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The Employee Ownership Update

Corey Rosen

September 28, 2001

(Corey Rosen)

IASB Pushes for Reporting Option Costs

The International Accounting Standards Board (IASB) has issued a discussion draft calling for using "fair value" to report the cost of stock options and other equity plans on a company's income statement. The proposal is not specific on how "fair value" would be calculated, but suggested that on issuance of an award, a company would compute the option's "minimum value" plus part of the option's time value. Presumably, this means that a company would start with the intrinsic value of an award (the difference between the current fair market value and the issuance value). So if a company gave an employee the right to buy stock at current fair market value, there would be no intrinsic value, but if the right were granted at a lower price, or shares were issued free or at a discount, that would be recorded. Then, the company would add to it some measure of the present value of the future right to acquire the stock at that price, adjusted periodically. Heavy opposition is expected to the IASB proposal, particularly in the UK and the US.

For details on the proposal, and to make comments, go to

Hatch and Shaw Introduce ESOP S Corporation Provision to Allow Distributions on Allocated Shares to Repay Loans

Senator Orrin Hatch (R-UT) and Representative Clay Shaw (R-FL) have introduced legislation that would make broad reforms in S corporation law. The bills include a provision that would allow distributions on allocated shares in an S corporation ESOP to be used to repay a loan. The broad-ranging bill makes a number of changes in S corporation law, including increasing the permissible number of shareholders to 150, allowing the issuance of preferred stock, and making a variety of tax changes. Given all the competing tax proposals, prospects are very uncertain.

Under the current law, companies with ESOPs can use dividends paid on both allocated and unallocated shares to repay an ESOP loan. However, S corporations technically do not pay dividends; they make distributions of earnings to shareholders. The IRS has issued private letter rulings suggesting approving the use of distributions on unallocated shares to repay a loan, but not allocated shares. The distinction is based on the requirements of the law that say that any ESOP can use earnings on shares attributable to stock held as collateral for a loan to repay that loan, but cannot use earnings on shares that are not held as collateral.

Excise Tax Does Not Apply in ESOP Liquidation

In PLR 200135044, the IRS concluded that a company that was terminating its ESOP on acquisition by another company through an asset acquisition could distribute cash to the ESOP participants without incurring an excise tax under Code Section 4978. Section 4978 requires a 10% excise tax on Section 1042 tax-deferred sales to an ESOP if the ESOP does not retain at least 30% ownership in the company for at least three years. One of the exceptions to this rule is for separation from service resulting in a one-year break in service. The acquisition was structured so that distributions would be made as soon as possible after that break in service occurred. However, some of the employees of the acquired company then went to work for the acquirer, which might not be considered a break in service under the "same desk" rule (where an employee does the same job for the acquirer). In this case, however, the IRS ruled that the employees hired by the acquirer were not providing services to the acquired corporation in a continuation of the acquired corporation's business. Thus, the excise tax would not apply.

Unvested Stock Options Can Be Divided in Divorce

In Baccanti v. Morton (MA, No 08442, 8/13/01), the Massachusetts Supreme Judicial Court ruled that unvested options could be divided in a marital estate. The court concluded that a party's estate includes all "vested and nonvested benefits, rights, and funds." This would include stock options, even though they are not specifically mentioned in the law. It said that unvested stock options could be compared to unvested retirement benefits. It noted that options could be the most valuable asset in a marriage, and thus could not properly be excluded form a settlement. The key issue for the court to determine would be whether the options were granted for work before, during, or after the marriage. In addition, the court must find a way to value the options.

In this case, the court decided that rather than ascribing a current value to the options, it would provide that the value would be divided if and when the options were exercised. Which options to divide presented a trickier problem. The court noted that the majority of decisions in cases around the country on this conclude that the court should look at the contributions of the spouses in acquiring the options, rather than simply looking at whether the options were acquired during the marriage. A minority view holds that all options granted during the marriage should be marital property. The key difference here is that unvested options that will be partly earned after the marriage would not be evenly divided between the spouses under the majority view. The Massachusetts court differed from the majority view, however, in concluding that options granted prior to the marriage could also be included in certain cases, since they had become part of current marital property. In addition, in certain circumstances, such as long-term marriages, options that vest after the divorce could be considered marital property if the courts concluded that both parties had contributed to their acquisition. In general, awards given solely for future service would be excluded, however, but awards for current and past service would generally be included. Awards that vest after the divorce would be divided based on how many years they had been outstanding and how many years remain until vesting.

Here, the court ruled that the gain from the exercise of existing options would be divided equally when the shares were sold. If the husband does not exercise the options upon vesting, the wife would be allowed to exercise her half of them.

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