RECENT DEVELOPMENTS IN EXECUTIVE COMPENSATION

Effect of New Capital Gains Rates on Stock Options

Should companies grant incentive stock options, instead of nonqualified stock options, now that the maximum tax rate on long-term capital gains has been reduced? Many companies are asking this question.

Under the 1997 tax legislation, as a general rule, an individual's short-term capital gains (gains from the sale of assets held for one year or less) are taxed at ordinary income tax rates, gains from the sale of assets held for more than one year but not more than 18 months are taxed at a maximum rate of 28%, and long-term capital gains (gains from the sale of assets held for more than 18 months) are taxed at a maximum rate of 20%. The reduced rates make incentive stock options (ISOs) even more valuable to employees than was previously the case.

An employee does not recognize income when an ISO is exercised (except that the ISO "spread" is taken into account for alternative minimum tax purposes). Instead, the employee recognizes income when the stock is sold. If the employee holds the stock acquired upon the exercise of an ISO for at least two years from the date of grant and one year from the date of exercise, the gain will be taxed as capital gain. Under the new law, if the sale occurs more than 18 months from the date on which the option is exercised, the gain will be taxed as long-term capital gain at a maximum 20% rate. If the holding period requirements are met but the employee sells the stock between 12 and 18 months after the option is exercised, the gain will be taxed at a maximum 28% rate. The company generally has no tax deduction with respect to an ISO (unless the holding period requirements are not met).

In contrast, when an employee exercises a nonqualified stock option, the employee recognizes ordinary income equal to the option "spread." The company generally receives a corresponding income tax deduction.

Since the company generally receives no tax deduction with respect to an ISO, ISOs are more costly to a company than nonqualified options. On the other hand, the combination of postponed tax and favorable long-term capital gain rates make ISOs very favorable to the employee.

Some companies view the tax benefits to employees (or at least selected employees) as more important than the tax benefits to the company and so are granting ISOs. Other companies consider the tax benefits to the company to be more important and are granting nonqualified options. Companies can increase the number of nonqualified options to take into account the less favorable tax consequences to the employee, or they can grant an employee a nonqualified option with a supplemental cash bonus structured to compensate the employee for the increased tax cost. The accounting consequences of such a cash bonus should be considered. We expect that companies will continue to choose between ISOs and nonqualified options, or use a combination of the two, depending on the company's objectives for the particular options and the tax cost to the company.

Company Violation of Fiduciary Duty May Cause Pension Loss

The U.S. Court of Appeals for the Second Circuit has held that Kodak breached its fiduciary duty by failing to notify a retirement plan participant that if she died before the effective date of her retirement, she would be ineligible to receive a single sum distribution of her benefits. The lump sum would have been in excess of $200,000. Because the participant died three days before her retirement date, her surviving spouse instead received a life annuity of $103 per month.

The participant went on short-term disability leave April 20, 1990. At the time she was eligible for early retirement under the Kodak retirement plan's "55/10" rule, which allowed employees who have attained age 55 and have 10 years of service to retire. The company amended the retirement plan at about the same time, effective Sept. 1, 1990, to permit employees to elect to receive their benefits in the form of a single sum payment.

Soon thereafter it became apparent that the participant would not return to work before the expiration of her short-term leave. She met with one of the company's benefits counselors and was advised that monthly long-term disability benefits for which she would be eligible would be greater than the monthly pension amount she would receive if she retired. In addition, she was advised that, even if she elected initially to receive long-term disability benefits, she could later change her election and begin to receive retirement benefits at "any time." Based on this information, the participant deferred her retirement and elected to receive long-term disability benefits.

The participant subsequently retired on Oct. 21, 1991. The benefits counselor then advised her for the first time that she would not receive her single sum retirement distribution if she died before her retirement date, and that under the terms of the plan, her retirement would be effective as of the first day of the following month, or Nov. 1, 1991. The participant died on Oct. 29, 1991, three days shy of her retirement date. As a result, her husband was ineligible to receive the single sum payment, which would have amounted to $212,620. Instead, the husband received a survivor's annuity providing monthly benefits totaling $103.42.

The Second Circuit found that the summary plan description for the retirement plan did not contain a distinct announcement that participants lose vested pension benefits if they die before their retirement effective date. This omission, the court noted, combined with the benefits counselor's "misrepresentation" that the participant could elect to retire at any time, constituted a breach of the company's fiduciary duty under ERISA to inform participants completely and accurately about benefits. Becker v. Eastman Kodak Company.

Distribution Options Can't Be Changed After Payments Begin

The U.S. Court of Appeals for the Third Circuit has held that Federal Express Corporation breached its fiduciary duty by failing to advise an ERISA plan participant that his election to receive benefits in the form of a 50% joint and survivor annuity was irrevocable once he retired and began receiving payments. Following the participant's election of the joint and survivor annuity option, he and his wife divorced. The participant then remarried and sought unsuccessfully to designate his second wife as the beneficiary of his pension proceeds.

Under the terms of Federal Express' pension plans, election of the payment option could not be rescinded, nor could the designation of the joint annuitant be changed, after a participant's retirement date. Information provided by the company, however, did not mention specifically the prohibition against post-retirement changes.

Under the participant's and his ex-wife's property settlement agreement, the ex-wife relinquished all claims to the participant's retirement benefits, including the joint and survivor annuity. The participant submitted a qualified domestic relations order (QDRO) to Federal Express and, as a result, Federal Express canceled the participant's ex-wife's right to receive benefits under the plans. However, Federal Express did not increase the participant's monthly benefits, nor did it permit him to designate his second wife as the new beneficiary. The company reasoned that the QDRO could extinguish the ex-wife's rights but could not designate a new beneficiary, nor could it increase the participant's monthly benefits because of the express restrictions as to such changes. The participant claimed that Federal Express violated ERISA's fiduciary provisions by failing to inform him of the prohibition against making post-retirement changes in his elections.

The Third Circuit found that fiduciaries under ERISA not only have a duty not to misinform, but also have an affirmative duty to inform participants when the fiduciaries know that silence may be harmful. The court reasoned that participants might expect a written explanation of benefits such as the one provided to all prospective retirees, to inform them of the post-retirement irrevocability of benefit elections. The court observed that, in light of the national divorce rate, irrevocability of elections may be a material consideration. Accordingly, the participant was allowed to pursue his claim, and the case was returned to the trial court to resolve factual issues. Jordan v. Federal Express Corporation. *

Courtesy of Morgan, Lewis & Bockivs, LLP

Editors:
Sheldon M. Geller, Esq.
Geller & Wind, Ltd.

Avery E. Neumark, CPA
Rosen Seymour Shapss Martin & Company