RCG Magazine - 1st Quarter 2004 | Table of Contents

Regulatory Update From Compensation Design Group

280G Stock Option Valuation

19 years ago, section 280G and section 4999 were added to the Internal Revenue Code. The IRS has now finalized the golden parachute regulations. In general, these rules are effective for payments contingent on changes in control occurring on or after January 1, 2004.

Overview

Section 280G denies a deduction to a corporation for any excess parachute payment, and section 4999 imposes a 20-percent excise tax on the recipient of any excess parachute payment. A parachute payment is any payment that meets all of the following four conditions:

An excess parachute payment is an amount equal to the excess of any parachute payment over the portion of the disqualified individual's base amount that is allocated to such payment. [Disqualified individuals are highly compensated individuals (in general, the top 1%, but not more than 250 individuals), 1% shareholders and officers, including officers of subsidiaries (but not more than 50 employees or, if less, the greater of 3 employees or 10% of employees). The portion of the base amount allocated to a parachute payment is the amount that bears the same ratio to the base amount as the present value of the parachute payment bears to the aggregate present value of all such payments.]

Generally, excess parachute payments may be reduced by an amount that the taxpayer establishes by clear and convincing evidence is reasonable compensation for services actually rendered before the change in control. [Such reasonable compensation is first offset against the portion of the base amount allocated to the payment.]

The grant or vesting of a stock option in connection with a change in control may constitute a parachute payment. In connection with the issuance of final parachute regulations, the IRS issued Revenue Procedure 2003-68, which provides new guidance on the valuation of stock options for this purpose. (This revenue procedure restates and modifies guidance issued in earlier revenue procedures and, like that earlier guidance, does not apply for purposes of valuing a payment in cash (or property), even though the amount of the payment is determined by reference to the cancellation of a stock option.) Revenue Procedure 2003-68 is effective January 1, 2004. However, taxpayers may apply it to a change in control occurring prior to such date.

Stock Option Valuation

Revenue Procedure 2003-68 provides that, in general, a taxpayer may value a stock option using any valuation method that is consistent with generally accepted accounting principles (such as FAS 123 or a successor) and takes into account factors including the option spread, stock volatility and the remaining option term. Thus, the value of a stock option is not properly determined if the option is valued solely by reference to the spread at the time of the change in control.

Revenue Procedure 2003-68 also establishes a safe harbor valuation method for options on both publicly and nonpublicly traded stock. [Revenue Procedure 98-34, which provides a methodology for the valuation of certain stock options for purposes of gift, estate, and generation-skipping transfer taxes, may also be used in certain cases.]

The valuation date is the payment date, that is, the date that the option is vested. The valuation of the option is determined based on the relevant factors as of that date. If an option on a different stock is substituted for the option, the valuation is based on the substituted option.

In what represents a significant change from earlier IRS guidance, the new revenue procedure allows the taxpayer to redetermine the value of an option. The value may be redetermined if, during the 18-month period beginning on the change in control, there is a change in either the term of the option due to a termination of employment or the volatility of the stock. However, while the term assumption and the volatility assumption are permitted to be redetermined, the spread and the interest rate assumptions continue to be determined as of the valuation date.

The initial valuation must be made in accordance with Revenue Procedure 2003-68 (but not necessarily in accordance with the safe harbor), without regard to whether the value will be redetermined. This initial valuation is used both to determine whether there are parachute payments and to calculate excess parachute payments and any excise tax liability associated with the option. If the value of an option is then recalculated, parachute payments and excess parachute payments must be recalculated using the redetermined valuation. However, the base amount does not have to be re-apportioned. Rather, the base amount allocated to the parachute payment is permitted to remain the same, with any adjustment to the excise tax made with respect to the option. Finally, note that for purposes of the redetermined valuation, a taxpayer is permitted to use a method other than the method used in the initial valuation, provided the method is also permitted under the Revenue Ruling.

The Valuation Safe Harbor

The Revenue Procedure 2003-68 safe harbor valuation method is based on the Black-Scholes model and takes into account, as of the valuation date, the following factors:

The volatility of the underlying stock The exercise price of the option The value of the stock (the "spot price") The term of the option

The safe harbor value equals the number of options times the spot price times the valuation factor.

The valuation factor is derived from the Table in Revenue Procedure 2003-68. The taxpayer must determine the volatility, spread, and option term factors, as described below. The determination of each factor must be reasonable and consistent with assumptions made with respect to other options that may be valued in connection with the change in control. Assumptions related to risk-free rates of interest and dividend yields are already included in the Table.

Volatility. The taxpayer must determine whether the volatility of the underlying stock is low, medium, or high in accordance with the following:

If the stock is publicly traded, the volatility must be the volatility for the most recent year disclosed in the company's most recent financial statements. If the stock is not publicly traded, the taxpayer must assume medium volatility.

Spread. The spread is calculated by dividing the spot price by the exercise price and subtracting 1. For purposes of the Table, the resulting percentage may be rounded down to the next lowest interval. If this factor exceeds 220%, the safe harbor valuation method cannot be used.

Term. The term of the option is the number of full months between the valuation date and the latest date on which the option will expire. For purposes of the Table, the number of full months may be rounded down to the next lowest 12-month interval. If the remaining term is less than 12 months, the taxpayer may round down to the 3-month interval. If the term of the option exceeds 10 years, the safe harbor valuation method cannot be used. For purposes of calculating the term of the option, the taxpayer is permitted to use the expected term of the option calculated in accordance with Revenue Procedure 98-34. [Revenue Procedure 98-34 allows taxpayers to compute the expected life of an option by dividing the FAS 123 weighted-average expected life of options granted during the year that includes the valuation date by the original term of the option and multiplying that result by the maximum remaining term of the option (rounded down to the nearest 1/10th of a year). Revenue Procedure 98-34 provides, however, that taxpayers must use the maximum remaining term rather than this computed expected life if, among other conditions, the option does not terminate within six months of termination of employment (other than in the case of death or disability).]

Example

On September 1, 2004, Corporation A grants the Employee options to purchase 100,000 shares of a stock at $10 per share for 10 years. The options will vest on September 1, 2007, if the Employee continues employment through that date or, if earlier, upon a change in control. If the Employee terminates employment after the options vest, the option must be exercised within 3 months.

On September 15, 2005, Corporation A is merged into Corporation B, and A options become fully vested and are converted into B options with the same aggregate spread and the same ratio between the exercise price and the value of the stock immediately before the conversion. At vesting, A stock has a fair market value of $20, and B stock has a fair market value of $50. Thus, the Employee receives fully vested options for 40,000 shares of B stock with an exercise price of $25.

As of the valuation date, the volatility of B stock is .25 (i.e., low), the remaining expected option term (calculated in accordance with Revenue Procedure 98-34) is 36 months and the spread factor is 100% (i.e., [$50/$25] - 1). Using the Table, Corporation B determines that the valuation factor is 54.8% and that the value of the options is $1,096,000 (i.e., 40,000 options x $50 spot price x 54.8%) or $27.40 each.

Under the regulations, if vesting is contingent only on the continued performance of services, only a portion of the value of the option is considered contingent upon a change in control. The portion considered contingent upon a change in control is the sum of (i) the value of the acceleration of the payment and (ii) an amount reflecting the lapse of the obligation to continue employment.

The value of the acceleration is the amount by which the accelerated payment ($1,096,000) exceeds the present value, as of September 15, 2005 (the accelerated vesting date), of a payment of $1,096,000 on September 1, 2007 (the vesting date absent the acceleration). [Present value is determined using 120% of the applicable Federal rate, discounted semiannually. For this purpose we have assumed an applicable Federal rate of 5%.] As prescribed by the regulations, the amount reflecting the lapse of the obligation to continue employment is equal to 1% of the value of the accelerated payment ($1,096,000) times the number of full months between the date vesting is accelerated and the date the options would otherwise have vested. Therefore, the portion of the $1,096,000 that is contingent on the change in ownership is $373,080, i.e., the sum of (i) $121,000 (the amount by which $1,096,000 exceeds $975,000, the present value of such amount), and (ii) $252,080 (23 months [September 2005 and September 2007 are not counted] times 1% times $1,096,000).

Assume the Employee is receiving parachute payments and that $50,000 in base amount is allocated to this payment. In that case, $323,080 of the payment is an excess parachute payment, and the excise tax is $64,616. In addition, Corporation B cannot claim the amount of the excess parachute payment as a deduction.

On July 1, 2006, the Employee's employment is terminated, shortening the term of the option. As a result, the actual option term from the change in control is 12 months (the 9 months the Employee was employed plus the 3 months following termination). Corporation B decides to recalculate the value of the options using the shortened term but the same volatility and spread factor used in the initial valuation. Using the Table, Corporation B redetermines the valuation factor as 51.5% and the value of the options as $1,030,000 (i.e., 40,000 options x $50 spot price x 51.5%) or $25.75 a share.

This value is then used to redetermine the portion of the payment that is contingent on the change in control. This amount is $350,800, i.e., the sum of (i) $113,900 (the amount by which $1,030,000 exceeds $916,100, the present value [using the same interest rate assumption as above] of such amount) and (ii) $236,900 (23 times 1% times $1,030,000). Using the base amount initially allocated to this payment, $50,000, the portion of the payment that is an excess parachute payment is $300,800, and the excise tax is $60,160. The Employee is permitted to file an amended tax return using the revised calculations as a basis for claiming a refund of $4,456.

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