Sitting On a Dock of the Bay, watching my post-termination exercise period, roll away

Tax considerations for modifying stock options to extend the post-termination exercise period

by John Ludlum

We are often asked by our private company clients about making changes to outstanding stock options.  In some cases, changes to the number of shares subject to an option are needed, or to the vesting schedule, or to the allowed payment forms for exercising the option.  The rules affecting these decisions come from several, primarily tax, authorities, and the implications to the option and the company are quite varied depending on the change being made. 

One common request is to extend the “post-termination” exercise period for stock options, often in connection with an executive’s separation from service.  Any amendment to an outstanding option should be approved by the company board, and if an option is an Incentive Stock Option (“ISO”), any amendment to change the terms that confers an additional benefit on the optionee will be considered to be a modification.  The result under the ISO rules is that the option must be treated as having been granted on the date of modification, a “deemed re-grant,” under which all of the requirements for ISO status must be met again.  If the option is in the money at the time of modification, the option will fail the ISO requirement that the option must be at least fair market value on the date of grant, so the award will be treated as a non-statutory stock option (“NSO”).

The other tax rules to consider when modifying an option to extend the post-termination exercise period are under Code Section 409A.  In general, Code Section 409A has rules affecting the modification or extension of “stock rights” that are implicated by any change that could reduce the exercise price or provide the holder with an additional period of time within which to exercise the stock right beyond the time originally prescribed under the terms of the stock right.  The consequences of making a change that is a modification or extension that causes a violation of the Code Section 409A rules include income inclusion at the vesting dates (regardless of whether the option was exercised), a 20% excise tax, and potential interest and reporting penalties.  However, extending the post-termination exercise period is allowed as an exception to the extension restrictions provided that the extension of the exercise period of a stock right is to a date no later than the earlier of (i) the latest date upon which the stock right could have expired by its original terms under any circumstances or (ii) the 10th anniversary of the original date of grant of the stock right. If you have questions about your equity awards, we work with these issues regularly and would be happy to help.