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The Treatment of Stock Options Under the Fair Labor Standards Act
Rarely does a Department of Labor (DOL) opinion letter excite the passions as much as the Wage and Hour Division's letter of February 12, 1999 has done. In its opinion letter to an unnamed employer, the DOL expressed the view that the "profit" an employee derives from the employer's stock option plan constitutes an element of his "regular rate" of pay for purposes of calculating overtime pay under the Fair Labor Standards Act (FLSA). The consequence of the DOL's position would be to retroactively increase the rate of an employee's overtime pay as well as the employer's overall cost of maintaining a stock option plan, making such plans less desirable as a benefit for non-management employees. This could put brakes on the current trend, particularly among high tech and start-up employers, to make stock options an integral part of the overall compensation package offered to all levels of employees. However, it now appears that legislative relief, which the DOL supports, may be on the way.
Little was known about the February 1999 ruling until late in 1999, but it has already gotten the attention of at least two Congressmen and a number of industry groups, all of whom are pressuring the DOL to reconsider. In a follow-up letter (January 11, 2000) to LPA, Inc., an advocacy group representing employer interests, the DOL declined to reconsider its position in the particular case described in the letter of February 1999, but left some hope that not all stock option plans will be subject to the same requirements.
The FLSA provides that a non-exempt employee must be paid one and one-half times his "regular rate" of pay for work in excess of 40 hours in any workweek. 29 USCA §207(a). For this purpose, "regular rate" is defined as all remuneration paid by an employer to an employee, with a few exceptions, such as amounts paid to non-exempt employees
- as gifts,
- for periods when no work is due (e.g., pay for holidays, vacation),
- as occasional discretionary bonuses,
- from a profit-sharing plan, thrift or savings plan, to the extent that such payments are not based on hours of work or production,
- as extra compensation paid at a premium rate of pay (e.g., nights shift differential, Sabbath, holiday pay).
29 USCA §207(e).
In the DOL opinion letter, an employer proposed to offer each of its full-time employees options to purchase 100 shares of employer stock. The exercise price of the options was established as of a specified date and the option period was fixed for five years from the date of option grant. Employees could exercise their options as of the earlier of the second anniversary of the date of option grant or immediately upon the stock being traded at or over a specified price for a specific number of days. The exercise is by the "cashless" exercise method (i.e., the employer "lends" the employee the money necessary to purchase the stock at the exercise price). Unexercised options would expire at the end of five-years and would be canceled upon an employee's termination of employment with the program's sponsor. An employee's "profit" under this arrangement, according to the DOL, would be the difference, or spread, between the exercise price and the price of the stock at the time his options are exercised.
Upon review of the terms of the arrangement, the DOL concluded that the option program did not fit within any of the categories of remuneration not considered in determining an employee's regular rate of pay, that is, it was neither a gift, nor a discretionary bonus nor a profit-sharing or thrift savings plan. Therefore, the agency found that a non-exempt employee's profit on the exercise of an option must be allocated to his regular rate of pay, retroactively over the option period, but not beyond the applicable two-year (104 workweeks) statute of limitations. Any overtime worked by the employee during the retroactive period would have to be recalculated and the difference paid to the employee.
Example: Let's assume that an employee makes $10 an hour (i.e., his regular rate of pay), which means that the employer must pay him $15 an hour for overtime pursuant to the FLSA. The employer offers the employee an option to purchase 100 shares of employer stock at $30 per share at any time during the next five years. In the twentieth week of the option period, the employee exercises his option and purchases all shares when the stock is selling for $50 per share. The employee's "profit" is $2000 ($50 - $30 x 100). This amount must be allocated to his regular rate of pay for the twenty-week option period. Thus, in each week of the option period, the employee's regular pay is deemed to have been increased by $2.50 per hour ($2000 ÷ 20 weeks = $100 ÷ 40 hours), and his overtime rate of pay is, therefore, increased to $18.75 ($10.00 + $2.50 x 1.5) per hour. If the employee worked 20 hours of overtime during the twenty-week option period, the employer paid him at a rate of $15.00 per hour, but would now owe the employee $75.00 additional compensation ($18.75 - 15.00 x 20 hours) after the exercise of his options.
The DOL's January 11th response to LPA, Inc., states that the opinion was based exclusively on the facts and circumstances presented by the employer who requested it, and, therefore, the DOL's guidance is to be limited to those facts and circumstances. Without further explanation, the DOL indicated that, "as with profit-sharing plans, discretionary bonuses, and gifts, there are circumstances under which stock option programs would not need to be included when calculating overtime...The February 12, 1999 letter does not state, nor was it intended to suggest, that all stock option programs would be treated in the same manner." Many of the elements of the stock option plan described in the opinion letter are common to most stock option plans, so it is not clear what latitude is being offered by the DOL. It may be that the DOL is buying itself some time to formulate a more flexible policy. Or, it may be that the DOL is feeling the heat. House Majority Leader, Dick Armey (R-Texas) has asked Labor Secretary Alexis Herman to clarify the Administration's position on whether employers must begin following the February 1999 opinion letter. BNA Pension & Benefits Daily, January 24, 2000. Congressman John Boehner (R-Ohio), who has sponsored his own legislation (discussed below) to encourage the availability of broad-based stock option plans, has also been critical of the opinion letter, stating that, "If this federal ruling were ever to be implemented, the only people in America receiving stock options ultimately would be senior executives." Boehner press release, January 12, 2000.
Boehner Bill: Congressman Boehner's bill (H.R. 3462) would create a new form of stock option plan that, subject to certain requirements to ensure broad-based participation by non-highly compensated employees, would allow employees to defer taxation on their stock option until the stock acquired by the exercise of such option is disposed of, and permit the employer to deduct the value of the stock option upon the employee's exercise of the option. Under present law, these two desirable tax results are not available in single option form. Currently:
employees are not taxed on grants of incentive stock options (ISOs) and are taxed only when they dispose of the stock acquired by the exercise of an ISO, but no deduction is available for employers upon the grant or exercise of ISOs;
employees are generally taxable on non-qualified stock options (NQSO) when the NQSO is exercised and employers receive a commensurate deduction at that point.
Congressman Boehner's bill is likely to have its intended result of expanding stock option plans to employees at all levels of an organization, but it is too early to tell if the bill has any support in Congress.
On March 2, 2000, a subcommittee of the House of Representatives Committee on Education and the Workforce held hearings to consider whether corrective legislation was necessary. T. Michael Kerr, the Administrator of the Wage and Hour Division of the Employment Standards Administration of the DOL, indicated that his agency had considered the extent to which stock option programs fit within the existing exceptions of the FLSA, whether DOL regulations might be modified to address stock options and whether legislation could correct the problem. His recommendation to the subcommittee was to amend the FLSA to provide for a specific exclusion from overtime calculations for bona fide stock option programs. He also reiterated the DOL's position that it does not want to discourage employers from offering such programs to all employees.
Based on Mr. Kerr's positive comments, we would encourage clients who currently maintain stock option programs in which non-exempt employees participate to do nothing at present to disrupt their programs. If you maintain such a program and are not currently including participants' stock option "profits" as part of their regular rate of pay, you should keep careful overtime records in the event that the DOL determines that adjustments must be made.
Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
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