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offer 5.001% stock option-- NHCE becomes HC

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Thru attribution, if an NHCE is offered a 5.001% (more than 5%) stock option, the employee's status changes to an HCE. Is the company required to draft an official stock option or is it enough if the company simply writes an official letter on their stationary (notarized, witnessed  etc) addressed to the employee offering him the option to purchase 5.001% of the company? Thank you.

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Depending on your state, the company's bylaws, and other facts and circumstances, granting a 5% option may require shareholder or board approval. If you're talking about the simple situation where A owns 100% and is going to give B an option (or cause the corporation to give B an option) you would probably not need approvals. My guess is that the approval issue aside, an employee in possession of a clearly written letter granting the option would be able to enforce it, and if that is the case, the IRS should buy it, but you are creating uncertainty and could get pushback from IRS in exam. Also, anyone who is thinking about causing a corporation to give an employee an option for 5% without creating an option agreement covering inspection rights, call option after termination from service, duration of option, yadda, yadda, yadda, is asking for trouble. Also, for 409A you need the option price to be no less than FMV at date of grant, so do something substantial there, e.g. an appraisal or see if you can come within the illiquid start-up safe harbor. If you're talking a corporation with some value, that may be growing and may have a liquidity event down the road, I can tell you that seat of the pants equity comp arrangements are a frequent source of trouble in transactions and often lead to litigation and alleged malpractice claims after the parties part ways.

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I agree with Luke, but if I'm offered a 5% stock option, I'm not an owner yet, until and only until I exercise that option fully.

That is the law as I understand it.

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I recall that quoting on this  forum is not allowed. If it is allowed, I will quote. In the meantime, I have seen that thru attribution if you have an option to acquire stock , such stock shall be considered as owned by such person (the person quoted this from the IRC). In addition, he writes,  that you can create a controlled group by giving one owner an option to purchase the other.

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But an employee stock option is only a right to exercise the option and does not  represent ownership until exercised. I'd love to see the cite on that. Thanks.

That's like saying I'll give you a right to buy my business 50% and by doing that, you become a 50% owner, without ever paying the exercise price !

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Bob, look at the attribution rules in section 1563 of the Internal Revenue code.

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19 hours ago, SSRRS said:

I recall that quoting on this  forum is not allowed. If it is allowed, I will quote. In the meantime, I have seen that thru attribution if you have an option to acquire stock , such stock shall be considered as owned by such person (the person quoted this from the IRC). In addition, he writes,  that you can create a controlled group by giving one owner an option to purchase the other.

Was there an arms length negotiation for this offer or did owner unilaterally decide to offer this "option"? 

 

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18 hours ago, Bob the Swimmer said:

But an employee stock option is only a right to exercise the option and does not  represent ownership until exercised. I'd love to see the cite on that. Thanks.

That's like saying I'll give you a right to buy my business 50% and by doing that, you become a 50% owner, without ever paying the exercise price !

Sorry Bob, you are just not aware of the law.  The attribution rules DO ATTRIBUTE a bona fide option to buy 5.01% of the business to the receiver of the option. That's simply the rules.  That makes the person who has the option to buy an HCE by definition.

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5 hours ago, RatherBeGolfing said:

Was there an arms length negotiation for this offer or did owner unilaterally decide to offer this "option"? 

 

SSRRS, RatherBeGolfing is raising a good point, i.e. that the option has to be something that is realistic and credible as something of value, not a sham.

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5 minutes ago, Luke Bailey said:

SSRRS, RatherBeGolfing is raising a good point, i.e. that the option has to be something that is realistic and credible as something of value, not a sham.

Absolutely.  I have attached a sample of what we have used a number of times (this is for a dental practice; appropriate modification needed for type of business).  Also, the cover letter explain that besides making this individual an HCE (who is a doc and doesn't want any contributions to the plan anyway), we are also limiting him to a zero contribution in the plan.

optiontopurchase.sample.pdf

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5 hours ago, RatherBeGolfing said:

Was there an arms length negotiation for this offer or did owner unilaterally decide to offer this "option"? 

 

A unilateral offer is just fine. So long as it is legitimate, it's attributable whether the participant likes it or not.  In all cases where we have used it, both parties were willing to utilize this methodology to make the individual an HCE. FWIW.

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19 hours ago, Mike Preston said:

Bob, look at the attribution rules in section 1563 of the Internal Revenue code.

Thank you Mike.

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1 hour ago, Luke Bailey said:

SSRRS, RatherBeGolfing is raising a good point, i.e. that the option has to be something that is realistic and credible as something of value, not a sham.

Thank you Luke and RatherBeGolfing. The offer will be within the FMV or slightly higher,  as is common. However, it will not be grossly in excess of the Current FMV. Your insight is always appreciated.

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1 hour ago, Larry Starr said:

Absolutely.  I have attached a sample of what we have used a number of times (this is for a dental practice; appropriate modification needed for type of business).  Also, the cover letter explain that besides making this individual an HCE (who is a doc and doesn't want any contributions to the plan anyway), we are also limiting him to a zero contribution in the plan.

optiontopurchase.sample.pdf 12.76 kB · 2 downloads

Thank you very much Larry Starr for your insight, advice, and input. It is really appreciated.

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5 hours ago, SSRRS said:

Thank you Luke and RatherBeGolfing. The offer will be within the FMV or slightly higher,  as is common. However, it will not be grossly in excess of the Current FMV. Your insight is always appreciated.

You won't like this but the above words indicate a complete lack of understanding. Please make sure that you involve a lawyer. 

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18 hours ago, Mike Preston said:

You won't like this but the above words indicate a complete lack of understanding. Please make sure that you involve a lawyer. 

Yes, this is not something that someone who is not UBER familiar with what it is all about should be doing on their own.  FMV is extremely difficult to determine, and when you are offering a 5.01% ownership, you also have discounts for lack of control, lack of marketability, etc.  Plus, it is almost axiomatic that the exercise of the option will never occur.  Who would buy 5% of a closely held business that pays no dividends and has no real market for resale where you effectively have no vote over anything either.  Just FWIW.

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Thanks to all--this is a weird application of 1563 that I had not seen in 44 years of consulting. And Larry, no one ever said the Code made sense---I'm attributed as a stock holder via an option that I probably will never exercise.

On the other hand, the option agreement here inserted is very sparse (I work in this area of LTIPs  consulting with public and private Compensation Committees) and there are a number of issues that are not addressed for the optionee. So caveat emptor as always.

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19 hours ago, Bob the Swimmer said:

Thanks to all--this is a weird application of 1563 that I had not seen in 44 years of consulting. And Larry, no one ever said the Code made sense---I'm attributed as a stock holder via an option that I probably will never exercise.

On the other hand, the option agreement here inserted is very sparse (I work in this area of LTIPs  consulting with public and private Compensation Committees) and there are a number of issues that are not addressed for the optionee. So caveat emptor as always.

Thankfully, the code makes no sense in many areas; that's why many of us have had successful careers in this industry all these years! 🙂 How about the famous ones of the non-involvement exception for attribution between husband and wife is destroyed just by the presence of minor children (because of the attribution through/via the children back to the parents).  Insane result, but fully logical under our IRC.

Are you referring to the option agreement I provided as being very sparse?  Would be interested in knowing your concerns (since we have spent a pretty penny with a very competent law firm developing that document).

I would also suggest that no one who operates in this business can afford to be without several resources including the ERISA Outline Book (published by ASPPA), Natalie Choate's book Life and Death Planning for Retirement Benefits, and Derrin Watson's book Who's The Employer which is now published online by ERISApedia and can be ordered here: http://www.employerbook.com/.  Full disclosure, I (and others) helped Derrin develop this book and originally market it and are given credit in the dedication but I have ZERO compensation from the sale of the book. The other two resources are also available as on line publications and while I own both the hard copy and the electronic versions, I almost exclusively use the electronic versions of all three publications.

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8 minutes ago, Larry Starr said:

Thankfully, the code makes no sense in many areas; that's why many of us have had successful careers in this industry all these years! 🙂 How about the famous ones of the non-involvement exception for attribution between husband and wife is destroyed just by the presence of minor children (because of the attribution through/via the children back to the parents).  Insane result, but fully logical under our IRC.

Are you referring to the option agreement I provided as being very sparse?  Would be interested in knowing your concerns (since we have spent a pretty penny with a very competent law firm developing that document).

I would also suggest that no one who operates in this business can afford to be without several resources including the ERISA Outline Book (published by ASPPA), Natalie Choate's book Life and Death Planning for Retirement Benefits, and Derrin Watson's book Who's The Employer which is now published online by ERISApedia and can be ordered here: http://www.employerbook.com/.  Full disclosure, I (and others) helped Derrin develop this book and originally market it and are given credit in the dedication but I have ZERO compensation from the sale of the book. The other two resources are also available as on line publications and while I own both the hard copy and the electronic versions, I almost exclusively use the electronic versions of all three publications.

Yes, Derrin Watson's book Who's The Employer, has extensive coverage on options, (including a control group being created through an option), and of course many other topics.

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