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S O C I A L S C I E N C E R E S E A R C H N E T W O R K
E M P L O Y E E B E N E F I T S , C O M P E N S A T I O N
& P E N S I O N L A W
Vol. 7, No. 5: March 16, 2006
Editor: PAMELA J. PERUN
Urban Institute
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Topic of This Issue:
Stock-Based Compensation
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T A B L E O F C O N T E N T S
"Restricted Stock and the Section 83(b) Election: A Joint Tax
Perspective"
MICHAEL S. KNOLL, University of Pennsylvania - School of
Law, University of Pennsylvania - Real
Estate Department
"How Did the 2003 Dividend Tax Cut Affect Stock Prices and
Corporate Payout Policy?"
GENE AMROMIN, Federal Reserve Bank of Chicago
PAUL HARRISON, Federal Reserve Board - Division of Research
& Statistics
NELLIE LIANG, Federal Reserve Board
STEVEN A. SHARPE, Federal Reserve Board - Research &
Statistics
"Legal, Economic and Psychological Issues of Accounting for
Employee Stock Options"
MICHAEL NWOGUGU, Independent
"Proposed Regulations Offer Complex Guidance on Deferred Pay
(Part 1)"
BARRY SALKIN, Winston & Strawn LLP
"The Subjective Valuation of Indexed Stock Options and Their
Incentive Effects"
LOUIS CALVET, University of Ottawa - School of Management
ABDUL RAHMAN, University of Ottawa - School of Management
"Executive Stock Options: Early Exercise Provisions and
Risk-Taking Incentives"
NEIL BRISLEY, University of Western Ontario - Richard Ivey
School of Business
"Section 174 R&E Deduction Upon Statutory Stock Option Exercise"
J. ANTHONY COUGHLAN, PricewaterhouseCoopers Ltd. of Hong Kong
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"Restricted Stock and the Section 83(b) Election: A Joint Tax
Perspective"
U of Penn, Inst for Law & Econ Research Paper No. 05-26
Contact: MICHAEL S. KNOLL
University of Pennsylvania - School
of Law, University of Pennsylvania - Real Estate
Department
Email: MKNOLL@LAW.UPENN.EDU
Auth-Page: http://ssrn.com/author=17323
Full Text: http://ssrn.com/abstract=795544
In the wake of the Financial Accounting Standard Board's decision
to require firms that grant employee stock options (ESOs) to
treat such options as an expense, many large and sophisticated
firms are switching from ESOs to restricted stock. Restricted
stock - stock granted to an employee as part of her compensation
and subject to the condition that if she leaves the firm within a
period of time (often 3 years) she forfeits the stock - appears
to be on its way to becoming the dominant form of equity-based
pay in the United States. Yet, in spite of its prominence, little
attention has been paid to how employers should design their
restricted stock programs in light of tax considerations. The tax
consequences to both the employee and the employer of a grant of
restricted stock are deferred until the restriction lapses and
the stock vests. There is however an exception to that general
rule: If, within 30 days of receiving the stock, the employee
makes what is called the Section 83(b) election, then both the
employer and the employee are taxed at the time of grant.
Employing a joint tax perspective that looks at the tax
consequences to both the employer and the employee, this paper
attempts to answer several compensation design issues raised by
the use of restricted stock. Specifically, I address the question
under what circumstances should the employer charge the employee
explicitly for her restricted shares and when should the employer
charge implicitly for the restricted stock through a lower
salary. I also look at the desirability to the employee, the
employer, and the employee and employer together of the employee
making the Section 83(b) election. Finally, I look at the value
to the employee and cost to the employer of the employee's option
to wait 30 days until making the Section 83(b) election.
______________________________
"How Did the 2003 Dividend Tax Cut Affect Stock Prices and
Corporate Payout Policy?"
FEDS Working Paper No. 2005-57
Author: GENE AMROMIN
Federal Reserve Bank of Chicago
Email: gamromin@frbchi.org
Auth-Page: http://ssrn.com/author=327203
Co-Author: PAUL HARRISON
Federal Reserve Board - Division of
Research & Statistics
Email: pharrison@frb.gov
Auth-Page: http://ssrn.com/author=39900
Co-Author: NELLIE LIANG
Federal Reserve Board
Email: nliang@frb.gov
Auth-Page: http://ssrn.com/author=62781
Contact: STEVEN A. SHARPE
Federal Reserve Board - Research &
Statistics
Email: SSHARPE@FRB.GOV
Auth-Page: http://ssrn.com/author=15720
Full Text: http://ssrn.com/abstract=873879
We examine the effects of the 2003 dividend tax cut on U.S. stock
prices and corporate payout policies. First, using an event-study
methodology, we compare the performance of U.S. stocks to that of
other securities that should not have benefited from the tax
change. We find that U.S. large-cap and small-cap indexes do not
outperform their European counterparts, nor REIT stocks, over the
event windows, suggesting little if any aggregate stock market
effect from the tax change. In cross-sectional analysis,
high-dividend stocks outperformed low-dividend stocks by a few
percentage points over the event windows. On the other hand,
non-dividend paying stocks are found to have outperformed the
overall market by a small margin, but this result does not appear
specific to the event windows, suggesting that non-tax factors
were at play. Second, the tax change did appear to induce an
increase in dividends, especially at firms where executive
compensation was weighted more heavily toward stock than options.
However, the effect on total payouts was more muted, as many
firms scaled back share repurchases.
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"Legal, Economic and Psychological Issues of Accounting for
Employee Stock Options"
Managerial Auditing Journal, Forthcoming
Contact: MICHAEL NWOGUGU
Independent
Email: datagh@peoplepc.com
Auth-Page: http://ssrn.com/author=335757
Full Text: http://ssrn.com/abstract=884486
This paper analyzes economic, legal, behavioral and public policy
issues pertaining to the accounting for employee stock options.
The paper explains: a) why employee stock options (ESOs) are
superior to other forms of incentive compensation; b) why ESOs in
their present form, are inefficient; and c) why particular
accounting, legal and tax treatments will provide the optimal
results for the economy, the government, management/employees and
shareholders.
______________________________
"Proposed Regulations Offer Complex Guidance on Deferred Pay
(Part 1)"
Practical Tax Strategies, Vol. 76, p. 4, January 2006
Contact: BARRY SALKIN
Winston & Strawn LLP
Email: Bsalkin@winston.com
Auth-Page: http://ssrn.com/author=374829
Abstract: http://ssrn.com/abstract=883107
In sharp contrast to the heavily regulated regime of tax
qualified plans, the area of nonqualified deferred compensation
had to a substantial degree been unregulated since the Revenue
Act of 1978, Section 132 of which required that the taxability of
benefits under a nonqualified deferred compensation plan (other
than one maintained by a government or tax exempt entity) be
determined based upon guidance in effect on January 1, 1978. That
environment produced a wide divergence of approaches among
practitioners, some very aggressive, and the accessibility of
benefits to key employees under these arrangements was among the
problematic features in the Enron and Worldcom scandals. In
response, in 2004, Section 409A was added to the Code by the
American Jobs Creation Act of 2004. Code Section 409A is to
nonqualified plans what ERISA was to tax qualified plans.
Section 409A greatly expands the types of arrangements that are
nonqualified deferred compensation plan (NQDCP). In addition to
traditional SERP and nonqualified deferred compensation plans
under which executives elect to defer a portion of this
compensation, Code Section 409 A covers, among other
arrangements, severance arrangements, bonuses, employment
agreements, and restricted stock unit plans. While tax qualified
plan and Code Section 457(b) plans are not subject to Code
Section 409A, Code Section 457(f) Plans are subject, and must
satisfy both statutes. The Act requires amounts deferred under a
NQDCP after 2004 (including earnings on those amounts) to be
included in income to the extent not subject to a substantial
risk of forfeiture and not previously having been included in
income, unless the plan complies, in both form and operation,
with distribution event rules (delayed distribution rules for key
employees at publicly traded corporations), election period
rules, subsequent election rules and anti-acceleration rules.
Section 409A applies to amounts deferred in tax years beginning
after 2004, as well as to amounts deferred in tax years beginning
before 2005, if the plan under which the deferral is made is
materially modified after October 30, 2004.
In December 2004, the IRS set forth its initial guidance with
respect to Code Section 409A in Notice 2005-1, and in October
2005 issued proposed regulations. While it is anticipated that
the final regulations under Code Section 409A will vary in some
significant ways from the proposed guidance, the article
discusses various aspects of Notice 2005-1 and the proposed
regulations including the relationship of Code Section 409A to
Code Sections 83, 451, and 457(f); funding restrictions on
certain foreign trusts and springing trusts; reporting and
withholding obligations (which have recently been suspended for
2005); important definitions under Code Section 409 Act,
including substantial risk of forfeiture, which differs in some
respect from the Code Section 83 definition, plan (including
aggregation rules) deferral of compensation, service provider,
service recipient, material modification, change of control, and
separation from service; special rules for equity arrangements,
including the special valuation rules that remove certain NQDCPs
from coverage under Code Section 409A; nonqualified plans that
are linked to tax qualified plans, such as 401(k) wrap plans and
defined benefit SERPS; and effective date and transitional rules.
______________________________
"The Subjective Valuation of Indexed Stock Options and Their
Incentive Effects"
Financial Review, Vol. 41, No. 2, May 2006
Contact: LOUIS CALVET
University of Ottawa - School of
Management
Email: calvet@management.uOttawa.ca
Auth-Page: http://ssrn.com/author=527737
Co-Author: ABDUL RAHMAN
University of Ottawa - School of
Management
Email: Rahman@management.uottawa.ca
Auth-Page: http://ssrn.com/author=491539
Abstract: http://ssrn.com/abstract=882482
We analyze the potential role of indexed stock options in future
pay-for-performance executive compensation contracts. We present
a unified framework for index-linked stock options, discuss their
incentive effects, argue that indexation schemes based on the
capital-asset pricing model (CAPM) are the most suitable for
executive compensation, and derive a subjective pricing model for
the class of CAPM-based indexed stock options. Contrary to
earlier work, executives would not be motivated to take on
investment projects with high idiosyncratic risk once their lack
of wealth diversification and degree of risk aversion are
factored into the analysis.
______________________________
"Executive Stock Options: Early Exercise Provisions and
Risk-Taking Incentives"
Journal of Finance, Forthcoming
Contact: NEIL BRISLEY
University of Western Ontario -
Richard Ivey School of Business
Email: nbrisley@ivey.uwo.ca
Auth-Page: http://ssrn.com/author=339459
Abstract: http://ssrn.com/abstract=886312
Traditional executive stock option plans allow fixed numbers of
options to vest periodically, independent of stock price
performance. Because such options may climb deep in-the-money
long before the manager can exercise them, they can exacerbate
risk aversion in project selection. Making the proportion of
options that vest a gradually increasing function of the stock
price can ensure that appropriate numbers of options are retained
while they provide risk-taking incentives, but are exercised once
they have lost their convexity. "Progressive performance vesting"
can allow the firm more efficiently to rebalance the manager's
risk-taking incentives.
______________________________
"Section 174 R&E Deduction Upon Statutory Stock Option Exercise"
Tax Lawyer, Vol. 58, No. 2, Winter 2005
Contact: J. ANTHONY COUGHLAN
PricewaterhouseCoopers Ltd. of Hong
Kong
Email: j.anthony.coughlan@hk.pwc.com
Auth-Page: http://ssrn.com/author=504840
Abstract: http://ssrn.com/abstract=872561
Employee stock options, in large measure, have fueled the
high-technology boom of recent years. Cash-strapped high-tech
startup firms make up for the low salaries they offer with grants
of stock options. Such firms face a choice: They can award
nonstatutory stock options, or they can award statutory options.
There are pros and cons to each type of option. Upon exercise,
nonstatutory stock options are taxable to the employee and may be
deducted by the employer under section 162. In contrast,
statutory options upon exercise are not taxable to the employee
and may not be deducted by the employer under section 162. These
pros and cons of each type of option may balance each other out,
and which type of option to award may therefore be of little
importance for many profitable companies.
Yet for many high-tech startup companies, not having a section
162 deduction upon the exercise of a statutory option is not so
bad: Because they are startups, they very well might not realize
a profit anyway. If they do not realize a profit, then they do
not have taxable income. And if they do not have taxable income,
then they do not need an additional deduction. That is, because
the company might never be able to utilize the good tax
attributes of a nonstatutory stock option (the deduction), there
does not seem to be much reason to saddle their employees with
the bad tax consequences (taxable income upon exercise of the
option). For this reason, the startup firm often would prefer to
grant statutory options.