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Stock Options – Non-Qualified Stock Options and Incentive Stock Options

by | Feb 19, 2016 | All Blog Entries, Corporate, Employee Compensation

Stock options and stock ownership plans are a popular and effective method of incentivizing employees, often at a low cost to both the employer and the employee.  Several types exist, including non-qualified stock options, incentive stock options, employee stock ownership plans, phantom stock, stock appreciation rights and more.  In this first of a series of blog posts, we will look at non-qualified stock options and incentive stock options.

An employee stock option is a contract issued by an employer to an employee to purchase a set amount of shares of company stock at a fixed price for a limited period of time. There are two broad classifications of stock options issued: non-qualified stock options (NSO) and incentive stock options (ISO).  NSOs are typically offered to non-executive employees and outside directors or consultants.  ISOs are reserved for employees, generally executives.  Tax treatment of the two differs as well.

Both plans operate under a vesting schedule.  The employer grants the shares on Day 1 Year 1 but may set a vesting schedule.  Many schedules are based on time: 20% vest at the end of Year 1, an additional 20% at the end of Year 2, etc.  Other vesting schedules are tied to milestones: 20% when sales have reach $15 million, or 20% when productivity reaches 75%.  Both types of vesting schedules need to be clearly documented and agreed to.

Under both plans, no taxes are due at the time of grant.  NSOs are taxed at the date of exercise.  The difference between the Fair Market Value (“FMV”) on the grant date and the FMV on the exercise date is taxed as ordinary income to the recipient and as expense to the company.

ISOs are not taxed when the options are exercised. When the securities are sold, they are taxed under capital gains rules.  If the securities are held for one year after the option exercise and two years after the date of grant, they qualify for long-term capital gain treatment.  If these two qualifications are not met, they are treated as non-qualified stock options and are taxed using ordinary income rates.

An attorney and a tax advisor should design the plan with your guidance to avoid any legal or tax consequences.

At JBV, we have valued many stock option plans, from ESOPs to NSOs to ISOs and more.  We are here to assist you with yours.

What Is Fair Market Value? The IRS v The Taxpayer

by | Nov 20, 2015 | All Blog Entries, Corporate, ESOP, Succession Planning

James and Julie Kress (the “Taxpayers”) filed a lawsuit in United States District Court for the Eastern District of Wisconsin [Case 1:15-cv-01067-WCG] on September 2, 2015. They sought a refund of federal gift taxes and interest they claim were erroneously assessed by the IRS on gifts made in 2007, 2008, and 2009.

The Facts

The Taxpayers are shareholders of an S corporation. The shares are owned by members of the Taxpayers’ family and certain employees and directors. The company’s bylaws and shareholders’ agreement restrict transfer of shares by family members to other family members or to trusts, as defined in the bylaws. An annual valuation opines the value of minority blocks of the shares.

The bylaws and shareholders’ agreement also stipulate transfers of stock by non-family shareholders are subject to a right of first refusal by the company. The bylaws and stockholder agreements specify these transfers must be at 120% of the company’s book value at the time of transfer.

In the years stated above, minority shares were gifted to members of the Taxpayers’ family at Fair Market Value as determined by an independent valuation. These valuations took into account the restrictions on transfers of shares held by family members.

The IRS challenged these amounts. It determined the gifts should have been valued at 120% of book value, the value which the company’s shareholders agreement and by-laws provide for transfers by non-family members.

The Issue

Fair Market Value is defined as the value a property would receive if it were sold in the open market. Among other factors, it assumes the buyer and seller are reasonably knowledgeable about the property in question, they are acting in their own best interest and neither party is under any undue influence.

In this Case, we see two sets of values. One is the values determined by the independent valuations, the other is 120% of book value. The Taxpayers assert the transfer price calculation for non-family members is to simplify transfers. (Shares transferred by non-family members typically had different, and much higher, bases than those transferred between family members).

The Taxpayers claim the restrictions on family transfers are a “bona fide business arrangement.” The restrictions, they claim, were not designed to attain discounted values.

So who is right?

The Taxpayers believe an independent valuation of their company should address the stock restrictions unique to family-owned shares. Because of these restrictions, the value of the shares is heavily discounted. The family contends the restrictions are intended to centralize ownership of the company in the family, not to lower the fair market value of transferred shares.

The IRS has been and is continuing to scrutinize transfers of stock among family members, especially those with high discounts. A perceived goal of the IRS is to prevent businesses from reducing the value of their shares through the imposition of severe restrictions limiting transferability of shares by family members. The IRS claims its valuation at 120% of book value better reflects what an external party would expect to pay for shares. It should be noted employees and directors are not third parties.

This case remains pending.

DOL Proposes New Definition for Fiduciary

by | Jul 27, 2015 | All Blog Entries, ESOP, Succession Planning

Since 1975 and prior to April 2015, the definition of fiduciary as put forth by the Department of Labor included a five-part test. Only if all five parts listed below were met would an adviser be considered a fiduciary. Advice was given:

  • as to the value of securities or other property, or make recommendations as to the advisability of investing in, purchasing or selling securities or other property;
    on a regular basis;
  • pursuant to a mutual agreement, arrangement or understanding, with the plan or a plan fiduciary;
  • that will serve as a primary basis for investment decisions with respect to plan assets; and
  • that will be individualized based on the particular needs of the plan or IRA.

In the April 2015 proposed rule, the definition of fiduciary is expanded. If a person meets this definition below, s/he is considered a fiduciary:

  • provides investment or investment management recommendations or appraisals to an employee benefit plan, a plan fiduciary, participant or beneficiary, or an IRA owner or fiduciary, including advice regarding rollovers and distributions from ERISA plans and IRAs;
  • for a fee or other direct or indirect compensation; and
  • either (a) acknowledges the fiduciary nature of the advice, or (b) acts pursuant to an agreement, arrangement, or understanding with the advice recipient that the advice is individualized to, or specifically directed to, the recipient for consideration in making investment or management decisions regarding plan assets.

Exceptions, or carve-outs, are provided:

  • statements or recommendations made to a “large plan investor with financial expertise” by a counterparty acting in an arm’s length transaction;
  • offers or recommendations to plan fiduciaries of ERISA plans to enter into a swap or security-based swap that is regulated under the Securities Exchange Act or the Commodity Exchange Act;
  • statements or recommendations provided to a plan fiduciary of an ERISA plan by an employee of the plan sponsor if the employee receives no fee beyond his or her normal compensation;
  • marketing or making available a platform of investment alternatives to be selected by a plan fiduciary for an ERISA participant-directed individual account plan;
  • the identification of investment alternatives that meet objective criteria specified by a plan fiduciary of an ERISA plan or the provision of objective financial data to such fiduciary;
  • the provision of an appraisal, fairness opinion or a statement of value to an ESOP regarding employer securities, to a collective investment vehicle holding plan assets, or to a plan for meeting reporting and disclosure requirements; and
  • information and materials that constitute “investment education” or “retirement education.”

A comment period expired in June with an expected final hearing date in late July 2015.

The DOL specifically carves out valuation analysts from the role of a fiduciary. At JBVal, we always consider it our mission of providing a defensible valuation that is fair to all to include all participants in the ESOP, as well as its Trustees and the company that sponsors it.

IRS May Try to Restrict Discounts

by | Jul 27, 2015 | All Blog Entries, Corporate, Employee Compensation, ESOP, Succession Planning

At the American Bar Association (ABA) Section of Taxation meeting on May 8th, 2015, Catherine Hughes, of the Office of Tax Policy in the U.S. Treasury Department, announced that proposed regulations under section 2704(b)(4) could be released before the fall. She indicated that the tax community could look to the Obama Administration’s prior budget proposals on valuation discounts for clues about what the proposed regulations might provide.

Section 2704(b)(4) states:

The Secretary may by regulations provide that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or partnership to a member of the transferor’s family if the such restriction has the effect of reducing the value of the transferred interest for purposes of this subtitle but does not ultimately reduce the value of such interest to the transferee.

Many believe the IRS does not have the authority to ignore minority and marketability discounts without Congressional action.

The IRS has unsuccessfully tried the Congressional route before.

A proposal was included in President Obama’s budget proposals in each of fiscal years 2010 to 2013. These proposals called for the elimination of discounts in family-controlled entities. None made it to the final approved budget.

Within the last ten years, the Certain Estate Tax Relief Act of 2009 appears to be the sole introduced bill on the topic. (Note my search was unscientific and may exclude other recent actions.)

HR 436: “Certain Estate Tax Relief Act of 2009”

This bill proposed the elimination of the ability to apply discounts for lack of marketability for transfers of “nonbusiness assets” of an entity. “Non-business assets” are those that are “not used in the active conduct of one or more trades or businesses.” For example, the new law would disallow a lack of marketability discount for the transfer of an interest in an entity that relates to the entity’s holdings of marketable securities.

Exceptions would have applied to two particular types of assets. First, an exception would have been made for real property owned by an entity is which the transferor materially participates, which would be measured in a manner similarly to passive activity limitations for income tax purposes. Second, an exception would have existed for “reasonably required” working capital of a trade or business.

Additionally, the Bill disallowed any minority discount for transfers of interests in a family controlled entity. This would have attributed ownership of the transferor to their spouses, parents, children, grandchildren, etc., thus eliminating the minority interest discount.

Status – Died in Congress

Does this mean the current attempt will fail? Who knows! However, panic mode is not called for.

DOL v PBI Banks, Inc. and The Miller’s Health Systems, Inc. Employee Stock Ownership Plan

by | Jun 10, 2015 | All Blog Entries, ESOP, Succession Planning

No case is clear cut, but lessons often can be learned.  In the recently filed action, the Department of Labor v PBI Bank, Inc. and The Miller’s Health Systems, Inc. Employee Stock Ownership Plan (United States District Court for the Northern District of Indiana, Civil Action: 3:13CV1400), some, but not all, of the issues surrounded the valuation report.

In this initial ESOP transaction, multiple drafts of a valuation report were produced.  The ultimate valuation, according to the Department of Labor’s filing, failed to consider several items.

  • No marketability discount was applied.  Though drafts of the report included a discount of 5%, the final version had none.
  • The stock purchase agreement included an earn-out agreement which provided the selling shareholders an amount equal to 40% of future earnings over a specified threshold for about eight years.  The valuation, according to the Department of Labor, failed to address this issue.
  • A stock option plan set aside 20% of Company shares for the selling shareholders, at a strike price of $4.08 per share.  The valuation for the initial transaction provided a total value of $42,379,000 for the 1,000,000 outstanding shares, according to the Department of Labor.  At the valuation date, these options apparently were “in the money” but according to the Department of Labor, the dilutive effect was not considered in the final report

Note that all of the above statements are based on our interpretation of the Department of Labor’s filing, not on a final Court decision.

Other issues outside the valuation report trumped those mentioned above.

The ‘lesson learned’ here is to ensure the valuation analyst knows the intricacies of an ESOP, particularly with the initial valuation.  At our firm, we review all important company resolutions and agreements, those directly associated with the ESOP and those created contemporaneously with the ESOP transaction.  We look at the financing arrangements.  We discuss all of items these with the Plan Administrator, the Trustee and company management.

We don’t opine unless we’re satisfied the final opinion is reasonable, fair to all parties, and, most importantly, can be supported. A DOL auditor recently remarked to a client our work product was among the most thoroughly documented he had reviewed.

Estate of Diane Tanenblatt v Commissioner of Internal Revenue

by | May 3, 2014 | All Blog Entries, Succession Planning

In this recent United States Tax Court case (T.C. Memo. 2013-263) concerning a real estate holding company operating as an LLC, two valuation issues were discussed: the sole consideration of a net asset value technique and the extent of lack of control and lack of marketability discounts. In an unrelated issue, the petitioner later attempted to negate his own expert’s property appraisal.  The Court rejected his attempt.

Net Asset Value Method
The two parties’ experts both relied on a net asset value technique.  The Court, in its decision, remarked,

“It is well established that, in general, an asset-based method of valuation applies in the case of corporations that are essentially holding corporations, while an earnings-based method applies for corporations that are going concerns.” Estate of Smith v. Commissioner, T.C. Memo. 1999-368, 1999 WL 1001184. That rule of thumb is no doubt based in part on the notion that a holding or investment company may be managed not for current income but, rather, for appreciation in the value of its holdings. If ownership interests in a holding or investment company are not traded in an established market, then net asset value may be the best indicator of the firm’s value. See, e.g., Hess v. Commissioner, T.C. Memo. 2003-251, 2003 WL 21991627;  Estate of Ford v. Commissioner, T.C. Memo. 1993-580, 1993 WL 501917, 53 F.3d 924 (8th Cir. 1995). The point is well stated in Rev. Rul. 59-60, sec. 5(a), 1959-1 C.B. 237, 242: “In general, the appraiser will accord primary consideration to earnings when valuing stocks of companies which sell products or services to the public; conversely, in the investment or holding type of company, the appraiser may accord the greatest weight to the assets underlying the security to be valued.”

“We have on occasion been presented with, and sanctioned, the valuation of a closely held real estate firm using a weighted approach, i.e., using both a net value approach and an income capitalization approach, attaching weight to each. E.g., Estate of Andrews v. Commissioner, 79 T.C. 938, 956-957 (1982); Estate of Weinberg v. Commissioner, T.C. Memo. 2000-51. We have here no evidence that an explicitly income-based approach to valuing the subject interest would necessarily have reached a different valuation conclusion, or what that valuation conclusion would be.”

Discounts
 The Court validated a lack of control, or minority, discount applied as the membership interest must be valued under the willing buyer-willing seller paradigm.  The Court pointed out that the willing buyer and willing seller did not have to have the same personal characteristics of the actual buyer and actual seller.  This is key when membership interest transfers are restricted to within the defined group, in this instance, a family group. Chapman Glen Ltd. v. Commissioner, 140 T.C.  (May 28, 2013).

“Certainly, in applying the willing buyer-willing seller standard to determine the value of the subject interest, it would be appropriate to take into consideration limitations in the operating agreement on the rights of a nonfamily member transferee to participate in control and management of the LLC and limitations on the transferee’s rights otherwise to be treated as a member.”

The IRS valuation expert, John Thomson of Klaris, Thomson & Schroeder, Inc, explained the lack of control discount or minority interest discount: “The hypothetical minority interest investor cannot control, or has little influence on, the disposition of assets, the payment of distributions, the appointment of management, or other prerogatives of control. Therefore, a lack of control discount is applied to account for the absence of these control features.”

His discount, which the Court affirmed, was at 10%.  The original petitioner’s valuation provided by the petitioner prepared by Management Planning, Inc. applied a lack of control discount at 20%.  No support for either of these discounts is provided in the Court filings.

The Court indicated a lack of marketability discount was appropriate to allow for the restrictions in the members agreement regarding transfers of interests.  Mr. Thomson provided a 26% lack of marketability discount.  Management Planning, Inc. applied a 35% lack of marketability discount.  The Court sided with Mr. Thomson.  Again, no support for either of these discounts is provided in the Court filings.

Conclusion
The Tax Court continues to allow both lack of control and lack of marketability discounts, though, as in the past, the justification for the scope of these discounts remains nebulous.  The Court allowed a net 33% discount from the pre-discounted value of the proportionate interest.