Rp 2003-68

Qualified State

Amount Allocated

Alabama

$133,549

California

1,045,289

Connecticut

103,008

Florida

497,496

Indiana

183,335

Kentucky

121,832

Maine

38,532

Maryland

162,471

Massachusetts

191,335

Michigan

299,169

Minnesota

149,421

Mississippi

85,484

Missouri

168,854

Nebraska

51,472

New Hampshire

37,954

Special Industries). For further information regarding this revenue procedure, contact Mr. Wilson at (808) 539–2874 or
Susan Reaman at (202) 622–3040 (not tollfree calls).
26 CFR 601.105: Examination of returns and claims
for refund, credit, or abatement; determination of
correct tax liability.
(Also, Part 1, 280G.)

Rev. Proc. 2003–68
SECTION 1. PURPOSE
This revenue procedure provides guidance on the valuation of stock options
solely for purposes of §§ 280G and 4999
of the Internal Revenue Code.
This
revenue procedure restates and modifies
Revenue Procedure 2002–13, 2002–1 C.B.
549, as modified by Revenue Procedure,
2002–45, 2002–27 I.R.B 40.

New Jersey

255,705

SECTION 2. BACKGROUND

New York

570,257

Ohio

339,974

Oregon

104,824

Section 280G denies a deduction for
any excess parachute payment. Section
4999 imposes a nondeductible 20-percent
excise tax on the recipient of any excess
parachute payment, within the meaning of
§ 280G(b).
An excess parachute payment is defined
in § 280G(b)(1) as an amount equal to
the excess of any parachute payment over
the portion of the disqualified individual’s
base amount that is allocated to such payment.
Section 280G(b)(2)(A) defines a
parachute payment as any payment in
the nature of compensation to (or for the
benefit of) a disqualified individual if (i)
such payment is contingent on a change
in the ownership of a corporation, the
effective control of a corporation, or the
ownership of a substantial portion of the
assets of a corporation (a change in ownership or control), and (ii) the aggregate
present value of the payments in the nature
of compensation which are contingent
on such change equals or exceeds an
amount equal to 3 times the base amount.
A parachute payment also includes any
payment in the nature of compensation
to, or for the benefit of, a disqualified
individual if the payment is pursuant to
an agreement that violates any generally
enforced securities laws or regulations.

Rhode Island

31,842

South Carolina

122,257

Tennessee

172,566

Texas

648,316

Utah

68,947

Vermont

18,354

Virginia

217,105

Washington

180,654

SECTION 4. EFFECTIVE DATE
This revenue procedure is effective
for allocations of housing credit dollar
amounts attributable to the National Pool
component of a qualified state’s housing
credit ceiling for calendar year 2003.
DRAFTING INFORMATION
The principal author of this procedure is
Christopher J. Wilson of the Office of Associate Chief Counsel (Passthroughs and

2003-34 I.R.B.

398

A payment in the nature of compensation for purposes of § 280G includes
the transfer of an option (including an option to which § 421 applies), without regard to whether the option has a readily
ascertainable fair market value within the
meaning of § 83. An option is considered transferred when the option becomes
substantially vested (within the meaning of
§ 1.83–3(b) and (j) of the Income Tax Regulations). Thus, for purposes of § 280G,
stock options must be valued when a payment in the nature of compensation includes the transfer of a stock option, such
as the grant or vesting of a stock option, in
connection with a change in ownership or
control. This revenue procedure provides
guidance on the valuation of a stock option
for this purpose. However, this revenue
procedure does not apply for purposes of
valuing a payment in cash (or property),
even though the amount of the payment
is determined by reference to the cancellation of a stock option.
Pursuant to §1.280G–1, Q/A–13, the
value of an option is determined under all
the facts and circumstances in the particular case. Factors relevant to such a determination include, but are not limited to:
the difference between the option’s exercise price and the value of the property subject to the option at the time of vesting; the
probability of the value of such property
increasing or decreasing; and the length of
the period during which the option can be
exercised. For purposes of Q/A–13, valuation may be determined by any method
prescribed by the Commissioner in published guidance of general applicability.
The determination of when there has
been a change in ownership or control for
purposes of section 280G is made under
§ 1.280G–1, Q/A–27 through Q/A–29.
Section 1.280G–1, Q/A–33, provides
that, to the extent provided in published
guidance of general applicability, an initial estimate of the value of an option is
permitted to be made, with the valuation
subsequently re-determined, and the base
amount reallocated.
Rev. Proc. 98–34, 1998–1 C.B. 983,
provides a methodology for the valuation
of certain stock options for purposes of
gift, estate, and generation-skipping transfer taxes. The methodology described in
Rev. Proc. 98–34 is an option pricing
model that takes into account factors similar to those established by the Financial

August 25, 2003

Accounting Standards Board in Accounting for Stock-Based Compensation, Statement of Financial Accounting Standards
No. 123 (Fin. Accounting Standards Bd.
1995) (FAS 123). The methodology in
Rev. Proc. 98–34 applies only to the valuation of a nonpublicly traded stock option for stock that, on the valuation date,
is publicly traded on an established securities market.
Concurrently with the issuance of proposed regulations under section 280G (see
§ 1.280G–1 of the Proposed Income Tax
Regulations at 67 Fed. Reg. 7630), Rev.
Proc. 2002–13 was issued concerning the
valuation of stock options (including a safe
harbor valuation method) for purposes of
§§ 280G and 4999. Rev. Proc. 2002–45
modified various portions of Rev. Proc.
2002–13.
This revenue procedure restates and further modifies Rev. Proc. 2002–13 and
Rev. Proc. 2002–45 to address additional
issues regarding the valuation of stock options in connection with a change in ownership or control under §§ 280G and 4999.
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

August 25, 2003

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

399

amount does not have to be re-apportioned; instead, the base amount allocated
to the parachute payment is permitted to
remain the same, with any adjustment to
the excise tax made with respect to the
option. This adjustment may be claimed
only by filing an amended return for the
taxable year that includes the payment
date.
SECTION 4. VALUATION SAFE
HARBOR
.01 In general. The safe harbor valuation method provided by this revenue
procedure is based on the Black-Scholes
model and takes into account, as of the
valuation date, the following factors: (1)
the volatility of the underlying stock, (2)
the exercise price of the option, (3) the
value of the stock at the time of the valuation (the “spot price”), and (4) the term
of the option on the valuation date. The
safe harbor value of the option equals (i)
the number of shares covered by the options multiplied by (ii) the spot price of the
stock, and then multiplied by (iii) a valuation factor determined using the factors
described above and reflected in the Table at the end of this revenue procedure.
Other relevant factors, including risk-free
rate of interest and assumptions related to
dividend yields, are included in the Table.
To determine the valuation factor, the taxpayer must determine the volatility, spread,
and option term factors, as described below. To rely on this revenue procedure, assumptions made for purposes of this revenue procedure and the determination of
each factor must be reasonable and consistent with assumptions made with respect to
other options that may be valued in connection with the change in ownership or
control.
.02 Volatility. The taxpayer must determine whether the volatility of the underlying stock is low, medium, or high. If
the valuation is based on a substituted option pursuant to section 3.03, volatility is
determined based on the stock under the
substituted option. For this purpose, a low
volatility stock has an annual standard deviation of 30 percent or less. A medium
volatility stock has an annual standard deviation greater than 30 percent but less than
70 percent. A high volatility stock has an
annual standard deviation of 70 percent or
greater. If the stock is publicly traded on

2003-34 I.R.B.

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

2003-34 I.R.B.

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.
SECTION 5. EXAMPLE
E is an employee of Corporation A, a
publicly traded corporation. On September 1, 2004, in connection with E’s performance of services, A grants E options to
purchase 100,000 shares of A stock at $10
per share. The options are exercisable for
10 years. The options will vest on September 1, 2007, if E continues to be employed
by A through that date, or on a change in
ownership or control, if earlier. Under the
terms of the option, if E’s employment is
terminated after the option is vested, the
option must be exercised on or before the
date that is 3 months after the termination
of employment.
On September 15, 2005, Corporation B
acquires all of the stock of A, and A is
merged into B. Contingent on the change
in ownership, E’s options become fully
vested and are converted into B options
with the same aggregate spread and the
same ratio between the exercise price and
the value of the stock (determined immediately before the conversion). At the time
of the vesting, A stock has a fair market
value of $20, and B stock has a fair market value of $50. Thus, in connection with
the change in ownership, E receives fully
vested options for 40,000 shares of B stock
with an exercise price of $25. The date of
the vesting and substitution is the payment
date and, therefore, the valuation date.
Using a valuation method that complies
with this revenue procedure, B determines
that, as of the valuation date, it is reasonable to assume that the volatility of B stock
is .25, that the remaining expected term
of the option is 36 months, and that the
risk-free interest rate is 5%. B determines
that the value of the option is $1,096,000
(or $27.40 per share).
Without regard to the change in ownership, this payment was contingent only
on continued performance of services for
Corporation A for a specified period of
time and the payment is attributable, in
part, to the performance of services before
the date the payment was made. Therefore,

400

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).

August 25, 2003

This value is then used to re-determine
the portion of the payment that is contingent on the change in ownership under
§ 1.280G–1, Q/A–24(c). This amount is
$350,800, the sum of (1) $113,900 (the
amount by which the value of the payment, $1,030,000, exceeds the present
value of the payment, determined to be
$916,100), and (2) $236,900 (23 times
1% times $1,030,000). Using the base
amount initially allocated to this payment,
$50,000, the portion of the payment that is
an excess parachute payment is $300,800,
and the excise tax is $60,160. E is permitted to file an amended return for 2005
using the revised calculations as a basis
for claiming a refund of $4,456.

SECTION 6. EFFECT ON OTHER
DOCUMENTS

SECTION 8. DRAFTING
INFORMATION

Rev. Proc. 2002–13, 2002–1 C.B. 549,
and Rev. Proc. 2002–45, 2002–27 I.R.B.
40, are revoked as of January 1, 2004.

The principal author of this procedure
is Erinn Madden of the Office of Chief
Counsel of the Division Counsel/Associate Chief Counsel (Tax Exempt and
Government Entities. However, other
personnel from the IRS and Treasury Department participated in its development.
For further information regarding this
revenue procedure, contact Ms. Madden
(202) 622–6030 (not a toll-free call).

SECTION 7. EFFECTIVE DATE
This revenue procedure is effective January 1, 2004. Taxpayers are permitted to
apply this revenue procedure with respect
to a change in ownership or control occurring prior to such date.

TABLE
Term (months)
Volatility
Low

3

12

24

36

48

60

72

84

96

108

120

200%

66.8%

67.3%

67.9%

68.4%

69.0%

69.5%

69.9%

70.3%

70.7%

71.0%

71.2%

180%

64.5%

65.0%

65.7%

66.4%

67.1%

67.7%

68.3%

68.8%

69.3%

69.6%

69.9%

160%

61.8%

62.4%

63.3%

64.1%

65.0%

65.8%

66.5%

67.1%

67.7%

68.1%

68.5%

140%

58.6%

59.4%

60.4%

61.5%

62.5%

63.5%

64.4%

65.1%

65.8%

66.4%

66.9%

120%

54.9%

55.8%

57.1%

58.4%

59.7%

60.9%

62.0%

62.9%

63.7%

64.5%

65.1%

100%

50.4%

51.5%

53.2%

54.8%

56.4%

57.9%

59.1%

60.3%

61.3%

62.2%

63.0%

80%

44.9%

46.3%

48.5%

50.6%

52.6%

54.3%

55.9%

57.3%

58.5%

59.6%

60.5%

60%

38.0%

40.0%

42.9%

45.6%

48.0%

50.1%

52.0%

53.7%

55.2%

56.5%

57.6%

40%

29.3%

32.3%

36.3%

39.7%

42.6%

45.2%

47.4%

49.4%

51.2%

52.7%

54.1%

20%

18.1%

23.3%

28.5%

32.7%

36.2%

39.3%

41.9%

44.3%

46.4%

48.2%

49.9%

0%

6.4%

13.6%

19.9%

24.7%

28.8%

32.3%

35.4%

38.1%

40.5%

42.7%

44.7%

-20%

0.6%

5.4%

11.2%

16.1%

20.4%

24.2%

27.6%

30.6%

33.4%

35.9%

38.1%

-40%

0%

0.9%

4.1%

7.9%

11.6%

15.2%

18.5%

21.7%

24.6%

27.3%

29.9%

-60%

0%

0.0%

0.6%

2.0%

4.0%

6.4%

9.0%

11.6%

14.3%

16.8%

19.3%

Spread Factor*

August 25, 2003

401

2003-34 I.R.B.

Term (months)

3

12

24

36

48

60

72

84

96

108

120

Volatility

Spread Factor*

Medium

200%

66.8%

67.4%

68.6%

69.9%

71.1%

72.2%

73.1%

73.9%

74.5%

75.0%

75.4%

180%

64.5%

65.2%

66.7%

68.2%

69.6%

70.9%

71.9%

72.8%

73.5%

74.1%

74.6%

160%

61.8%

62.7%

64.5%

66.3%

68.0%

69.4%

70.6%

71.6%

72.5%

73.2%

73.7%

140%

58.6%

59.8%

62.0%

64.2%

66.1%

67.7%

69.1%

70.3%

71.2%

72.0%

72.7%

120%

54.9%

56.4%

59.2%

61.7%

63.9%

65.8%

67.4%

68.8%

69.9%

70.8%

71.6%

100%

50.4%

52.5%

55.9%

58.9%

61.5%

63.7%

65.5%

67.0%

68.3%

69.4%

70.3%

80%

44.9%

47.9%

52.2%

55.7%

58.7%

61.2%

63.2%

65.0%

66.5%

67.7%

68.8%

60%

38.2%

42.6%

47.8%

52.0%

55.4%

58.3%

60.6%

62.7%

64.3%

65.8%

67.0%

40%

30.0%

36.3%

42.7%

47.6%

51.6%

54.8%

57.6%

59.9%

61.8%

63.5%

64.9%

20%

20.3%

29.1%

36.8%

42.5%

47.0%

50.8%

53.9%

56.5%

58.8%

60.7%

62.3%

0%

10.4%

21.2%

30.0%

36.4%

41.6%

45.8%

49.4%

52.4%

55.0%

57.2%

59.1%

-20%

3.0%

13.0%

22.2%

29.2%

34.9%

39.7%

43.7%

47.2%

50.2%

52.8%

55.0%

-40%

0.3%

5.7%

13.8%

20.8%

26.8%

32.0%

36.4%

40.4%

43.8%

46.8%

49.5%

-60%

0%

1.2%

5.9%

11.4%

16.9%

22.1%

26.7%

31.0%

34.8%

38.3%

41.4%

200%

66.8%

68.1%

70.7%

73.1%

75.0%

76.6%

77.8%

78.8%

79.5%

80.0%

80.4%

180%

64.5%

66.1%

69.1%

71.7%

73.9%

75.6%

77.0%

78.1%

78.9%

79.5%

79.9%

160%

61.8%

63.8%

67.3%

70.3%

72.7%

74.6%

76.1%

77.3%

78.2%

78.9%

79.4%

140%

58.6%

61.3%

65.3%

68.6%

71.3%

73.4%

75.1%

76.4%

77.4%

78.2%

78.8%

120%

54.9%

58.3%

63.0%

66.8%

69.7%

72.1%

73.9%

75.4%

76.6%

77.4%

78.1%

100%

50.6%

55.0%

60.4%

64.6%

67.9%

70.6%

72.6%

74.3%

75.6%

76.6%

77.3%

80%

45.3%

51.1%

57.4%

62.2%

65.9%

68.8%

71.1%

73.0%

74.4%

75.6%

76.5%

60%

39.1%

46.6%

54.0%

59.4%

63.5%

66.8%

69.4%

71.4%

73.1%

74.4%

75.4%

40%

31.7%

41.4%

50.0%

56.1%

60.7%

64.4%

67.3%

69.6%

71.5%

73.0%

74.2%

20%

23.2%

35.4%

45.3%

52.1%

57.4%

61.5%

64.8%

67.4%

69.6%

71.3%

72.7%

0%

14.3%

28.5%

39.6%

47.4%

53.3%

57.9%

61.6%

64.7%

67.1%

69.1%

70.8%

-20%

6.4%

20.8%

32.9%

41.5%

48.1%

53.4%

57.6%

61.1%

64.0%

66.4%

68.3%

-40%

1.5%

12.7%

24.8%

34.0%

41.4%

47.3%

52.2%

56.3%

59.7%

62.5%

64.8%

-60%

0.1%

5.2%

15.2%

24.3%

32.1%

38.8%

44.4%

49.1%

53.2%

56.6%

59.5%

High

*Spot (market) Price/Exercise Price — 1 or (S/X–1)

2003-34 I.R.B.

402

August 25, 2003