Nonqualified stock options and the research credit.

• Author: Yasukochi, David K.

In Apple Computer, 98 TC No. 18 (1992), the Tax Court determined that the "spread" on nonqualified stock options (NQOs) at exercise (i.e., the difference between the fair market value of the stock at the exercise date over the exercise price) qualified as "wages paid or incurred to an employee" for purposes of claiming the research activities credit under Sec. 44F (now Sec. 41). In ruling for Apple, the court refused to stray from the statutory definition of wages. Sec. 44F(b)(2)(D)(i) (and present day Sec. 41(b)(2)(D)(i))states that such term "has the same meaning given such term by section 3401(a)," which defines wages for Federal income tax withholding purposes. If Congress again extends the research activities credit in substantially the same form the Apple Computer decision presents many interesting planning opportunities to companies that use NQOs to compensate employees performing qualifying research.

Under Apple Computer, the use of NQOs by a growing company presents a tremendous opportunity to leverage the tax savings generated by the research credit. Future appreciation in the underlying stock may generate qualifying research expenses far in excess of that which may be obtained through current cash compensation. The flip side is that marginal stock appreciation may generate insignificant qualifying expenses. In addition, growing companies may find that the increasing gross receipts generated in future years will deprive them of some of the benefits of the stock appreciation, since increased gross receipts will increase their base amount in future tax years when the NQOs are exercised.

Many companies have trouble generating a significant research credit because their research activities remain relatively stable over the years, resulting in little incremental increase in expenditures. Companies may wish to use NQOs to "load up" on their qualifying expenses in a designated year; i.e., they can encourage the acceptance of NQOs in lieu of current cash compensation and maximize the number of options to be exercised in a single year by timing the vesting and exercise period of these options to coincide in one year. This would maximize one year's qualifying wages and, hence, maximize the credit. None of the proposals introduced in Congress to extend the credit would change the base period used to determine the "fixed-base percentage" (i.e., tax years beginning after Dec. 31, 1983 and before Jan. 1, 1989 as prescribed under Sec...