Changing NSOs to ISOs (!)

Posted by Achaessa / on 05/16/2011 / 2 Comments

In April I received a call from an NCEO member that posed an interesting scenario. The new plan administrator's supervising CFO had asked to review the company's 2010 option grants which had all been granted as NSOs, and then told the administrator that a subset of the grants (those to executives) were wrong and to change them to ISOs. The administrator wanted to know how to respond to this request. This is what I recommended:

Board authorization. The board authorization is the governing document and any questions about award details should always be traced back to the board authorization.

  • If the board authorization does, in fact, say that the awards were ISOs, then correcting the grant documents is the correction of an administrative error with no tax or accounting consequences.
  • If the board authorization states that the awards are NSOs then any change would be a modification that requires a subsequent board authorization and would trigger other consequences, addressed below.
  • If the board authorization is silent as to the award type we must look to IRC Section 422 and customary practice for guidance. IRC Section 422 requires that tax-qualified stock options (ISOs) be authorized by the board of directors or an appointed compensation committee. In practice, this means that if the board does not specify the award type then the award is not an ISO. In addition, ISOs can only be issued to employees. So, if the board is in the habit of authorizing options for both employees and non-employees without specifying the award type, then the awards must be NSOs because a non-employee cannot receive an ISO. And, finally, if the board was authorizing executive and staff awards together without specifying the type, then it would never pass an audit to "correct" only the executive awards to ISOs and not the staff awards as well.

Modification. Once the board's intent has been revealed through the authorizing board minutes or consents, if the CFO still wants to change the type of award from NSO to ISO, it is not simply a matter of changing paperwork and getting new recipient signatures. Here are some issues to be considered before taking action:

  • Grant price. Again, per IRC Section 422, the board would specifically have to authorize a modification to the prior grants changing them to ISOs. Endowing the grant with tax-qualified status would be adding a benefit to the recipient's award and so would be considered the cancellation of the old grant and issuance of a new grant - and would require the exercise price to be changed to the fair market value of the company's underlying stock on the date of the modification.
  • Deferred compensation. If the grant price is not changed to the current fair market value the awards would be out of compliance and non-exempt from IRC Section 409A deferred compensation regulations with onerous consequences to the award recipient. Without going into details, this would result in immediate recognition as ordinary income of the difference between the original grant price and the current fair market value of the company's stock, which amount would also be subject to penalties and interest charges.
  • Restatement of financials. If the original NSO awards were large enough to generate a significant deferred tax asset, as would be possible with large executive awards, changing the awards to ISOs could potentially cause the company to restate financials based on the loss of the asset. Under the new Dodd-Frank Act, restatement of financials caused by material noncompliance may trigger a mandatory clawback of incentive-based compensation from current or former executive officers during the 3-year period preceding the date of the restatement.
  • Alternative minimum tax. If the CFO's intention is to avoid the ordinary income taxes associated with the exercise of NSOs, apart from the prior consequences mentioned, changing the awards to ISOs could bump the award recipients out of the frying pan and into the fire. Alternative minimum tax calculations are required to be performed whenever ISOs are exercised and when calculating whether AMT income exemptions are met the taxpayer is not allowed to include many of the usual standard deductions such as mortgage interest. With these restrictions on deductions, the AMT often reaches even into the ranks of middle managers and as many technology executives discovered less than a decade ago, alternative minimum tax liability can be onerous and painful.
  • Alternatives. If the CFO's intention is to avoid the payment of taxes on ordinary income realized upon the exercise of the NSOs, an alternative could be to cover the tax obligation by selling some of the exercised stock. There are other alternatives, like gross ups and bonus arrangements that carry their own consequences and are beyond the scope of this post.

In short, in this situation I would let the authorizing board document guide the decision on how to handle the CFO's request and, after that, tactfully point out the regulatory consequences that could result from taking action on the request.  And, need I point out, that this is just another situation where having a Certified Equity Professional on staff - someone that knows what questions to ask and has the professional network in place to get the questions answered - has potentially saved a CFO's job, or at least saved the company significant heartache. The CEP in this new plan administrator position has assured me that grant procedures will be in place before June to ensure that going forward board authorizations are clear about grant type and that a cross-check is in place before the final grant documents are issued.

 

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Comments

  • Scott says:

    Thanks for posting this. The situation reminds me of the backdating scandals.

    May 17, 2011 at 9:32 AM | Permalink

  • Achaessa says:

    That's a valid observation, Scott, and the consequences could be similar. Like backdating, changing the type of the option is legal to do, but covering up the activity or doing it improperly can cause serious unwanted consequences.

    May 17, 2011 at 3:41 PM | Permalink

 

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