Corporate Finance Lawyer & Attorney : Davis Wright Tremaine Law Firm

On September 28, 2007, Senator Carl Levin introduced the "Ending Corporate Tax Favors for Stock Options Act."

The bill would limit the deduction for compensation for personal services paid for with stock options to an amount that would not exceed the amount the taxpayer has treated as an expense with respect to such stock options for the purposes of ascertaining income, profit or loss in a report or statement to shareholders, partners or other proprietors, and would allow the deduction in the same period the accounting expense is recognized.

You can find a summary of the impact of the bill's provisions here.

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96 law firms have written another letter to the IRS asking for more time on 409A compliance, even after the IRS responded favorably (at least in some respects) to the first request.

Again, this demonstrates the complexity of this area.  We are happy to assist you with compliance.

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In a recently decided Tax Court case, Marcus v. Commissioner, 129 T.C. No. 4 (August 15, 2007), another taxpayer lost in a case involving the exercise of incentive stock options ("ISOs") in highly appreciated stock before the bursting of the stock market bubble in 2001.

In a series of option exercises beginning in 1998 and continuing through 2000, the taxpayer exercised ISOs on 40,362 shares of stock having an aggregate fair market value of $5.9M.  The taxpayer paid $175,000 to acquire this stock.  As a result of exercising the ISOs, the taxpayer incurred significant AMT liability, and on his first tax return filed for 2000 paid $1.6M in AMT.

In 2001, the taxpayer sold 30,297 of the shares for a total of $1.6 million.  The taxpayer had a regular tax basis in those shares of $127,920, the exercise price.  Thus, for regular income tax purposes in 2001 the taxpayer had capital gain of $1.5M.  The taxpayer's AMT basis in the shares sold in 2001 was $4.4M.  Thus, for AMT purposes the taxpayer had a capital loss of $2.7M in 2001.

The taxpayer filed an amended 2000 tax return and reduced his 2000 AMTI by a claimed alternative tax net operating loss ("ATNOL") deduction carried back from 2001 in the amount of $1.9M.  The IRS denied this deduction and issued the taxpayer a deficiency.

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On August 15, 2007, the Delaware Chancery Court, Chancellor Chandler, in a case called In Re Tyson Foods, Inc. Consolidated Shareholder Litigation,  refused to dismiss a complaint alleging breach of fiduciary duty for granting so-called "spring-loaded" stock options.

("Spring-loaded" stock options are options priced at fair market value on the date of grant, but granted immediately before or close in time before the release of good news, which can be expected to drive the price of the stock up, making the options more valuable.  "Bullet dodging" stock options, in contrast, are options granted at fair market value, but immediately after the release of bad news, after the market has marked down the value of the stock to take into account the bad news.)

Chancellor Chandler's recent decision reaffirms his earlier decision that under certain circumstances the grant of spring-loaded options can constitute the breach of fiduciary duty. 

The practical implication of this decision?  Boards should evaluate their stock option grant practices to make sure that they are above reproach in terms of their timing and pricing to avoid the arguments made in the Tyson case.  In the words of Chancellor Chandler:  "[I]f a board of directors candidly discloses why and when it awarded options, and accounted for them in a lawful manner consistent with the actual facts, the board has, absent unusual circumstances, insulated itself from fiduciary liability for misleading investors or regulatory authorities.  What the directors would remain subject to was a well-pled claim that the compensation awarded was actionably excessive because, for example, it involved self-dealing and was not fair to the corporation."

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The SEC has issued proposed rules regarding the exemption of compensatory employee stock options from registration under Section 12(g) of the Securities Exchange Act of 1934.  

Under Exchange Act Section 12(g), an issuer with more than 500 holders of record of a class of securities and assets in excess of $10 million at the end of its most recent fiscal year must register that class of equity security (see SEC Release No. 34-37157 (May 1, 1996)), unless an exemption is available.  Stock options issued to employees are considered a separate class of security for this purpose.  There is currently no exemption available for employee stock options, and issuers with more than 500 optionees that meet the assets test instead have been relying on the SEC no-action action letter process.

The SEC has proposed an exemption from Exchange Act Section 12(g) registration for:  (i) private, non-reporting issuers for compensatory employee stock option options issued under employee stock option plans, and (ii) compensatory employee stock options of issuers that have registered under Exchange Act Section 12 the class of equity security underlying those options.

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In Robert J. Merlo v. Commissioner, the taxpayer feels the full brunt of the the harshness of the alternative minimum tax in connection with the exercise of an incentive stock option.  The taxpayer exercised an incentive stock option for public company stock in the tax year 2000, when the stock was worth over $1 million.  The taxpayer could not sell the stock during 2000 because the company's blackout period was in effect throughout the remainder of the tax year 2000.  The stock became worthless in 2001, and the Tax Court held that the resulting capital loss could not be carried back as an alternative tax net operating loss to the tax year 2000 to offset the income from the options exercise. 

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Broc Romanek blogs about this opinion ("Delaware Chancery Court Addresses Cancellation Value of Stock Options in Mergers").  The opinion is also available online.   In a cash merger, out-of-the-money options were rendered worthless.  The question was whether the terms of the stock option plan governing the options prohibited this treatment and instead required that the former officers and directors be compensated for the full value of their options.  The court found for the plaintiffs and awarded them a sum of money equal to the full economic value of their options.

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