The Non-Option: Understanding the Dearth of Discounted Employee Stock Options
David I. Walker
Boston University School of Law
October 17, 2008
CLEA 2008 Meetings Paper
Boston Univ. School of Law Working Paper No. 08-30
Boston University Law Review, 2009
Contemporaneous grants of both stock and at-the-money options to individual employees of U.S. public companies indicates demand for equity compensation packages that are in the money, i.e., packages of equity pay instruments that in aggregate have payoff profiles and incentive properties that are similar to explicit in-the-money employee stock options. However, several tax rules (and formerly accounting rules) strongly discourage grants of explicit in-the-money options, including recently enacted IRC - 409A, which essentially precludes the use of explicitly discounted options by taxing these instruments at vesting, rather than at exercise, and adding a 20% penalty tax. This article explores whether the tax and accounting distinction between discounted and non-discounted options makes sense.
The stated legislative rationales for rules discriminating against explicit in-the-money options are weak, reflecting a dichotomous view of equity compensation divided between discounted and non-discounted options, when, in fact, option design is a continuum. However, this article sets forth a novel tax policy rationale for forcing firms to bifurcate in-the-money pay packages into discrete grants of stock and non-discounted options, a combination that I refer to as a synthetic in-the-money option. In short, doing so precludes the unwarranted expansion of preferential option tax treatment to instruments resembling restricted stock.
Number of Pages in PDF File: 59
Keywords: Employee stock options, In-the-money, options, Discounted options, NQSO, ISO, Restricted stock
JEL Classification: H24, H25, J33, K22, K34
Date posted: June 28, 2008 ; Last revised: June 29, 2009