For each incorrect answer, you will be given a reference to help you find the correct answer, as well as the option to pop up a window with the correct answer and an explanation. Below are sample questions, followed by the reference and then by the correct answer and explanation you could pop up:
Question: When an optionee terminates employment, treatment of his/her options:
a) is determined by the company's legal counsel.
b) is determined by the company's human resources department.
c) is stated in the employee's work contract.
d) is stated in the stock plan agreement.
Answer: D
Source: Selected Issues in Equity Compensation (3d ed.), Section 1.4.1
Explanation: A company's stock option plan generally lays out how an employee's options will be handled upon termination of employment.
Question: "Blue Sky Laws" refer to:
a) exemptions from federal securities law available to public companies.
b) exemptions from federal securities law available to private companies.
c) state securities laws, which must be complied with before the company can issue stock to employees.
d) international requirements that must be complied with before the company can issue stock to non-U.S. employees.
Answer: C
Source: The Stock Options Book (7th ed.), Section 7.1
Explanation: Public companies are generally eligible for stock-exchange-related exemptions from such state securities laws and regulations, which are primarily aimed at speculative schemes.
Question: On March 1, 2001, Employee A is granted an incentive stock option to purchase 1,000 shares at a price of $25 per share. The option vests in full one year after the date of grant. Employee A exercises the option in full on April 4, 2002, when the market value is $34 per share. On March 5, 2003, Employee A sells the shares she acquired by exercising her option at $39 per share. Which of the following is true in 2003?
a) Employee A's employer is entitled to a tax deduction of $9,000.
b) Employee A'semployer is entitled to a tax deduction of $14,000.
c) Employee A recognizes a capital gain of $9,000.
d) Employee A recognizes a capital gain of $14,000.
Answer: A
Source: The Stock Options Book (7th ed.), Section 3.4
Explanation: Because the employee does not hold the shares for a full year from the exercise date, the sale of stock is a disqualifying disposition. The employee must pay ordinary income taxes on the difference between the exercise price and the stock's fair market value on the date of exercise, or $9,000. The employer is thus entitled to a tax deduction equal to that amount. The remainder of the profit from the sale is taxed at capital gains rates, and thus the employer gets no deduction on that amount.
Question: Which of the following stock plans would most likely be considered non-compensatory under FAS 123(R)?
a) A stock option plan that is approved by the company's shareholders.
b) A stock option plan offered to all employees of the company.
c) A Section 423 employee stock purchase plan with a discount of 5% off the price on the purchase date.
d) All stock plans are compensatory under FAS 123(R).
Answer: C
Source: The Stock Options Book (7th ed.), Section 10.5.6
Explanation: Some employee stock purchase plans are considered non-compensatory under FAS 123(R). To be considered non-compensatory, an ESPP must not offer any option-like features, such as a look-back, and must include substantially all employees, a standard that is satisfied if the plan meets the requirements of Internal Revenue Code Section 423. Furthermore, if the plan offers a discount, it can be no greater than the company's costs of raising capital through a public offering. A safe harbor in the standard allows a discount of up to 5% without further justification.
Question: A company accelerates vesting of options upon termination of an employee. Which of the following is NOT true?
a) If the options are incentive stock options, they automatically become nonstatutory stock options.
b) If the employee is terminated late in the year, the acceleration can be delayed into the next year to delay tax consequences.
c) Accelerated vesting will result in a new measurement date, unless acceleration terms are in the original agreement.
d) Accelerated vesting may result in a compensation expense based on the intrinsic value added by the modification.
Answer: A
Source: The Stock Options Book (7th ed.), Section 17.1.1
Explanation: Acceleration does not automatically lead to ISOs becoming NSOs so long as the acceleration does not cause the optionee to exceed the $100,000 first exercisable rule. Answer B is wrong because the employee is taxed in the year in which the option is accelerated, meaning that if the acceleration is in the year after the employee is terminated, the tax consequences are not felt until that year. Answers C and D are wrong because accelerated vesting that isn't provided for in the initial option agreement does count as a modification for accounting purposes, meaning it forces a new measurement date and can result in a compensation expense.
Question: Section 16 of the Securities Exchange Act of 1934 defines all of the following to be an "officer" EXCEPT the:
a) principal financial officer.
b) principal accounting officer.
c) acting chief executive officer.
d) principal human resources officer.
Answer: D
Source: Selected Issues in Equity Compensation (3d ed.), Section 4.3
Explanation: Function rather than title determines Section 16 status. A principal human resources officer could be considered an officer, but doesn't have to be.
Question: Employee X quits XYC Corp. on February 28, 2003. On December 27, 2003, his former spouse, who has never been an employee of XYC Corp. but was awarded options in the divorce, exercises her nonqualified stock options. How is the withholding of taxes on the spread on exercise handled?
a) All taxes are withheld from the non-employee former spouse's (NEFS) proceeds.
b) FICA and FUTA taxes are withheld from the NEFS proceeds, but the former employee pays federal and state income taxes.
c) The NEFS pays federal and state income taxes, but the former employee pays FICA/FUTA.
d) The former employee is responsible for all taxes on the spread.
Answer: A
Source: The Stock Options Book (7th ed.), Exhibit 9-1
Explanation: In the past, because the non-employee former spouse exercised her option in the same calendar year as her ex-husband left his job, she pays the income taxes herself, but the FICA and FUTA taxes on the spread on exercise were the employee's responsibility. This rule changed last year. Under the new requirements, when an option is transferred pursuant to divorce, all taxes are withheld from the ex-spouse. While FICA payments are based on the employee's income and attributed to the employee (and reported on the employee's W-2), the actual payments are collected from the ex-spouse.
Question: Stock appreciation rights (SARs) with time-based vesting and that must be settled in stock receive the following accounting treatment under FAS 123(R):
a) Stock-settled SARs are tantamount to the receipt of cash and therefore are taxed as compensation at the time of issuance.
b) Stock-settled SARs are treated like the receipt of restricted stock with the value being amortized until exercise.
c) Stock-settled SARs are accounted for like stock options.
d) Stock-settled SARs always receive variable accounting.
Answer: C
Source: Beyond Stock Options (4th ed.), Section 2.4
Explanation: Under FAS 123(R), stock-settled SARs are treated the same as stock option awards. For purposes of determining their "fair value," the option pricing model calculation is the same.
Question: Company X, a public company, grants ISOs to employees, NSOs to outside directors and consultants, and maintains an IRC Section 423 employee stock purchase plan. Company X is a global corporation, with employees in 35 countries. Each September the stock plan administrator for Company X surveys for potential dispositions of stock that the company needs to report for tax purposes (i.e., include in income on a W-2). What shares should be included in the administrator's survey?
a) ISOs exercised but not sold and still within the statutory holding period; ESPP shares purchased but not sold and still within the statutory holding period.
b) ISOs exercised but not sold, regardless of the statutory holding period; ESPP shares purchased but not sold and still within the statutory holding period.
c) ISOs exercised but not sold and still within the statutory holding period; ESPP shares purchased but not sold, regardless of the statutory holding period.
d) ISOs exercised but not sold, regardless of the statutory holding period; ESPP shares purchased but not sold, regardless of the statutory holding period.
Answer: C
Source: The Stock Options Book (7th ed.), Section 9.3
Explanation: For ISOs, only disqualifying dispositions are reported for tax purposes, so the company need only survey while the shares are still held during the statutory holding period. For ESPPs however, the company needs to report both qualifying and disqualifying dispositions, so the survey should include all shares purchased, regardless of whether or not the statutory time period is over. ESPP shares should be tracked for both qualifying and disqualifying dispositions, while ISO shares only need to be tracked for disqualifying dispositions.
Question: Company X, a public company, has started recovering from the recent downturn in the stock market. However, the executive committee has determined that options granted in 2000, at the height of the market, are so far out of the money that the shares are a disincentive to employees. Company X has decided to conduct a "6+1" option exchange, allowing optionees to have the existing grants cancelled and replaced with a new grant in six months and one day at the market value on that future date. Company X wants to implement the program as soon as possible. Accordingly, Company X must do ALL of the following, except:
a) notify all optionees.
b) comply with all securities laws designed specifically for repricings, although it will avoid incurring variable plan accounting.
c) comply with certain securities laws designed to cover tender offers (originally created for mergers), although it will avoid incurring variable-plan accounting.
d) offer the option exchange and give the optionees a seven business day decision period for participation.
Answer: D
Source: Selected Issues in Equity Compensation (3d ed.), Section 7.1.4
Explanation: Company must comply with answer A, and B is correct because for all purposes other than APB Opinion No. 25, a 6+1 option exchange program is treated as a repricing and must comply with all the same securities laws that are applicable to a repricing. C is correct because this sort of exchange, when offered to more than just a handful of employees, is considered a tender offer and must comply with the laws applicable to such offers.
Question: Company X, a public company, issues only premium options; that is, the option price is always above the current market value. It considers such grants to be partially performance based, as the stock value must rise significantly before the optionees see any gain, but without having to use variable-plan accounting. On December 6, 2003, Company X grants Employee A an ISO for 10,000 shares that vest in four equal annual installments. The market value is $50. The option price is $60. How many of Employee A's shares (assuming this is her first ISO grant) can receive preferential tax treatment in 2004?
a) 1,666
b) 2,000
c) 2,500
d) 10,000
Answer: B
Source: Executive Stock Options and Stock Appreciation Rights, Release 19.(New York: Law Journal Press, 2004), 3.02[3][f]
Explanation: According to her vesting schedule, 2,500 shares are scheduled to vest in 2004. However, the $100,000 limit must be applied. The limit is based in the market value of the company stock on the date of grant, thus $100,000/$50=2,000. The calculation should not be done using the price of the shares, but rather the market value.
Question: Company X, a public company, accounts for employee stock options using FAS 123(R). On February 3, 2006, Company X modifies the company stock plan to allow employees who retire at age 65 with at least 20 years of employment with the company to have three years to exercise any vested option shares after retirement. Previously, there was no special retirement provision and employees had only three months to exercise vested shares after any type of termination. Company X makes this modification retroactive to all previously issued, outstanding options. For accounting purposes, this type of modification:
a) has no impact since the company is free to set termination conditions.
b) causes all previously issued, oustanding grants to be subject to variable accounting.
c) causes all previously issued, outstanding grants to have new measurement dates, and Company X must recognize compensation cost for the instrinsic value for all the grants immediately.
d) causes all previously issued, outstanding options to be treated as having been a canceled and regranted.
Answer: D
Source: Accounting for Equity Compensation (3d ed.), Section 8.2
Explanation: The extention of the period in which to exercise an option after termination is considered to be a modification under FAS 123(R). As a result, the options are treated as having been canceled and regranted.
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