Stock Options

<div class="Section1">The 2017 tax reform legislation created a new IRC Section&nbsp;83(i) that changes the rules that govern certain stock options and restricted stock units (RSUs) that are granted to employees.<a href="#_ftn1" name="_ftnref1">¹</a> Under the 2017 tax reform legislation, employees are now permitted to defer gain on these benefits for up to five years.<div class="Section1"><br /> <br /> Generally, IRC Section&nbsp;83(a) requires that, when a taxpayer receives property in exchange for services, the value of the property is taxable when it becomes transferrable or when it is vested (basically, when it is no longer subject to a substantial risk of forfeiture). As a result, when an employee receives an equity grant, appreciation on the stock can be taxed at ordinary income tax rates during the time between granting and vesting. Section&nbsp;83(b) allows taxpayers to make an irrevocable election to pay income taxes on the unvested stock at its fair market value on the date of transfer (so that subsequent appreciation is taxed at capital gains rates). However, many employees who receive equity grants do not have the funds to make this election and cover the tax liability, especially with respect to companies where the stock is not readily tradeable (i.e., the employee cannot sell the stock to help pay the taxes).<br /> <br /> IRC Section&nbsp;83(i) allows employees who receive these specific types of equity grants to elect to defer taxation for five years after the stock vests.<br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> Essentially, this can be helpful to employees when the stock that will be transferred to them is not readily tradeable, making it potentially difficult to pay the associated taxes immediately.<br /> <br /> <hr><br /> <br /> The election must be made within 30 days after the date upon which the employee&rsquo;s rights in the stock are transferable or are no longer subject to a substantial risk of forfeiture (whichever is earlier).&nbsp;The election must be filed with the IRS and the employee must also provide a copy to the employer.<a href="#_ftn2" name="_ftnref2">²</a>&nbsp;The employer is required to provide notice of the potential to defer income to the employee receiving the grant. If a deferral election is made with respect to an incentive stock option, that option is treated as a nonqualified stock option for FICA tax purposes.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> Only income taxes are deferred during the deferral period. Employment taxes (Social Security and Medicare taxes) still must be paid.<br /> <br /> <hr><br /> <br /> At the end of the deferral period, the employee recognizes income based upon the value of the stock on the vesting date (regardless of whether the value has decreased during the deferral period).<br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> While the eventual tax paid is based on the value of the stock at vesting, the holding period for long-term capital gains treatment will begin to run during the deferral period.&nbsp;Therefore, if the stock value increases during the deferral period, ordinary income tax rates will only apply to the stock value at the start of the deferral period.&nbsp;The remainder will be taxed at the lower long-term capital gains rates if the stock is not sold for at least one year.<br /> <br /> <hr><br /> <br /> Income must be recognized for the first taxable year that includes one of the following (1) the first date the qualified stock becomes transferable (including transferable to the employer), (2) the date the employee becomes an &ldquo;excluded employee,&rdquo; (3) the date on which any of the stock becomes readily tradeable on an established securities market, (4) five years after the first date the employee&rsquo;s right to the stock becomes substantially vested or (5) the date upon which the employee revokes the deferral election.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> Under the rules that have been provided thus far, it does not appear that termination of employment with the employer will cause the deferral period to end.<br /> <br /> <hr><br /> <br /> &ldquo;Excluded employees&rdquo; include any individual (1) who was a one-percent owner of the corporation at any time during the 10 previous calendar years, (2) who is, or has ever been, CEO or CFO of the company (or has acted in that capacity), (3) who is a family member of an individual described in (1) or (2), or (4) who has been one of the four most highly compensated officers of the company for any of the 10 previous tax years.<a href="#_ftn5" name="_ftnref5">⁵</a> Employees must also agree to an escrow provision in order to take advantage of the new deferral option. All deferral stock must be held in an escrow arrangement established by the employer to qualify.<a href="#_ftn6" name="_ftnref6">⁶</a><br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> Failure to establish an escrow account to hold the deferral stock provides employers with the option to compensate employees with stock, but preclude them from making the new Section&nbsp;83(i) election.&nbsp;The terms of the stock option or RSU can also provide that no Section&nbsp;83(i) election will be available.<br /> <br /> <hr><br /> <br /> The election is only available with respect to qualified stock, which means stock in an employee&rsquo;s employer that is (1) received in connection with the exercise of an option or in settlement of an RSU and (2) granted in connection with services that are being performed by the employee.&nbsp;The stock will no longer be qualified if the employee may sell the stock, or otherwise receive cash in lieu of the stock from, the corporation.<a href="#_ftn7" name="_ftnref7">⁷</a><br /> <br /> To issue equity grants that qualify for the Section&nbsp;83(i) deferral election, the employer must be a private company that has a written plan in place stating that at least 80 percent of the employer&rsquo;s full-time U.S. employees will be granted stock options or RSUs on substantially the same terms.&nbsp;The number of shares granted to each employee need not be equal, so long as each employee is entitled to a more than de minimis amount. Rights and privileges with respect to the exercise of a stock option are not treated for this purpose as the same as rights and privileges with respect to the settlement of an RSU.<a href="#_ftn8" name="_ftnref8">⁸</a><br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong>&nbsp;The IRS has released guidance clarifying that this 80 percent requirement is based only on stock options or RSUs granted in a particular calendar year. Further, the employer is required to take the total number of employees employed at any time during the year into account in calculating the 80 percent requirement, as well as all of the employees receiving grants, regardless of whether the person was employed at the beginning or the end of the year in question.<a href="#_ftn9" name="_ftnref9">⁹</a><br /> <br /> <hr><br /> <br /> All related entities are considered in determining whether the 80 percent requirement is satisfied.&nbsp;The definition of controlled group under IRC Section&nbsp;414(b) applies for purposes of determining corporations that are members of a controlled group (and are thus treated as a single corporation).<a href="#_ftn10" name="_ftnref10">¹⁰</a> Further, only corporations that make grants to employees are eligible under this provision (LLCs that elect partnership taxation are excluded).<br /> <br /> The election is not available if the company has repurchased any of its stock in the past year, unless at least 25 percent of the stock repurchased is stock that has been deferred under Section&nbsp;83(i) elections (and determination of which employees to repurchase the stock from is made on a reasonable basis). <a href="#_ftn11" name="_ftnref11">¹¹</a>If the company repurchases all Section&nbsp;83(i) stock, the 25 percent requirement and reasonable basis requirement are deemed to have been satisfied.<a href="#_ftn12" name="_ftnref12">¹²</a><br /> <br /> A transition rule provided that a corporation will be deemed to comply with this &ldquo;80 percent&rdquo; restriction if it complies with a reasonable good faith interpretation of the rules. Further, an employer will be treated as satisfying the notice requirements restriction if it complies with a reasonable good faith interpretation of the rules.&nbsp;This transition relief will apply until the IRS releases regulations or other guidance on the 80 percent rule and notice requirements (employers are now required to comply with the rules for calculating the 80 percent rule found in Notice 2018-97).<a href="#_ftn13" name="_ftnref13">¹³</a><br /> <br /> If the Section&nbsp;83(i) election is made, RSUs are not eligible for the IRC Section&nbsp;83(b) election. Further, qualified stock will not be treated as a nonqualified deferred compensation plan for Section&nbsp;409A purposes, but only with respect to employees who may receive qualified stock.<br /> <br /> <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a> for a discussion of the notice and reporting requirements that apply with respect to the deferral election.<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp; IRC &sect;&nbsp;83(i)(2).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp; IRC &sect;&nbsp;83(i)(4). Making this election is similar to making the Section&nbsp;83(b) election.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp; IRC &sect;&nbsp;83(i)(1)(B).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp;&nbsp; IRC &sect;&nbsp;83(i)(1)(B). Revocation of a deferral election will be as established by the Secretary.<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp;&nbsp; IRC &sect;&nbsp;83(i)(3)(B).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp;&nbsp; Notice 2018-97.<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp;&nbsp; IRC &sect;&nbsp;83(i)(2)(B).<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>.&nbsp;&nbsp; IRC &sect;&nbsp;83(i)(2)(C).<br /> <br /> <a href="#_ftnref9" name="_ftn9">9</a>.&nbsp;&nbsp; Notice 2018-97.<br /> <br /> <a href="#_ftnref10" name="_ftn10">10</a>.&nbsp;&nbsp; IRC &sect;&nbsp;83(i)(5).<br /> <br /> <a href="#_ftnref11" name="_ftn11">11</a>.&nbsp;&nbsp; IRC &sect;&nbsp;83(i)(4)(B)(iii).<br /> <br /> <a href="#_ftnref12" name="_ftn12">12</a>.&nbsp;&nbsp; IRC &sect;&nbsp;83I(i)(4)(C)(iii).<br /> <br /> <a href="#_ftnref13" name="_ftn13">13</a>.&nbsp;&nbsp; IRC &sect;&nbsp;83(i)(7)(g).<br /> <br /> </div></div><br />

<div class="Section1">The term “wages” excludes remuneration received on account of the following: (1) a transfer of a share of stock to any individual pursuant to an exercise of an incentive stock option; or (2) any disposition by the individual of such stock. The exclusion applies to stock acquired pursuant to options exercised after October 22, 2004.<a href="#_ftn1" name="_ftnref1">¹</a></div><br /> <div class="Section1"><br /> <br /> Proposed regulations had provided that an individual exercising an incentive stock option would receive wages for FICA and FUTA purposes. However, in 2002, the IRS announced that until further guidance was issued, the Service would not assess the FICA or FUTA tax, or apply federal income tax withholding obligations, upon the exercise of the option or upon the disposition of the stock acquired by an employee pursuant to the exercise of an option.<a href="#_ftn2" name="_ftnref2">²</a> In AJCA 2004, Congress codified the exclusionary rule, above.<br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC § 3121(a)(22); Act § 251(d), AJCA 2004.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.   REG-142686-01, 66 Fed. Reg. 57023 (11-14-2001); Notice 2002-47, 2002-2 CB 97. <em><em>See also</em></em> Notice 2001-72, 2001-2 CB 548, Notice 2001-73, 2001-2 CB 549.<br /> <br /> </div>

<div class="Section1">If the transfer of stock to an individual upon exercise of an incentive stock option was a <em>qualifying transfer</em> (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7546">7546</a>), then no taxable event occurs until the stock is disposed of.<a href="#_ftn1" name="_ftnref1">¹</a> At the time of disposition, the general rules for treatment of a sale of stock will apply; thus, the taxpayer will recognize capital gain or loss to the extent of the difference between the sale price of the stock and its adjusted basis. <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7517">7517</a> regarding the sale of stock, and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a> for an explanation of the treatment of capital gains and losses.<div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp; IRC &sect;&nbsp;421(a).<br /> <br /> </div></div><br />

<div class="Section1">Under long-standing rules (the status of which, as discussed below, is not clear), the tax treatment provided for incentive stock options has been available for the combination of an incentive stock option (ISO) and a stock appreciation right (SAR) even though the right to exercise one affects the right to exercise the other, provided the SAR, by its terms, meets certain requirements:<br /> <blockquote>(1)   The SAR will expire no later than the expiration of the underlying ISO.<br /> <br /> (2)   The SAR may be for no more than 100 percent of the spread (i.e., the difference between the exercise price of the underlying option and the market price of the stock subject to the underlying option at the time the SAR is exercised).<br /> <br /> (3)   The SAR is transferable only when the underlying ISO is transferable, and under the same conditions.<br /> <br /> (4)   The SAR may be exercised only when the underlying ISO is eligible to be exercised.<br /> <br /> (5)   The SAR may be exercised only when there is a positive spread (i.e., when the market price of the stock subject to the option exceeds the exercise price of the option).</blockquote><br /> The SAR could be paid in either cash or property or a combination thereof, so long as any amounts paid are includable in income under IRC Section 83.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> When the IRS issued final ISO regulations in August 2004, however, it removed the previous rules, apparently without comment. It is unclear whether the pre-existing rules are still valid.<br /> <br /> A SAR granted after an ISO as a matter of right upon satisfaction of a condition and pursuant to a common plan or plans will be considered to have been granted at the same time as the ISO for purposes of IRC Section 422 so long as the SAR otherwise meets the above requirements.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.   Temp. Treas. Reg. § 14a.422A-1, A-39, removed by T.D. 9144, 69 Fed. Reg. 46401 (Aug. 3, 2004).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.   Let. Rul. 9032016.<br /> <br /> </div>

<div class="Section1">An incentive stock option is an option to purchase stock of a corporation granted to an individual in connection with employment by that corporation (or its parent or subsidiary corporation), if all of the following requirements are met:<br /> <blockquote>(1)   The option is granted pursuant to a plan that specifies the number of shares to be issued and the employees or class of employees to receive the option. The plan must be approved by the stockholders of the corporation within 12 months before or after the date the plan is adopted;<br /> <br /> (2)   The option is granted within 10 years of the date the plan is adopted or approved by the shareholders, whichever occurs first;<br /> <br /> (3)   The option must, by its terms, be exercisable within 10 years of the date it is granted;<br /> <br /> (4)   The exercise price of the option is not less than the fair market value of the stock at the time it is granted;<br /> <br /> (5)   The option is nontransferable and exercisable only by the transferee (except that it may be transferred by will or the laws of descent and distribution); and<br /> <br /> (6)   The grantee of the option may not own stock representing more than 10 percent of the voting power of all classes of stock of the employer corporation, or its parent or subsidiary corporation. There is an exception to this rule where (i) the option price is at least 110 percent of the fair market value of the stock subject to the option, and (ii) the option is exercisable only within five years after it is granted.<a href="#_ftn1" name="_ftnref1">¹</a></blockquote><br /> In determining the extent of an individual’s ownership of stock for purposes of the<br /> 10 percent limitation, an individual will be considered to own stock of the employer corporation<br /> or of a related corporation that is owned (directly or indirectly) by the individual’s brothers, sisters, spouse, ancestors, and lineal descendants.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> If the stock covered by options that <em>may be exercised</em> by any individual employee for the first time in a calendar year (under all plans of the employer corporation, and its parent and subsidiary corporations) has an aggregate fair market value that exceeds $100,000, the excess options may not be treated as incentive stock options. For purposes of the $100,000 limitation, the options are taken into account in the order in which they were granted, and their fair market value is determined as of the date the option was granted.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> An employee exercising an ISO may pay for the stock with stock of the corporation granting the option.<a href="#_ftn4" name="_ftnref4">⁴</a> In determining whether the exercise price of the option is not less than the fair market value of the shares at the time the option is granted, a down payment required prior to exercise may be aggregated with the price to be paid at the time of exercise.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC §§ 422(b), 422(c)(5); Treas. Reg. § 1.422-2.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.   Treas. Reg. § 1.424-1(d).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.   IRC § 422(d).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.   IRC § 422(c)(4)(A).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.   Let. Rul. 9109026.<br /> <br /> </div>

<div class="Section1">The modification, renewal or extension of an incentive stock option is, for tax purposes, the equivalent of the granting of a new option; therefore, the requirements explained in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7545">7545</a> will apply.<a href="#_ftn1" name="_ftnref1">¹</a>&nbsp;Thus a new option price is required if the fair market value of the stock is greater than the price of the original option, since the option price must equal at least 100 percent of the fair market value of the stock at the time the option is granted.<div class="Section1"><br /> <br /> &ldquo;Modification&rdquo; 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 <em>is</em> 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.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> The IRC states that the following changes in the terms of an option will not be considered a &ldquo;modification&rdquo;: (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.<a href="#_ftn3" name="_ftnref3">³</a> For examples of reorganizations that did not result in modifications of options, <em><em>see</em></em> Letter Rulings 9810024 and 9849002.<br /> <br /> The Service has privately ruled that a downward adjustment to the exercise price of a company&rsquo;s outstanding stock options, made to reflect a return of capital to the company&rsquo;s shareholders, was a &ldquo;corporate transaction,&rdquo; and not a modification, extension, or renewal of those options.<a href="#_ftn4" name="_ftnref4">⁴</a> A company&rsquo;s failure to adjust options to reflect a reverse stock split did not result in a modification.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> The IRS has determined that modification did not take place where the exercise of incentive stock options was conditioned on the achievement of performance-related goals which changed from time to time.<a href="#_ftn6" name="_ftnref6">⁶</a><br /> <br /> The Service has also determined that an amendment to a plan, which would allow payment for option stock through constructive delivery (rather than physical delivery) of previously owned shares of company stock, would not result in modification of the options.<a href="#_ftn7" name="_ftnref7">⁷</a><br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp; IRC &sect;&nbsp;424(h).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp; IRC &sect;&nbsp;424(h)(1);&nbsp;Treas. Reg. &sect;&nbsp;1.424-1(e)(4).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp; IRC &sect;&nbsp;424(h)(3).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp;&nbsp; Let. Rul. 9801030.<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp;&nbsp; Let. Rul. 200007033.<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp;&nbsp; Let. Rul. 8444071.<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp;&nbsp; Let. Ruls. 9809025, 200207005.<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> No income is realized by the employee upon the grant of an incentive stock option. If the transfer of stock pursuant to the exercise of an incentive stock option is a <em>qualifying transfer</em>, no income will be realized by the employee at the time the option is exercised.<a href="#_ftn1" name="_ftnref1">¹</a>&nbsp;The transfer will be a qualifying transfer if both of the following requirements are met:<br /> <blockquote>(1)&nbsp;&nbsp; <em>Holding period requirement:</em> no <em>disposition</em> (defined below) of the stock may be made by the employee within two years of the date the option was granted, nor within one year of the date the stock was transferred pursuant to the option; and<br /> <br /> (2)&nbsp;&nbsp; <em>Employment requirement:</em> the transferee must be employed by the corporation granting the option (or its parent or subsidiary) at all times from the date the option was granted until three months before the date of exercise.<a href="#_ftn2" name="_ftnref2">²</a></blockquote><br /> If an employee becomes permanently and totally disabled, the three-month employment period is extended to 12 months.<a href="#_ftn3" name="_ftnref3">³</a> In the case of the death of an employee, the employment and holding requirements are waived.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> If an incentive stock option is exercised by an individual who does not meet the employment requirement described above (except in the event of the employee&rsquo;s death), there will <em>not</em> be a qualifying transfer and the individual will recognize compensation income in the year the option is exercised.&nbsp;The amount of compensation income realized will be the excess, if any, of the fair market value of the stock over the exercise price of the option<a href="#_ftn5" name="_ftnref5">⁵</a> (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7553">7553</a> regarding disqualifying transfers).<br /> <br /> In other words, if the employment requirement is met, the question of whether a transfer is a <em>qualifying transfer</em> can be answered with certainty only after the holding periods have been satisfied. If the holding periods and employment requirement are met, the taxpayer&rsquo;s subsequent disposition of the stock will be taxed as explained in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7552">7552</a>. If the one-year and two-year holding periods are not eventually satisfied, ordinary income is realized as of the date the option is exercised, which is recognized (i.e., taxed), in the year of the disposition, as explained in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7553">7553</a>.<br /> <br /> For purposes of the holding period requirement, &ldquo;disposition&rdquo; includes sales, exchanges, gifts, and transfers of legal title.&nbsp;The following will not constitute a disposition: (i) a transfer from a decedent to an estate or a transfer by bequest or inheritance; (ii) certain exchanges pursuant to a corporate reorganization or exchanges of stock for stock of the same corporation or a controlled corporation; or (iii) the making of a mere pledge or hypothecation. Additionally, the acquisition of stock as a joint tenant with right of survivorship or transfer of stock to joint ownership will not constitute a disposition until the joint tenancy is terminated.<a href="#_ftn6" name="_ftnref6">⁶</a> A transfer between spouses or former spouses incident to divorce also will not be considered a disposition, and the transferee spouse will receive the same tax treatment that would have applied to the transferor.<a href="#_ftn7" name="_ftnref7">⁷</a>&nbsp;The IRS determined that a transfer to a grantor trust, resulting in ownership of stock by two spouses with right of survivorship, did not constitute a disposition.<a href="#_ftn8" name="_ftnref8">⁸</a><br /> <br /> For purposes of the one-year and two-year holding period requirements, a transfer resulting from bankruptcy proceedings will not be considered a disposition.<a href="#_ftn9" name="_ftnref9">⁹</a> However, such a transfer will be considered a disposition for purposes of the recognition of capital gain or loss.<a href="#_ftn10" name="_ftnref10">¹⁰</a><br /> <br /> Generally, an individual&rsquo;s basis in stock acquired in a qualifying transfer upon exercise of an incentive stock option is the amount paid to exercise the option. (If there is a <em>disqualifying disposition</em>, the individual&rsquo;s basis is increased by amounts includable as compensation income (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7553">7553</a>).<br /> <br /> In informational guidance released in 2002, the IRS analyzed whether the &ldquo;deemed sale&rdquo; election under Section&nbsp;311(e) of&nbsp;TRA &rsquo;97 (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a>) is a &ldquo;disposition&rdquo; within the meaning of IRC Section&nbsp;424(c) under two circumstances: (1) where employees are holding incentive stock options that were granted to them prior to 2001, but that were not exercised as of January&nbsp;1, 2001, and (2) where employees were granted incentive stock options and exercised those options during November&nbsp;2000. In the first situation, the IRS stated that there is no provision in<br /> Section&nbsp;311(e) or the incentive stock option rules providing for a &ldquo;deemed exercise&rdquo; of the option in order to have the holding period start in 2001. In the second situation, the Service stated it appeared that any deemed sale of the stock acquired upon exercise of an incentive stock option would be treated as a disqualifying disposition for purposes of the incentive stock option rules, thus triggering the application of IRC Section&nbsp;83.&nbsp;The Service concluded by stating that the informational guidance did not constitute a ruling on any issue.&nbsp;The Service also recognized that the interaction of the incentive stock option rules with the Section&nbsp;311(e) election is a novel issue that the Service has not yet addressed.<a href="#_ftn11" name="_ftnref11">¹¹</a><br /> <br /> The Service released regulations relating to the required return and information statements under IRC Section&nbsp;6039 in 2009.<a href="#_ftn12" name="_ftnref12">¹²</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp; IRC &sect;&nbsp;421(a);&nbsp;Treas. Reg. &sect;&nbsp;1.422-1(a)(1).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp; IRC &sect;&nbsp;422(a).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp; IRC &sect;&nbsp;422(c)(6).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp;&nbsp; IRC &sect;&nbsp;421(c)(1).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.422-1(c); IRC &sect;&nbsp;83(a).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp;&nbsp; IRC &sect;&nbsp;424(c).<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp;&nbsp; IRC &sect;&nbsp;424(c)(4).<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>.&nbsp;&nbsp; Let Rul. 9021046.<br /> <br /> <a href="#_ftnref9" name="_ftn9">9</a>.&nbsp;&nbsp; IRC &sect;&nbsp;422(c)(3).<br /> <br /> <a href="#_ftnref10" name="_ftn10">10</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.422-1(a)(2)(ii).<br /> <br /> <a href="#_ftnref11" name="_ftn11">11</a>.&nbsp;&nbsp; INFO 2002-0137 (7-5-2002).<br /> <br /> <a href="#_ftnref12" name="_ftn12">12</a>.&nbsp;&nbsp; Treas. Reg. &sect;&sect;&nbsp;1.6039-1, 1.6039-2;&nbsp;TD 9470, 74 Fed. Reg. 59087 (11-17-2009).<br /> <br /> </div></div><br />

<div class="Section1">For purposes of the alternative minimum tax, the excess of the fair market value of the stock on the date of exercise of the option over the exercise price will be added to alternative minimum taxable income in the year the option is exercised, provided the taxpayer&rsquo;s rights are not subject to a substantial risk of forfeiture. But if the taxpayer is subject to the alternative minimum tax, the basis in the stock for alternative minimum tax purposes will be increased by the amount included in income.<a href="#_ftn1" name="_ftnref1">¹</a> A taxpayer with unvested stock may wish to make a special election under IRC Section&nbsp;83(b) to include in gross income for the taxable year an amount equal to the excess of the fair market value of the property at the time it was transferred over the amount (if any) paid for such property. By making the special election, the adjustment for AMT purposes will be reported in the year the election is made instead of the year the stock actually vests.&nbsp;This may be beneficial if the stock price is expected to significantly appreciate before the stock vests.<div class="Section1"><br /> <br /> The Service has stated that for tax years in which a taxpayer is liable for both incentive stock option AMT and non-incentive stock option AMT, it would apply the taxpayer&rsquo;s payments first to the non-incentive stock option liabilities and related interest and penalties (if any).<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> <em>2008 legislative relief for incentive stock options</em>. As noted above, under the AMT a taxpayer must pay tax on the stock value when the option is exercised.&nbsp;The economic downturn in 2000 resulted in many individuals having to pay tax on &ldquo;phantom income&rdquo; because the stock prices dropped dramatically after the date of exercise. Congress provided relief for these situations in 2006, but recognized that additional relief was still needed to correct this problem.&nbsp;The&nbsp;Tax Extenders and Alternative Minimum&nbsp;Tax Relief Act of 2008 addressed problems concerning the treatment of certain underpayments, interest, and penalties attributable to the treatment of incentive stock options.&nbsp;The Act provided relief by (1) abating any underpayment of tax outstanding on the date of enactment related to incentive stock options and the AMT, including interest; (2) eliminating the income phase-out; and (3) extending and modifying the AMT credit allowance against incentive stock options.&nbsp;This relief provision has since been repealed.<a href="#_ftn3" name="_ftnref3">³</a> For details, <em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="777">777</a>.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp; IRC &sect;&nbsp;56(b)(3).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp; PMTA 2009-027 (2-12-2009).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp; PL 113-295.<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp;&nbsp; IRC &sect;&nbsp;53(f), as added by&nbsp;TEAMTRA 2008.<br /> <br /> </div></div><br />

<div class="Section1">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 <em>disqualifying disposition</em>), the employee&rsquo;s gain (if any) on the disposition will be treated as follows:<br /> <ol><br /> <li>Any gain that is <em>compensation attributable to the exercise of the option</em> will be taxed as ordinary income (and the employer will have a corresponding deduction) in the year the disposition occurs. &ldquo;Compensation attributable to the exercise of the option&rdquo; 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.&nbsp;The employee&rsquo;s basis in the stock is then increased by the amount included as income.<a href="#_ftn1" name="_ftnref1">¹</a></li><br /> <li>Any gain in excess of compensation attributable to the exercise of the option will be treated as capital gain. <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a> for the treatment of capital gains and losses.<a href="#_ftn2" name="_ftnref2">²</a></li><br /> </ol><br /> 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).&nbsp;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.&nbsp;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 <em>over</em> the option price.&nbsp;The income includable as a result of such a disposition will generally be treated as compensation.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> 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.&nbsp;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 <em>over</em> the option price.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> In 2002, the Service announced an exception from reporting on Form&nbsp;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&nbsp;1099-B provided certain conditions are met.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <blockquote><em>Example 1</em>: On June&nbsp;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&nbsp;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&nbsp;422(a)(1), Mr. Stephens must not dispose of the stock before June&nbsp;1, 2026. But Mr.&nbsp;Stephens transfers the stock on September&nbsp;1, 2024, for $150 (the stock is transferable and not subject to a substantial risk of forfeiture).&nbsp;The amount of compensation attributable to Mr. Stephens&rsquo; 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&rsquo; 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&rsquo; 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.<br /> <br /> <em>Example 2:</em> Assume the same facts as example (1), except that instead of selling the stock on September&nbsp;1, 2024, for $150, Mr. Stephens sells it for $75.&nbsp;The rule in IRC Section&nbsp;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.&nbsp;Stephens&rsquo; 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.<br /> <br /> <em>Example 3:</em> Assume the same facts as example (2), except that the sale on September&nbsp;1, 2024, is to Mr.&nbsp;Stephens&rsquo; daughter, Janice. Under the related party sale rules of IRC Section&nbsp;267, no loss sustained on such a sale may be recognized.&nbsp;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&rsquo; exercise of the option, provided certain withholding requirements are met.</blockquote><br /> <p style="text-align: center;"><strong>Alternative Minimum&nbsp;Tax</strong></p><br /> If there is a recognizable loss on a disqualifying disposition in the same year as the exercise of the option, the taxpayer&rsquo;s alternative minimum taxable income will be increased only by the excess of the amount realized on disposition over the adjusted basis of the stock.<a href="#_ftn6" name="_ftnref6">⁶</a> For a definition of &ldquo;disposition,&rdquo; <em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7546">7546</a>.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp; IRC &sect;&nbsp;421(b);&nbsp;Treas. Reg. &sect;&nbsp;1.421-2(b)(1).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.421-2(b)(1)(ii), Example (2).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp; IRC &sect;&nbsp;422(c)(2);&nbsp;Treas. Reg. &sect;&nbsp;1.422-1(b)(2).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp;&nbsp; Let. Rul. 9308021.<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp;&nbsp; Rev. Proc. 2002-50, 2002-2 CB 173.<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp;&nbsp; IRC &sect;&nbsp;56(b)(3).<br /> <br /> </div></div><br />

<div class="Section1">IRS guidance on the Section 83(i) tax deferral option requires employers to establish an escrow arrangement if they wish to provide employees with the opportunity to defer taxes under IRC Section 83(i). This escrow arrangement is designed to solve potential income tax withholding issues associated with the rules. If the employee and employer do not agree to the escrow arrangement, the employee is not a qualified employee for purposes of the Section 83(i) deferral option.</div><br /> <div class="Section1"><br /> <br /> All deferral stock must be deposited in the escrow account before the end of the calendar year in which the Section 83(i) election is made, and must remain in the account until the employer recovers the income tax withholding obligation. At any time between the date of income inclusion under Section 83(i)(1)(B) and March 31 of the following year, the employer is permitted to remove from escrow and retain the number of shares of deferral stock with a fair market value equal to the income tax withholding obligation that has not been otherwise received from the employee.<br /> <br /> <hr /><br /> <br /> <strong>Planning Point:</strong> Practically, this escrow arrangement could force corporations to repurchase their own stock in order to satisfy the employee’s income tax withholding obligations, potentially making the Section 83(i) deferral option less attractive for employers who may not wish to use their own funds to satisfy these obligations.<br /> <br /> <hr /><br /> <br /> Fair market value, for purposes of these rules, means the fair market value as determined under the Section 409A regulations, and is the fair market value of the shares at the time the corporation retains the shares held in escrow to satisfy the employee’s income tax withholding obligations.<br /> <br /> After the employee has satisfied his or her income tax withholding obligations, the shares held in escrow must be delivered to the employee as soon as reasonably practicable.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.   Notice 2018-97.<br /> <br /> </div>