Stock Options - A Brief History in the US

In the 1980s and beyond, stock options gained immense popularity as an effective method for startup companies to offer incentive compensation to their initial employees, especially when financial resources were scarce for salaries and benefits. Stock options also served as a tool to align employees with the interests of shareholders by emphasizing the importance of increasing share value. This blog post will explore stock options in more depth, offering detailed background information and hypothetical scenarios to illustrate their application.

History of Stock Options

Stock options were initially included in executive compensation packages in the early 20th century, but their adoption was restricted by tax consequences. The United States Revenue Act of 1950 altered individual and corporate tax rates, and introduced "restricted stock options" with more advantageous tax treatment. This change enabled executives to be taxed at a reduced rate, resulting in the growing popularity of stock options and restricted stock awards for executive compensation.

The 1969 Tax Reform Act

In 1969, the enactment of "The Tax Reform Act of 1969" by Congress resulted in the removal of special tax advantages for restricted stock options. This had a significant impact on stock options, particularly for executives, as outlined below:

- Elimination of Special Tax Treatment: The act abolished the special tax treatment for restricted stock options, which previously allowed executives to be taxed at the lower capital gains rate instead of the higher income tax rates.

- Treatment as Ordinary Income: The changes meant that stock options were now treated more akin to ordinary income for tax purposes, rather than as deferred compensation or capital gains.

- Introduction of Section 83: Section 83 of the Internal Revenue Code was introduced under the Tax Reform Act of 1969 to govern the taxation of property exchanged in connection with services. Under Section 83(a), property such as stock exchanged for services is taxable as ordinary income once it is no longer subject to a substantial risk of forfeiture or becomes transferable, typically resulting in taxation upon vesting of stock options.

- Section 83(b) Election: Recipients were granted the option to make a "Section 83(b) election," allowing them to opt for taxation on the fair market value of restricted property at the time of grant rather than waiting until vesting. This election must be filed within 30 days of receiving the property. Opting for this early election, especially when the fair market value of stock options is equal to or less than the exercise price, avoids ordinary income taxation at the time of grant.

- Incentive Stock Options (ISOs): ISOs are generally exempt from Section 83 and have their own tax treatment under Section 422. No ordinary income is recognized at grant or exercise unless the stock is immediately sold, potentially triggering Alternative Minimum Tax (AMT) at exercise.

- Non-Qualified Stock Options (NQSOs): NQSOs are subject to Section 83. No taxation occurs at grant unless the fair market value is readily ascertainable. They are taxed as ordinary income at exercise based on the difference between the exercise price and fair market value.

The 1972 APB Opinion 25

In 1972, the FASB (Financial Accounting Standards Board) introduced Accounting Principles Board Opinion #25, allowing companies to avoid recording stock options as expenses if they were issued at fair market value.

• Intrinsic Value Method: APB 25 required companies to use the intrinsic value method for assessing stock options granted to employees. This method permitted companies to provide "at-the-money" stock options (options with an exercise price equal to the stock's market price at the grant date) without having to declare any expenses on their income statements.

• Criticism at the time: It later became apparent that options were valued higher than the intrinsic value determined by APB 25, leading to criticism that this method significantly underestimated the true cost of stock options.

• Tax Benefits: Despite not recognizing option-related expenses under APB 25, companies still enjoyed tax advantages when employees exercised their options.

• Summarize: APB 25 allowed companies to issue stock options to employees without having to acknowledge expenses in most cases, a practice that sparked growing controversy as the use of stock options for compensation became more prevalent.

The Tax Reform Act of 1976

In 1976, Congress passed the Tax Reform Act of 1976, had significant impacts on the treatment of stock options:

• Repeal of Qualified Stock Options: The Act repealed the special tax treatment for qualified stock options. This effectively eliminated the tax advantages that had previously been associated with these options.

• Reclassification of Profits: Profits from stock options were designated as ordinary income rather than capital gains. This change resulted in higher tax rates for option holders when they exercised their options.

• Strict Limitations on Deductions: The Act placed strict limitations on deductions related to stock options[5]. This affected how companies could use stock options for tax purposes.

• Shift to Non-Qualified Stock Options: With the elimination of tax advantages for qualified stock options, there was likely a shift towards greater use of non-qualified stock options.

The Economic Recovery Act of 1981

Also known as Reagan's Economic Recovery and Tax Act affected stock options in some of the following ways:

• Restoration of Qualified Stock Options: This act restored qualified stock options, which had been effectively eliminated by previous tax reforms in the 1970s.

  The qualified stock options were renamed as Incentive Stock Options (ISOs).

• ISOs were given favorable tax treatment. They were again taxed at the lower capital gains rate rather than as ordinary income. ISOs could only be granted to employees, not to contractors or non-employee directors[5]. To qualify for the tax benefits, employees had to hold the stock for at least one year after exercise and two years after the option grant.

The Tax Reform Act of 1986

In 1986, Congress passed The Tax Reform Act of 1986 which affected stock options in several ways:

• Repeal of Exercise Order Requirement: The act repealed the requirement that incentive stock options (ISOs) must be exercised in the order they were granted.

• Capital Gains Tax Rate Increase: The act raised the tax rate on long-term capital gains. This change affected the tax treatment of profits from stock options, potentially making them less attractive.

• Indirect Effects on Corporate Behavior: The act broadened the definition of business taxable income and postponed the recognition of certain expenses. This could have influenced how companies structured their compensation packages, including stock options.

• Clarification of Stock Redemption: The act clarified that no amount paid or incurred by a corporation in connection with a redemption of its stock is deductible.

The 1990s - Fewer Tax Law Changes, but...

In 1995, the Financial Accounting Standards Board (FASB) walked back an earlier decision to require companies to report the value of stock options on their balance sheets. Instead, they encouraged companies to disclose their estimated stock options expense in a footnote to their income statements. It also issued Statement of Financial Accounting Standards No. 123 (FAS 123), which allowed companies to choose between two methods of accounting for stock options :a) Continuing to use the intrinsic value method under APB 25 (which often resulted in no expense being recorded for at-the-money options).b) Adopting a fair value method, which would recognize the estimated value of options as an expense.

The 2000s

The late 1990s and early 2000s saw whole range of events that affected stock options:

1. The Bursting of the Dot Com Bubble

2. Enron and WorldCom scandals in 2001-2002 highlighted potential abuses related to stock options.

3. The stock options backdating scandal emerged in 2005-2006, involving over 130 companies.

With that came a range of changes both by Congress and the accounting profession:

1. Sarbanes-Oxley Act of 2002: While not specifically focused on stock options, this act introduced new financial regulations in response to corporate scandals like Enron. It indirectly affected corporate governance practices, including executive compensation.

2. Accounting rule changes: In 2004-06, the Financial Accounting Standards Board (FASB) issued a new rule requiring companies to expense stock options on their income statements. This was not legislation, but it was a significant change that affected how companies reported stock option costs. This change reduced the incentive for companies to use stock options now that they had to show the compensation expense for the changes of value in the options.

Following the mid-2000s, options have been in and out of favor once the companies were required to record the compensation expense. Since 2006, the following changes/events have occurred in the US:

• Internal Revenue Code Section 409A (enacted in 2004, effective 2009) which Imposed strict requirements on setting exercise prices for stock options and required options to be priced at or above fair market value to avoid severe tax penalties for recipients. The Internal Revenue Service began looking for "red flags" in stock option practices that could trigger further scrutiny under 409A[8] include the examination of valuation methodologies, appraiser credentials, and whether companies are recording cheap stock charges.

• Tax Reform Act of 2017: Created a new Section 83(i) allowing certain employees of private companies to defer taxation on stock options for up to 5 years after exercise.

Conclusion

In conclusion, the historical content discussed in this post sheds light on the significant events and developments that have shaped our past. From ancient civilizations to modern revolutions, understanding our history is crucial in comprehending the present and preparing for the future.

In a future blog, we'll look at Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs) including some terminology and an example to illustrate the two types of options.