So, you accidentally granted one or more discount stock options. Now what?
As quick background, a discount stock option has an exercise price below the fair market value of the underlying stock on the date of grant.[1] For whatever reason, Congress doesn’t like this type of stock option and so has made it (i) taxable at vesting, and (ii) subject to a tax penalty of 20%. California adds an extra 5% for its residents. The amount of taxable income that occurs on the vesting date is the amount by which the value of the shares vesting on such date exceeds the exercise price for such shares. There’s a true-up (additional tax) at year end.
Sounds fun right? This means you can have income as your option vests subject to tax rates as high as 77.65%.[2]
There is a potential fix. Under relevant tax rules, subject to certain conditions, you can retroactively increase the exercise price of the problematic option grants to the fair market value of the underlying stock on the date of grant. This is referred to as an upward repricing or “uppricing” of a stock option.
So, what are the conditions?
Condition #1: To be fixable a stock option must be unexercised.
Condition #2: To be fixable a stock option must have been granted in the year of the fix or the prior tax year.
Condition #3: If granted in the prior tax year, to be fixable the stock option may not have been granted to an insider. For this purpose, an insider includes any director, officer, and any service provider who is directly or indirectly the beneficial owner of more than 10% of any class of any equity security of the Company.
There are of course a few technical things to consider. These include:
Determine who Participates
To participate an option holder must be a current service provider on the date the repricing occurs, and it is common to let all current service providers with unexercised discount options participate in the repricing to the extent eligible.
Historic 409A Valuation
If you don’t have one already, consider getting a private valuation firm to provide a tax code Section 409A valuation effective as of the date of the option grants in question. A valuation done retroactively like this doesn’t create the same safe harbor that would have existed had the valuation been done at the time, however as long as the valuation is reasonable in my view it is unlikely to be challenged.
Notice 2008-113 Statement
There is a statement that will need to be attached to the company’s tax return for the year in which the fix occurs. For example, if the fix occurs in 2020, this statement would be due with the company’s 2020 tax return (usually filed in early 2021). In addition, if the fix is occurring with respect to any prior year option grants, a similar statement will need to be attached to each participating optionee’s individual tax return.
Consent and Tender Offer Rules
Absent express authority in a plan to reprice without consent, consent is needed.
If consent is needed from more than say ~10 folks (market rule of thumb), the tender offer rules generally need to be followed, including the 20-business day rule.
Non-Exempt Employees (Worker Economic Opportunity Act)
Generally, option gain is included in “regular rate” of pay for purposes of Fair Labor Standards Act overtime rules, unless an option is not exercisable for 6 months after grant. I am not aware of any express guidance as to whether a repricing would be treated as a new grant for purposes of the 6-month exercise prohibition.
Accounting
An option repricing can affect the compensation expense charge of the stock options. Companies should consult their accountants for the impact under FASB ASC Topic 718.
Steps to Implement (assuming Tender Offer is necessary)
1. Obtain a 409A valuation.
2. Have legal counsel draft repricing offer.
3. The Board approves repricing offer and it starts. It stays open for 20 business days (terminating at midnight ET).
4. The day after the end of the exchange offer, the Board approves the amendment of the options.
5. Updated option paperwork is distributed.
6. The company Notice 2008-113 Statement is filed with the company’s tax return.
7. If necessary, individual Notice 2008-113 Statements are filed with the respective optionholder tax returns.
Mike Baker frequently advises with respect to stock option uppricings. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.
[1] There is a special type of discount stock option that avoids the tax problems discussed in this article. Such special options are sometimes referred to as “409A-compliant options” or “fixed-exercise options.” These stock options must only be exercisable on the earlier of, one or more of the optionee’s death, disability, or separation from service, or a fixed date or change in control. These types of options are rarely granted and are not the type of discount stock option I am discussing in this article.
[2] 37% federal ordinary income tax + 1.45% employee-side Medicare + .9% Additional Medicare + 13.3% California state tax + 20% federal 409A penalty + 5% California state tax penalty.