Every year I get a new hard copy set of income tax regulations. These come in four phone book-size volumes. I probably look forward to getting these more than I should—they come at the end of December, and for a tax guy like me it always feels like a belated Christmas present.
I’ve noticed that with some regularity the first regulation I tab with a post-it is Treas. Reg. 1.424-1(e).[1] This is the regulation that governs incentive stock option modifications. Why does this usually get tabbed first? I guess because so many of you are amending options! And the rules involve enough nuance that I always like to take a quick look when asked about this.
So, you ask, can you modify the vesting schedule of an option? Here’s the skinny:
Nonstatutory stock options (NSOs)
As long as an NSO is exempt from tax code Section 409A (because for instance, it was granted with a fair market value exercise price on common stock of the employer), a company can unilaterally accelerate the vesting of the NSO without any tax problem. With optionee consent, a company can lengthen the vesting period. In each instance, board approval is required.
There is a non-tax rule to consider. If an option is granted to an employee who is non-exempt for purposes of the Fair Labor Standards Act, generally you’ll want it to not be exercisable until at least 6 months following the date of grant of such option (except in the event of such employee’s death, disability or retirement, upon a change in control, or as otherwise permitted by the Worker Economic Opportunity Act). The thing you’re trying to avoid is having to include any value with respect to the option in the employee’s overtime pay.
Incentive stock options (ISOs)
Some changes to an incentive stock option are considered a “modification” and as such are treated as a new grant. This means you retest the exercise price, and thus, if the option is in-the-money, it becomes an NSO.
It is not considered a modification to amend the vesting schedule of an ISO that is not early-exercisable. Even if the ISO is early-exercisable, I think there’s a reasonable position that the company can first remove early-exercisability and then revise the vesting schedule without such revision being considered a modification.
There is one additional tax trap with ISOs. There is a rule that any optionee can only hold $100,000 worth of ISOs (using share value on grant date) that first become exercisable in a calendar year. Any excess will be treated as an NSO.
Because the rule is phrased in terms of “first becoming exercisable,” if an ISO is early-exercisable it counts in its entirety against the $100K limit in the year it is granted, and accelerating vesting won’t change this. On the other hand, for a non-early-exercisable ISO, the option “first becomes exercisable” when it vests, so modifying the vesting would affect the test.
So, with ISOs you may need to first remove early-exercisability, and in any event, you should consider the effect of the acceleration on the $100K limit. Just like with NSOs, board approval is required, optionee consent is usually required if the change might negatively affect the optionee, for example, because the vesting period is being lengthened or ISO status is affected, and you’ll likely not want to make the option exercisable within 6 months of grant for hourly employees.
Mike Baker frequently advises with respect to option modifications. 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] Treas. Reg. 1.424-1(e)(4)(i) For purposes of §§1.421-1 through 1.424-1 the term modification means any change in the terms of the option (or change in the terms of the plan pursuant to which the option was granted or in the terms of any other agreement governing the arrangement) that gives the optionee additional benefits under the option regardless of whether the optionee in fact benefits from the change in terms. In contrast, for example, a change in the terms of the option shortening the period during which the option is exercisable is not a modification. However, a change providing an extension of the period during which an option may be exercised (such as after termination of employment) or a change providing an alternative to the exercise of the option (such as a stock appreciation right) is a modification regardless of whether the optionee in fact benefits from such extension or alternative right. Similarly, a change providing an additional benefit upon exercise of the option (such as the payment of a cash bonus) or a change providing more favorable terms for payment for the stock purchased under the option (such as the right to tender previously acquired stock) is a modification.
(ii) If an option is not immediately exercisable in full, a change in the terms of the option to accelerate the time at which the option (or any portion thereof) may be exercised is not a modification for purposes of this section. Additionally, no modification occurs if a provision accelerating the time when an option may first be exercised is removed prior to the year in which it would otherwise be triggered. For example, if an acceleration provision is timely removed to avoid exceeding the $100,000 limitation described in §1.422-4, a modification of the option does not occur.