has incurred ordinary income tax on the $10,000 of spread represented by the 200 shares sooner than would have been the case if he had held the original option without exercising it until just before its expiration date. (On average, options are held by executives for periods of five to seven years.)
The answer to whether this was a good decision by the executive will depend on the future growth in the stock. For example, if the 200 shares of stock double in value in the next 18 months, the executive then will be in a position to sell and realize long-term capital gains on the $10,000 of growth (at a 20 percent federal tax rate, leaving him with $8,000 after federal taxes) versus ordinary income tax (at a 41.05 percent federal tax rate, including Medicare tax, leaving him with $5,895 after federal taxes).
Other considerations involved in the decision by the executive to exercise the original option now rather than later include:
(i) the use-of-money cost on the taxes paid today on the exercise of the original option, a cost that could have been deferred until a later exercise of the option and
(ii) dividends, if any, paid on the employer's stock (assuming no dividend equivalents are paid on the option, which usually is the case).
For a discussion of deferring taxes on stock option exercise through a stock-option-gain-deferral program, see this column that appeared on Aug. 25, 1997. Such a deferral is the "opposite side of the coin" from the subject of early exercise of an option with a view to obtaining capital gains treatment and also can involve an option reload program. This highlights an important consideration discussed in the Aug. 25 column. Deferral of tax on option gains over a significant period, such as five or 10 years, even though the end result is taxed at an ordinary income tax rate may produce a better after-tax result for the executive than an early exercise of the options with long-term capital gains on the growth following exercise.
1 Section 311(a) of the Taxpayer Relief Act of 1997, amending § 1(h) of the Internal Revenue Code of 1986, as amended. In addition, under circumstances beyond the scope of this column, further reductions in the capital gains rate are provided.
2 The value of the grant subject to this test is determined by multiplying the number of shares becoming exercisable for the first time in the year in question by the fair market value of a share at the time of grant. Code § 422(d).
3 The loan would be treated as indirectly secured by the stock if the sale of the stock would accelerate maturity of the loan. Fed. Res. Reg § 207.2(f)(1)(ii) promulgated under § 7 of the Securities Exchange Act of 1934. In such case, the transaction would be subject to the margin rules. Nonetheless, if the stock plan pursuant to which the loan arrangement is entered into is approved by stockholders and otherwise meets the requirements of Fed. Res. Reg. § 207.5(a)(2), the maximum secured loan amount can be based on the full value of the shares at the time of the loan (in contrast to a broker loan which generally is based on 50 percent of current market value). If, for some reason, the rule described in the preceding sentence is not available or not workable, the executive would have to be free to sell the stock without accelerating maturity of the loan in order to avoid a margin problem.
4 Rev. Rul. 72-265 (1972-1 C.B. 222).