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?
If exercise of an incentive stock option would otherwise qualify as a nontaxable event except that the one-year or two-year holding requirement is not met (i.e., there is a disqualifying disposition), the employee’s gain (if any) on the disposition will be treated as follows:
- 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
- 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