The Advisors' Blog

– Broc Romanek

Here’s a note that I received from a member last night worth reading:

Recently proposed tax legislation (first by the by the House of Representatives, which has since reversed its position – but then the Senate bill revived this position) would impose federal income tax on the value of employee stock options as they vest, which could severely curtail the use of this long-standing equity compensation scheme. Under current tax law, stock options are generally not taxed until exercise, which allows the option holder to trigger taxation based on a stock price and date the option holder feels is optimal for their situation.

The proposed legislation also taxes subsequent increases in the value of the stock option on an annual basis in the event the participant does not exercise the stock option on the vest date. Under the proposed legislation it is unclear if a subsequent reduction in the value of an unexercised stock option would result in a reduction in taxable income, although it’s hard to imagine option holders delaying exercise after the option is taxed at vest, hoping to see the stock price drop so they can recoup some of the tax.

Most employee stock options vest over a three- to four-year period, typically in equal increments. A number of high tech companies vest stock options in monthly or quarterly increments after the 1st anniversary of the award. Putting aside the tax inefficiency created by the new tax legislation, the administrative burden of taxing stock options annually, monthly or quarterly might be sufficient reason for many employers to abandon stock options.

For some stock option critics, including a well-known investor from Omaha, Nebraska, the demise of stock options is long overdue. These critics argue that stock option holders benefit from a rising stock market (“rising tides lift all ships”) and the resulting gains are often undeserved. Others have referred to stock options as a “blunt instrument” for delivering compensation, as the resulting value is usually much higher or lower than the “expected” value at the time of grant.

Based on a recent survey of over 400 companies conducted by Deloitte Consulting in conjunction with the NASPP, the prevalence and emphasis on stock options has been on the decline for some time. Based on the latest findings, 51% of survey participants grant stock options compared to 89% of participants who grant time vested restricted stock and 81% of whom grant performance shares. Even among “high tech” survey participants, only 51% grant stock options.

There are several reasons for the decline in stock options, including the high level of uncertainty and compensation volatility, the significant number of shares and corresponding dilution required when using stock options compared to other equity compensation alternatives, and proxy advisory firm pressure to award performance-vested stock awards.

Despite the decline in stock option usage (with an increase in RSUs, etc.), there are a number of companies that continue to rely exclusively on stock options to attract & reward employees. Among these are start-up companies that have limited resources, and can only share future value creation with employees. Private equity owned portfolio companies are also significant users of stock options, as private equity owners are paid based on stock price appreciation, and stock options are an elegant way to align the interests of the owners and employees.

What is truly perverse about the proposed legislation is it actually produces less tax revenue for the Federal government than the current rules. Here is a simple example, to illustrate the point. Assume a stock option is granted with an exercise price of $10, and it vests on the third anniversary of the grant when the FMV is $13. The option is exercised in year 7 when the FMV is $20.

Under current tax law, the option holder earns $10 of ordinary income, and assume the federal government collects 25%, or $2.50. Under the proposed rule, the option is taxed at vest, which will most likely cause the option holder to exercise and sell the shares. In this case, the option holder realizes $3 of ordinary income, and at 25%, the Federal Government collects $.75 of tax. While it is true, the Fed gets its money in year 3 versus year 7, given the Fed’s low cost of funds, the present value of the year 7 tax equals about $2.30 in year 3 compared to $.75, a reduction of close to 68% in collections.

Of course, the stock has to increase beyond the year 3 stock price of $13 at 10% per year for the math to work as illustrated, but why would the Fed want to bet against future appreciation of 10’s of millions of stock options, when it is trying to pursue policies that spark accelerated economic growth for the economy?

The proposed stock option law, if passed, will be hugely unpopular among many companies and their employees, rob start-ups and other very entrepreneurial organizations with an effective way to share value creation with employees, lower tax receipts and undoubtedly result in a shift to other forms of compensation that cost shareholders more and are less effective in motivating employees. So, let’s hope Congress takes a deep breath, counts to 10, and decides to forget the whole thing.