SECTION 3. STOCK OPTION

VALUATION

.01 General rule. A taxpayer may value a stock option, without regard to whether the option is on publicly or nonpublicly traded stock, using any valuation method that (i) is consistent with generally accepted accounting principles (such as FAS 123 or a successor standard) and (ii) takes into account the factors provided in § 1.280G–1, Q/A 13. The safe harbor method provided in section 4 of this revenue procedure and Rev. Proc. 98–34 are considered consistent with generally accepted accounting principles and take into account the factors provided in § 1.280G–1, Q/A 13. For purposes of §§ 280G and 4999 and this revenue procedure, the value of a stock option will not be considered properly determined if the option is valued solely by reference to the spread between the exercise price of the option and the value of the stock at the time of the change in ownership or control.

.02 Payment date. For purposes of this revenue procedure, the valuation date is the payment date as determined in accordance with § 280G. Thus, the valuation of a stock

option is determined based on the spread, the volatility of the underlying stock, the option term, and any other relevant factors as of that date.

.03 Substitution of an option. If, in addition to vesting, there is, contingent on the change in ownership or control, a substitution of an option on different stock for the option, the valuation is based on the substituted option.

.04 Recalculation. Pursuant to § 1.280G–1, Q/A–33, for purposes of §§ 280G and 4999, the payor is permitted to re-determine the value of an option, during the 18-month period beginning on the date of the change in ownership or control (the re-determination period), in accordance with this revenue procedure. Recalculation is permitted if, during the re-determination period, either of the following occurs: (1) there is a change in the term of the option due to a termination of employment, or (2) there is a change in the volatility of the stock.

Without regard to whether the value of the option will be re-determined, an initial determination of the value of the option must be made in accordance with this revenue procedure. This initial valuation is the amount of the payment, subject to adjustment as otherwise applicable ( e.g., pursuant to § 1.280G–1, Q/A–24). This amount is used both to determine whether there are parachute payments and to calculate excess parachute payments and any excise tax liability associated with the transfer of the option.

A recalculation under this revenue procedure must be determined as of the date of payment used in the initial calculation ( i.e., the valuation date). Thus, while the term assumption and the volatility assumption are permitted to be re-determined, the spread and the interest rate assumptions continue to be determined as of the valuation date.

For purposes of re-determining the value of the option, an employer is permitted to use a method other than the method used in making the initial determination, provided that both methods are otherwise permitted under this revenue procedure.

If the value of an option is recalculated under this revenue procedure, parachute payments and excess parachute payments must be recalculated using the re-determined valuation. However, the base

August 25, 2003 399 2003-34 I.R.B.

the portion of the payment that is contingent on the change in ownership is determined under § 1.280G–1, Q/A–24(c). The acceleration of the vesting of a stock option is considered to significantly increase the value of the payment. Therefore, the future value of the payment is assumed to be equal to the payment. Under § 1.280G–1, Q/A–31 and 32, the present value of the option is determined to be $975,000. The vesting of the option has been accelerated by 23 full months. Therefore, the portion of the payment that is contingent on the change in ownership is $373,080, the sum of (1) $121,000 (the amount by which $1,096,000, exceeds $975,000), and (2) $252,080 (23 months times 1% times $1,096,000).

The value of the payment related to the options, $373,080, is taken into account for purposes of determining whether A has received parachute payments and, if so, the portion of the parachute payments that are excess parachute payments. For purposes of this example, assume E is receiving parachute payments and that $50,000 in base amount is allocated to this payment. In that case, $323,080 of the payment is an excess parachute payment, and the excise tax under section 4999 is $64,616. B must satisfy its obligations under section 4999(c) with respect to this amount, and E is responsible for the excise tax related to this payment for E’s 2005 taxable year. B cannot claim the amount of the excess parachute payment as a deduction.

On July 1, 2006, E’s employment is terminated, shortening the term of the option. As a result, the actual term of the option, measured from the date of the change in ownership, is 12 months (the 9 full months that E was employed following the change in ownership plus the 3 months following a termination of employment during which E can exercise the option). B decides to recalculate the value of the options as of the valuation date in accordance with section 3.04 of this revenue procedure, using the value of B stock at the change of ownership, $50, and the exercise price of $25 a share. In addition, B uses the same 5% risk-free assumption rate used in the initial valuation. Finally, B determines that .25 continues to be a reasonable assumption for volatility. The value of the option, as recalculated, is $1,030,000 (or $25.75 a share).

an established securities market (or otherwise), the expected volatility of the underlying stock used for purposes of volatility under this revenue procedure must be the volatility for the most recent year disclosed in the most recent financial statements of the corporation. If the stock is not publicly traded on an established securities market or otherwise, but the stock is required to be registered under the Securities Exchange Act of 1934, the volatility for such stock is assumed to be the same as the volatility for a comparable corporation that is publicly traded. For this purpose, whether a corporation is considered comparable is determined by comparing relevant characteristics such as industry, corporate size, earnings, market capitalization, and debt-equity structure. If the stock is not publicly traded and the corporation is not required to register under the Securities Exchange Act of 1934, the taxpayer must assume medium volatility. If the stock is not required to be registered under the Securities Exchange Act of 1934, but the corporation voluntarily registers its stock and its stock is publicly traded, the corporation must use the volatility of the underlying stock.

.03 Spread between exercise price and spot price. The factor based on the spread between the exercise price and the spot price is calculated by dividing the spot price by the exercise price and subtracting 1. If the stock is not publicly traded, the determination of the spot price for this purpose must be reasonable and consistent with the price, if any, otherwise determined for the stock in connection with the transaction giving rise to the change in ownership or control under § 280G(b)(2)(A). For purposes of determining the factor based on the spread between the exercise price and the spot price under the Table, the resulting percentage may be rounded down to the next lowest interval. If this factor exceeds 220%, this safe harbor valuation method cannot be used to value the stock option.

.04 Term of the option. The term of the option is the number of full months between the valuation date and the latest date on which the option will expire. For purposes of determining the term factor under the table, the number of full months may be rounded down to the next lowest 12-month interval. If the term of the option exceeds 10 years (120 months), then this safe harbor valuation method cannot

be used to value the stock option. If the remaining term of the option is less than 12 months, the taxpayer may round down to the 3-month interval. For purposes of this paragraph, the taxpayer is permitted to use the expected term of the option calculated in accordance with Rev. Proc. 98–34.