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The Future of Stock Options

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April 10, 2018 | Barbara Baksa

The Future of Stock Options

Under the Tax Reform and Jobs Act, stock options are no longer exempt from the $1 million deduction limit that applies to executives under Section 162(m). This change applies to a very narrow group of stock options recipients but it could have a significant impact on the overall use of stock options. Or could it?

The Facts About Option Use Today

According to the NASPP/Deloitte Consulting 2016 Domestic Stock Plan Design Survey, only about half of public companies currently grant stock options. Those that do grant stock options are mostly granting the options at the NEO or other senior executive level. Only a quarter of respondents grant options to middle managers and options are even rarer for lower ranking employees.

The overwhelming majority of companies that grant options are granting NQSOs. Only 11% of respondents grant ISOs.

Philosophy or Tax Deduction?

If asked, I suspect most companies that grant options will say that they are philosophically committed to this equity vehicle. But up until now, this commitment has also assured the company of a tax deduction (assuming, of course, that the options were exercised). Now that options granted to covered employees under Section 162(m) are no longer exempt, it will be interesting to see if companies remain as committed to them. Is the Tax Cuts and Jobs Act the final nail in the coffin for stock options...

Or an ISO Resurgence?

If companies do continue to grant options, now is a good time to give ISOs another look.
  • For public companies, most employees will execute same-day sale exercises, regardless of the type of option they have, which means that both ISOs and NQSOs are likely to have the same consequence for the company in terms of a tax deduction. And, now that the corporate tax rate has dropped to 21%, that tax deduction is less important anyway.
  • ISO exercises, even same-day sales, are not subject to withholding. Consequently, the company doesn't have to make matching FICA payments for ISOs. This makes ISO same-day sales less expensive for the company than NQSOs.
  • Assuming that most employees engage in same-days sales, the impact on tax expense for both ISOs and NQSOs is also ultimately the same. The reduction to tax expense is delayed for ISOs until the point of exercise, but the amounts are the same.
  • ISOs never result in a tax shortfall, which means ISOs won't ever result in an unexpected (and hard to explain to investors) increase in tax expense. This makes forecasting tax effects a little easier.
  • Because all tax effects for stock options are now recorded to tax expense (thanks to ASU 2016-09), the diluted EPS treatment of both ISOs and NQSOs is now the same; ISOs are no longer more dilutive than NQSOs.
  • Because ISOs aren't taxed until the shares are sold, they might be preferable for executives who can't sell because of ownership guidelines or holding requirements. The company will forego its tax deduction for these individuals but if they are covered employees under 162(m), the company likely won't be entitled to a tax deduction anyway. And for the rest, now that the corporate tax rate has been reduced to 21%, this is less of a concern.
  • The Tax Cuts and Jobs Act has increased the income exemption and phase-out thresholds for AMT, so where employees exercise ISOs and hold the shares, fewer will be subject to AMT. Of course, as noted above, most employees in public companies engage in same-day sales, even with ISOs, making AMT a moot issue.

What do You Think?

What do you think is in the future for stock options? Take my poll (click here if it doesn't appear below):

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View the poll results.

- Barbara

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