The purpose of this post is to discuss whether incentive stock option (“ISO”) awards should be designed to destroy ISO treatment with respect to terminated employees, thereby preserving the compensatory deduction to the corporation and increasing shareholder value.

Background

• ISOs are Favorable to Employees.  Generally, an option that is treated as an ISO is tax-favorable to employees because the optionee recognizes NO ordinary taxable income at the time of exercise (though the spread between the exercise price and the then fair market value of the underlying stock is an item of adjustment for AMT purposes), and any gain upon a later sale of the underlying shares would be captured at long-term capital gains rates if certain ISO qualification requirements, ISO employment requirements and ISO holding period requirements are satisfied.
• ISOs Result in Lost Compensatory Deduction.  With respect to ISOs, no deduction is permitted by the corporation at the time the ISO is exercised.  In contrast, had the option been a non-statutory option (an "NSO"), then at the time the option is exercised the corporation would be entitled to a deduction equal to the spread between the exercise price and the fair market value of the underlying stock as of the date the option is exercised.
• Post-Termination Exercise Period.  Of the many requirements for an option to maintain ISO treatment, one requirement is that the option must be exercised no later than three months following the date the optionee is no longer an employee of the corporation (or such lesser period if set forth in the option award agreement).

Idea to Preserve Shareholder Value - Inches Might Matter in the Aggregate

Consider whether it makes sense to design the ISO award agreement so that ISO status is maintained if the option is exercised while the optionee is an employee, and that ISO status is lost to the extent the option is exercised after the optionee's employment is terminated (i.e., exercised by a terminated employee within the post-termination exercise period set forth in the option award agreement).   Supporting this from a shareholder policy perspective:

• Shouldn't ISO status be limited to only those optionees who continue to provide shareholder value on a post-exercise basis (i.e., only those optionees who remain employed with the corporation after the option is exercised)?
• Shouldn't the corporation capture the compensatory deduction under the premise that former employees provide no shareholder value?
• Is this idea worth implementing given that an educated optionee would likely maintain ISO treatment by exercising his or her ISOs prior to terminating employment?

The answer is maybe (not all ideas are good ideas and not all ideas are practical).   If the foregoing were applied to situations where the optionee's employment is being terminated by the corporation without Cause or by the optionee for Good Reason (i.e., situations that commonly trigger accelerated vesting), then the deductibility "win" could apply to the portion of the option that would have otherwise remained deductible after application of the $100,000 limitation of Section 422(d)(1) of the Code.  A win, but not much of a win since the $100,000 limitation eliminated ISO treatment with respect to a portion of the option.

In the end, the merits of this idea likely comes down to whether you believe tax minimization is a game of inches.  To that end, consider the philosophy set forth in Al Pacino's inch-by-inch speech in the movie "Any Given Sunday,".  To sum up the point of the speech, every inch matters.