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Option Valuation
- Avoiding the "Cheap Stock" Trap
Many companies reward their
employees with stock options or bonus shares, which are taxable as income
to employees. Should there be a perceived understatement of value, the
IRS will assess the employee additional income tax and penalties. To
avoid placing employees in this potential "cheap stock" trap,
a valuation by an independent third party is recommended.
The marketplace sets the
value of publicly traded stock, and the value of options to buy this
stock can be readily calculated. However, if the company is closely
held, or non-publicly traded, stock compensation poses an interesting
valuation issue. The options or bonus shares must be valued in two steps:
1) value the stock underlying the options and 2) value the options themselves.
First, the company's value determines the value of its stock. Depending
on the situation, several methods might be appropriate for determining
a business' fair market value. If public information is available on
sales of similar private companies, these sales may help determine the
subject company's value. Or, the company may be valued based on its
ability to generate cash flow in excess of working capital requirements.
Simply put, projected cash flows are discounted back to the present
at a rate equal to the company's weighted average cost of capital (WACC)
to yield the company's business enterprise value. Interest-bearing debt
is then subtracted from the business enterprise value to yield the value
of the company's equity.
It is often appropriate to discount the indicated value of the stock
underlying the options for various reasons. For instance, non-publicly
traded stock should be discounted for lack of marketability. In situations
in which SEC Rule 144 applies, the beneficiary is restricted from selling
his shares until at least two years from the date of full payment. This
restriction also makes a discount appropriate.
Second, the value of stock
options is a function of many variables. These variables include the
value of the stock itself, the options' exercise price, the restrictions
on the exercise of the options, the stock's volatility, the risk-free
rate of return, and the potential dilution of equity if options are
exercised. Selection of the appropriate stock option valuation model
is critical. The Black-Scholes, Noreen-Wolfson, Kassouf, or other models
may be applicable in any given situation.
Another factor to consider is whether the options are part of a qualified
stock option plan. In nonqualified plans, options are taxed at the date
of issuance, and in qualified plans, options are taxed at the date of
exercise. The valuation date should be chosen accordingly.
The professionals at Adams Capital have the experience and credentials
to make defensible assertions on the value of any type of stock option
or bonus. These valuations are complex problems requiring critical decisions
by experts. Every situation is unique, so every valuation should be
treated with a fresh perspective using the latest market data. We use
the latest data and information technology to ensure that our opinions
are fair and accurate. If we can answer any questions about stock options
or bonus share valuation, please contact us.
 Courts
Affirm Cost Recovery - Significant Tax Savings for Real Property
Cost
recovery studies are conducted to allow real property owners to accelerate
depreciation for newly purchased or constructed real property, thereby
increasing cash flow and maximizing owners' wealth. A cost recovery
study separates the cost of carpet, window treatments, wiring and other
items, and allows such shortlife property accelerated depreciation over
5, 7, or 15 years instead of 39 years.
The benefits can be significant
as shown in Figure 1 - Typical Cost Recovery Savings (see below). In
nearly all cases, the taxpayer will recover fees and expenses for the
study on the first year's tax return. Total MACRS savings for taxpayers
are often as much as 50 times the investment for a cost recovery study.
The recent HCA1 ruling affirms that cost recovery is appropriate.
HCA declared portions of its facilities to be tangible personal property
(TPP) for purposes of MACRS depreciation, and the Court ruled in HCA's
favor in all but a few instances. In one of those instances, the Court
agreed with HCA's position, but HCA had not given sufficient information
to support the particular claim at issue.
The ruling underscores the need
for specificity and detail in documenting claims supporting MACRS TPP
claims. For instance, despite the fact that wire and conduit in general
are structural components of a building, an electrical circuit and associated
hardware can be considered TPP if they are used for a qualified purpose
(i.e., to supply power to equipment that is TPP). HCA had claimed that
outlets in laboratories and maintenance shops were TPP. The Court disallowed
this claim. To support such a claim, a taxpayer must state a specific
use for the circuit. It means nothing that an outlet is located in a
laboratory, but if it is specifically used to supply power to a centrifuge
that is TPP, and stated as such, the outlet and the associated circuit
are also TPP.
The Court also confirmed a broad construction of the extension of TPP
to associated supply systems, first expressed in Morrison v. Commissioner2.
The HCA ruling specifically states that the portion of the electrical
distribution system considered to be TPP is not only the secondary circuit
directly connected to the equipment in question, but also extends back
to the primary electrical system in the proportion to which it is loaded
by the specific equipment that is TPP.
We interpret this finding to mean that the cost of taxpayer-owned electrical
equipment back as far as the connection to the electrical utility grid
may be rapidly depreciated in the proportion to which it is loaded by
TPP.
The Court ruled likewise with respect to other building systems. HCA
claimed that a boiler was TPP because a portion of its output was used
to heat a dishwasher. The IRS position was that the boiler was a structural
component of the building because it provided heat that was necessary
to operate and maintain the building. The Court held that the boiler,
like the electrical distribution system, was TPP in the proportion that
it is loaded by qualified TPP. HCA had no evidence to show in what proportion
the dishwasher and other TPP loaded the boiler, so the Court disallowed
all claims related to the boiler.
As might be expected, the Court upheld HCA's classification of carpet
as TPP. The Court also upheld HCA's TPP classification of vinyl wall
coverings, roll and seamless vinyl floor coverings, and even standard
12-inch square vinyl floor tiles. HCA had claimed that some of the wall
coverings and seamless vinyl floor coverings were hospital-specific
in design and usage, and thus were rightfully considered TPP, but since
the Court also allowed standard vinyl floor tiles, the hospital-specific
design and application of these components is apparently irrelevant.
The Court ruled against HCA on some issues. HCA claimed that certain
overbed lights were useful only for examination of patients by medical
personnel and convenient for patient use, and, as such, were not structural.
The Court found that HCA intended these lights to be permanent and that
their removal would compromise the structural integrity of the building.
The Court also disallowed the classification of suspended acoustical
ceilings as TPP. HCA seemed to have a fairly strong claim that acoustical
tile ceilings are necessary in the hospital business, because they prevent
dust and debris from falling off overhead pipes, ducts, etc. onto patients.
The Court, however, found that the ceilings were necessary for the operation
and maintenance of the building, and thus were structural.
HCA had claimed that easily removable hardware such as grab bars, mirrors,
shower curtain rods, and toiletry shelves in the patient bathrooms was
TPP. The Court found that HCA installed these items with no intention
of moving them before the end of their useful life, and that the items
were more than incidental to the operation of the building, so therefore
the hardware was structural in nature and not TPP.
As this discussion makes clear, a meaningful and effective cost recovery
study is beyond the scope of accounting alone. At Adams Capital, we
are qualified to produce cost recovery reports that will withstand scrutiny.
Specifically, we have the engineering qualifications to determine mechanical
and electrical system loading and allocate costs accordingly, and the
accounting and financial knowledge to ensure appropriate tax treatment
of cost recovery property.
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