7554 / What is the tax effect of modification, renewal, or extension of an incentive stock option?
“Modification” generally means any change in the terms of the option that gives the employee additional benefits under the option. For example, a change that shortens the period during which the option is exercisable is not a modification. However, a change that provides more favorable terms for the payment for the stock purchased under the option is a modification. A change in the number of shares subject to the option will not be considered a modification of the existing option, but it will constitute the grant of a new option with respect to the additional shares. A change in the number or price of shares of stock subject to an option merely to reflect a stock dividend or stock split-up is not a modification of the option.2
The IRC states that the following changes in the terms of an option will not be considered a “modification”: (i) changes attributable to certain corporate reorganizations and liquidations; and (ii) in the case of an option not immediately exercisable in full, changes that accelerate the time at which the option may be exercised.3 For examples of reorganizations that did not result in modifications of options, see Letter Rulings 9810024 and 9849002.
The Service has privately ruled that a downward adjustment to the exercise price of a company’s outstanding stock options, made to reflect a return of capital to the company’s shareholders, was a “corporate transaction,” and not a modification, extension, or renewal of those options.4 A company’s failure to adjust options to reflect a reverse stock split did not result in a modification.5