7553 / What is the tax on disposition of stock acquired pursuant to the exercise of an incentive stock option if the requisite holding periods are not met?

1. Any gain that is compensation attributable to the exercise of the option will be taxed as ordinary income (and the employer will have a corresponding deduction) in the year the disposition occurs. “Compensation attributable to the exercise of the option” means the excess of the fair market value of the stock on the date the option was exercised over the amount paid for the share at the time of exercise. The employee’s basis in the stock is then increased by the amount included as income.¹
2. Any gain in excess of compensation attributable to the exercise of the option will be treated as capital gain. See Q 702 for the treatment of capital gains and losses.²

If, in a disqualifying disposition, the employee recognizes a loss, then the compensation income attributable to exercise of the option will be limited to the excess of the amount realized on disposition over the adjusted basis of the stock (i.e., generally the amount paid to exercise the option). This rule applies only to transactions in which loss would otherwise be allowable; it does not apply, for example, to losses on related party sales or wash sales. Thus, in the event that the disqualifying disposition is a related party sale, wash sale, or other transaction on which loss would be disallowed, the transferor will be required to recognize gain in the amount of the excess of the fair market value of the stock at the time the option was exercised over the option price. The income includable as a result of such a disposition will generally be treated as compensation.³

It has been determined that where stock acquired through the exercise of an incentive stock option is transferred to a charitable remainder trust before the one-year holding period is up, the transfer will be treated as if a loss on a related party sale occurred. Thus, the transferor must include in gross income in the year of transfer the difference between the fair market value of the stock at the date the option was exercised over the option price.⁴

In 2002, the Service announced an exception from reporting on Form 1099-B for transactions involving an employee, former employee, or other service provider who has obtained a stock option. Where the employee purchases stock through the exercise of the stock option, and then sells that stock on the same day through a broker, the broker executing such a sale is not required to report the sale on Form 1099-B provided certain conditions are met.⁵

Example 1: On June 1, 2024, CB Corporation grants an incentive stock option to Mr. Stephens, an employee of CB Corporation, entitling him to purchase one share of CB stock for $100, its fair market value on that date. Mr. Stephens exercises the option on August 1, 2024, and the stock is transferred to him the same day. Its fair market value on the date of exercise is $125. In order to meet the holding period requirements of IRC Section 422(a)(1), Mr. Stephens must not dispose of the stock before June 1, 2026. But Mr. Stephens transfers the stock on September 1, 2024, for $150 (the stock is transferable and not subject to a substantial risk of forfeiture). The amount of compensation attributable to Mr. Stephens’ exercise of the option will be $25 (the excess of the fair market value on the date of exercise over the exercise price). On his 2024 return, as a result of the disposition of the stock, Mr. Stephens’ will include $25 as compensation income and $25 as capital gain income. CB Corporation will be permitted a deduction of $25 for compensation attributable to Mr. Stephens’ exercise of the option (assuming that no capital expenditure is involved). If Mr. Stephens sold the stock in 2025 instead of 2024, he would include the $25 compensation income and the $25 capital gain as income on his 2025 return.

Example 2: Assume the same facts as example (1), except that instead of selling the stock on September 1, 2024, for $150, Mr. Stephens sells it for $75. The rule in IRC Section 422(c)(2) applies to limit the amount of income attributable to the exercise of the option to the excess (if any) of the sale price ($75) over the adjusted basis of the stock ($100). Mr. Stephens will not be required to recognize any compensation income, and he will be permitted a capital loss of $25 (the adjusted basis of the share minus the amount realized on the sale). CB Corporation will not be permitted any deduction for compensation attributable to Mr. Stephens’ exercise of the option. If Mr. Stephens had, instead, sold the stock for $115, he would realize compensation income of $15 (the sale price minus his adjusted basis), but he would realize no capital gain income since the sale price was less than the amount that was the fair market value of the stock on the date he exercised the option.

Example 3: Assume the same facts as example (2), except that the sale on September 1, 2024, is to Mr. Stephens’ daughter, Janice. Under the related party sale rules of IRC Section 267, no loss sustained on such a sale may be recognized. Thus, Mr. Stephens must recognize compensation income of $25 (the excess of the fair market value on the date of exercise over the exercise price) and will not recognize a capital gain or loss on the transaction. CB Corporation will be permitted a deduction of $25 for compensation attributable to Mr. Stephens’ exercise of the option, provided certain withholding requirements are met.