\[4830-01-p\]

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 14a

\[REG-122917-02\]

RIN 1545-BA75

Statutory Options

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking; withdrawal of previous
rulemaking; and notice of public hearing.

SUMMARY: This document contains proposed regulations relating to
statutory options. These proposed regulations affect certain taxpayers
who participate in the transfer of stock pursuant to the exercise of
incentive stock options and the exercise of options granted pursuant to
an employee stock purchase plan (statutory options). These proposed
regulations provide guidance to assist these taxpayers in complying with
the law in addition to clarifying rules regarding statutory options.
This document also withdraws a previous notice of proposed rulemaking.

DATES: Written and electronically submitted comments and requests to
speak, with outlines of topics to be discussed at the public hearing
scheduled for September 2, 2003, must be received by August 12, 2003.
ADDRESSES: Send submissions to CC:PA:RU (REG-122917-02), room 5226,
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC
20044. Submissions may be hand delivered Monday through Friday between
the hours of 8 a.m. and 5 p.m. to: CC:PA:RU (REG-122917-02), Courier's
Desk, Internal Revenue Service, 1111 Constitution Avenue, NW.,
Washington, DC or sent electronically, via the IRS Internet site
[www.irs.gov/regs]{.underline}. The public hearing will be held in the
IRS Auditorium, Internal Revenue Building, 1111 Constitution Avenue,
NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Erinn
Madden at (202) 622-6030 (not a toll-free number). To be placed on the
attendance list for the hearing, please contact Guy Traynor at (202)
622-7180.

SUPPLEMENTARY INFORMATION:

**Paperwork Reduction Act**

The collection of information contained in this notice of proposed
rulemaking has been submitted to the Office of Management and Budget for
review in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C.
3507(d)). Comments on the collection of information should be sent to
the **Office of Management and Budget**, Attn: Desk Officer for the
Department of the Treasury, Office of Information and Regulatory
Affairs, Washington, DC 20503, with copies to the **Internal Revenue**
**Service**, Attn: IRS Reports Clearance Officer, W:CAR:MP:T:T:SP;
Washington, DC 20224. Comments on the collection of information should
be received by August 8, 2003. Comments are specifically requested
concerning:

Whether the proposed collection of information is necessary for the
proper performance of the functions of the **Internal Revenue Service**,
including whether the information will have practical utility;

The accuracy of the estimated burden associated with the proposed
collection of information (see below);

How the quality, utility, and clarity of the information to be collected
may be enhanced;

How the burden of complying with the proposed collection of information
may be minimized, including through the application of automated
collection techniques or other forms of information technology; and

Estimates of capital or start-up costs and costs of operation,
maintenance, and purchase of service to provide information.

The collection of information in this proposed regulation is in
1.6039-1. Section 6039 of the Code requires all corporations that
transfer stock to any person pursuant to the exercise of a statutory
option to furnish that person with a written statement describing the
transfer. Additionally, the corporation may be required to furnish the
person a second written statement when the stock originally transferred
pursuant to the exercise of the statutory option is subsequently
disposed of by the person. The information on the statements required to
be provided by the corporation will be used by recipients to complete
their income tax returns in the year of the disposition of the statutory
option stock. The likely respondents are for-profit corporations.

Estimated total annual reporting burden: 16,650 hours.

Estimated average annual burden hours per respondent; 20 minutes.

Estimated number of respondents: 50,000.

Estimated annual frequency of responses: annually.

An agency may not conduct or sponsor, and a person is not required to
respond to, a collection of information unless it displays a valid
control number assigned by the Office of Management and Budget.

Books or records relating to a collection of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns and
tax return information are confidential, as required by 26 U.S.C. 6103.

**Background**

This document contains proposed amendments to 26 CFR part 1 under
sections 421, 422, and, 424 of the Internal Revenue Code (Code). Changes
to the applicable tax law concerning section 421 were made by sections
11801 and 11821 of the Omnibus Budget Reconciliation Act of 1989, Public
Law 101-508 (104 Stat. 1388). Changes to the applicable tax law
concerning section 424 were made by section 1003 of the Technical and
Miscellaneous Revenue Act of 1988 (TAMRA), Public Law 100-647 (102 Stat.
3581), sections 11801 and 11821 of the Omnibus Budget Reconciliation Act
of 1989 (OBRA 89), Public Law 101-508 (104 Stat. 1388), which included
re-designating section 425 as section 424 of the Code, and section
1702(h) of the Small Business Job Protection Act of 1996, Public Law
104-188 (110 Stat. 1755). Changes concerning section 422 were made by
section 251 of the Economic Recovery Tax Act of 1981 (95 Stat. 172),
which added section 422A to the Code. Related changes to section 422A
were made by section 102(j) of the Technical Corrections Act of 1982,
Public Law 97-448, section 321(a) of Tax Reform Act of 1986 (96 Stat.
2365), Public Law 99-514 (100 Stat. 2807), section 1003(d) of TAMRA, and
sections 11801 and 11821 of OBRA 89, which included re-designating
section 422A as section 422 of the Code.

Regulations under section 421 governing the requirements for restricted
stock options and qualified stock options, as well as options granted
under an employee stock purchase plan, were published in the **Federal
Register** on December 9, 1957 (TD 6276), November 26, 1960 (TD 6500),
January 18, 1961 (TD 6527), January 20, 1961 (TD 6540), December 12,
1963 (TD 6696), June 23, 1966 (TD 6887), July 24, 1978 (TD 7554), and
November 3, 1980 (TD 7728). Temporary regulations under section 422A
providing guidance and transitional rules related to incentive stock
options were published in the **Federal Register** on December 17, 1981
(TD 7799) and September 18, 1992 (TD 8435). Final regulations under
section 422 related to stockholder approval were published in the
**Federal Register** on December 1, 1988 (TD 8235) and November 29, 1991
(TD 8374). Regulations under section 425 were published in the **Federal
Register** on June 23, 1966 (TD 6887).

Proposed changes to the final regulations under sections 421, 424, and
6039 and proposed regulations under section 422A were previously
published in the **Federal Register** at 49 FR 4504 on February 7, 1984
(the 1984 proposed regulations). With the exception of certain
stockholder approval rules that were published in the **Federal
Register** on June 23, 1966 (TD 6887) and amended by TD 7728 on October
31, 1980, the 1984 proposed regulations provided a comprehensive set of
rules under section 422 of the Code. The 1984 proposed regulations are
withdrawn.

In general, the income tax treatment of the grant of an option to
purchase stock in connection with the performance of services and of the
transfer of stock pursuant to the exercise of such option is determined
under section 83 of the Code and the regulations thereunder. However,
section 421 of the Code provides special rules for determining the
income tax treatment of the transfer of shares of stock pursuant to the
exercise of an option if the requirements of section 422(a) or 423(a),
as applicable, are met. Section 422 applies to incentive stock options,
and section 423 applies to options granted under an employee stock
purchase plan (collectively, statutory options).

Under section 421, if a share of stock is transferred to an individual
pursuant to the exercise of a statutory option, there is no income at
the time of exercise of the option with respect to such transfer, and no
deduction under section 162 is allowed to the employer corporation with
respect to such transfer. However, pursuant to section 56(b)(3), section
421 does not apply with respect to the exercise of an incentive stock
option for purposes of the individual alternative minimum tax.

Section 422(a) of the Code provides that section 421 applies to the
transfer of stock to an individual pursuant to the exercise of an
incentive stock option if (i) no disposition of the share is made within
2 years from the date of grant of the option or within 1 year from the
date of transfer of the share, and (ii) at all times during the period
beginning on the date of grant and ending on the day 3 months before the
exercise of the option, the individual is an employee of either the
corporation granting the option or a parent or subsidiary of such
corporation, or a corporation (or a parent or subsidiary of such
corporation) issuing or assuming a stock option in a transaction to
which section 424(a) applies. Section 422(b) provides several
requirements that must be met for an option to qualify as an incentive
stock option. Section 422(c) provides special rules applicable to
incentive stock options, and section 422(d) provides a \$100,000
limitation with respect to incentive stock options.

Section 424 of the Code provides special rules applicable to statutory
options, including rules concerning the modification of statutory
options and the substitution or assumption of an option by reason of a
corporate merger, consolidation, acquisition of property or stock,
separation, reorganization, or liquidation. Section 424 also contains
definitions of certain terms, including [disposition]{.underline},
[parent corporation]{.underline}, and [subsidiary
corporation]{.underline}. Finally, section 424 provides special rules
related to attribution of stock ownership and the effect of stockholder
approval on the date of grant of a statutory option.

**Explanation of Provisions**

[Overview]{.underline}

These proposed regulations would provide a set of comprehensive rules
governing incentive stock options. These proposed regulations
incorporate many of the rules contained in the 1984 proposed
regulations, although these proposed regulations are re-numbered and
re-organized. These proposed regulations would also make changes to the
final regulations under sections 421 and 424 to provide additional
guidance, as discussed below, in certain areas, to reflect the new
organizational structure of the statutory option rules (including the
re-designation of §1.425-1 as §1.424-1), and to remove obsolete rules
and cross-references.

[Section 421: General Rules]{.underline}

The proposed regulations under section 421 would remove obsolete
provisions and update the cross-references to reflect amendments to the
applicable statutes and re-organization of the regulations. These
proposed regulations also incorporate many provisions of the 1984
proposed regulations. There are two sections of these proposed
regulations under section 421: §1.421-1, which would provide rules
concerning the meaning and use of terms, and §1.421-2, which would
provide general rules regarding the application of section 421.

The terms defined in §1.421-1 of these proposed regulations are the same
as those previously defined in §1.421-7, but these proposed regulations
make changes to the definitions of certain terms. For example,
§1.421-1(a) of these proposed regulations expands the definition of
[option]{.underline} to include warrants.

These proposed regulations would provide that an option must be
evidenced in paper or in an electronic form. Under either form, however,
the option must be enforceable under applicable law. Similarly, these
proposed regulations provide that the plan pursuant to which incentive
stock options are granted must be in paper or electronic form, provided
that the paper or electronic form establishes an enforceable plan.

In addition, as with any taxpayer record, the form used for the option
or plan, whether paper or electronic, must be one that provides adequate
substantiation of the applicability of section 421. Thus, for example,
the form must be one that provides adequate substantiation of the
applicable requirements, such as the date on which the option is
granted, the number of shares subject to the option, and the option
price. In addition, the taxpayer must retain records relating to the
option that are sufficient to comply with section 6001 and the
regulations thereunder. If these records are kept electronically, the
records must meet the requirements of Rev. Proc. 97-22 (1997-1 C.B.
652), or subsequent guidance, and if the records are kept in an ADP
system, the records must meet the requirements of Rev. Proc. 98-25
(1998-11 I.R.B. 7), or subsequent guidance.

The definition of [statutory option]{.underline} in §1.421-1(b) of these
proposed regulations is revised to provide that a statutory option may
include an option transferred to a trust if, under section 671 and
applicable state law, the individual to whom the option was granted
remains the beneficial owner. In contrast, these proposed regulations
provide that a transfer of a statutory option incident to divorce will
result in the option failing to qualify as a statutory option as of the
date of transfer.

Section 1.421-1(i) of these proposed regulations defines
[corporation]{.underline} to have the same meaning prescribed by section
7701(a)(3) and §301.7701-2(b). Thus, for example, a
[corporation]{.underline} includes an S Corporation, a foreign
corporation, and a limited liability corporation that is treated as a
corporation for all Federal tax purposes. In addition, section
1.421-1(d) of these proposed regulations provides that
[stock]{.underline} includes ownership interests other than capital
stock. Thus, under these proposed regulations, it would be permissible
for any entity that is classified as a corporation for federal tax
purposes pursuant to the provisions of §301.7701-2(b) to grant statutory
stock options with respect to ownership interests in that entity.

Section 1.421-2 of these proposed regulations incorporates both the
provisions of §1.421-8 and many of the related provisions of the 1984
proposed regulations. These proposed regulations also provide further
revisions, including specifying that the deduction in connection with a
disqualifying disposition is allowed only if otherwise allowable under
sections 83(h) and 162 and if the reporting requirements under
§1.83-6(a) are met.

[Section 422: Incentive Stock Options]{.underline}

The proposed regulations under section 422 would provide a new set of
comprehensive rules, with the exception of the rules regarding
stockholder approval described in §1.422-5 of the final regulations
(re-numbered as §1.422-3 by these proposed regulations). There are four
sections under these proposed regulations: §1.422-1, general rules;
§1.422-2, definition of incentive stock option; §1.422-4, the \$100,000
limitation; and §1.422-5, permissible provisions.

[1. Special rules regarding disqualifying dispositions]{.underline}

The 1984 proposed regulations provided rules concerning the consequences
of disqualifying dispositions. The general disqualifying disposition
rules for incentive stock options are provided in §§1.421-2(b)(1) and
1.422-1(b)(1) of these proposed regulations. In addition, §1.422-1(b)(2)
of these proposed regulations clarifies the operation of the special
rules applicable to a disqualifying disposition of an incentive stock
option under section 422(c)(2) (section 422A(c)(2), prior to amendment
by OBRA 89).

The general rules concerning disqualifying dispositions are described in
§1.421-2(b) of these proposed regulations. Under these rules, if there
is a disqualifying disposition of a share of stock, the special tax
treatment provided by section 421 and §1.421-2(a) does not apply to the
transfer of the share. Instead, the exercise of the option is treated as
the exercise of a nonstatutory option under §1.83-7. Thus, in the
taxable year in which the disqualifying disposition occurs, the
individual must recognize compensation income equal to the fair market
value of the stock on the date the stock is transferred less the
exercise price (determined without reduction for any brokerage fees or
other costs paid in connection with the disposition). A deduction
attributable to the transfer of the share of stock pursuant to the
exercise of the option is allowable for the taxable year in which such
disqualifying disposition occurs, to the employer corporation, its
parent or subsidiary corporation, or a corporation substituting or
assuming an option in a transaction to which §1.424-1(a) applies, if
otherwise allowable under sections 83(h) and 162 and if the requirements
of §1.83-6(a) are met.

Section 422(c)(2), however, provides a special rule that is applicable
if an individual makes a disqualifying disposition of stock acquired
through the exercise of an incentive stock option and if the disposition
is a sale or exchange with respect to which a loss (if sustained) would
be recognized by the individual. Under this special rule, the amount
includible in gross income on the disqualifying disposition, and the
amount deductible, as compensation attributable to the exercise of the
option, shall not exceed the excess (if any) of the amount realized on
such sale or exchange over the adjusted basis of the share. Under
section 422(c)(2), this special rule is not applicable if the
disposition is a sale or exchange with respect to which a loss (if
sustained) would not be recognized by the individual. Section
1.422A-1(b)(2) of the 1984 proposed regulations described these special
rules concerning the disqualifying disposition of an incentive stock
option and this description is incorporated into §1.422-1(b)(2) of these
proposed regulations.

For example, if the disposition is a sale described in section 1091
(relating to a loss from wash sales of stock or securities), a gift, or
a sale described in section 267(a)(1) (relating to sales between related
parties), any loss sustained would not be recognized. Because a loss in
any of these transactions would not be recognized, under
§1.422-1(b)(2)(ii) of these proposed regulations, the special rule
provided in §1.422-1(b)(2)(i) of these proposed regulations does not
apply. Instead, the general rules for disqualifying dispositions
described in §1.421-2(b) of these proposed regulations apply.

For example, assume E, an employee of Corporation X, is granted an
incentive stock option to acquire X stock. The option price on the date
of grant is \$100 (the fair market value of X stock on the date of
grant). E exercises the option and is transferred X stock when the fair
market value of the stock is \$200. E later sells the stock for \$150 to
M before the applicable holding periods expire. Because the sale is a
disqualifying disposition that meets the requirements of
§1.422-1(b)(2)(i) of these proposed regulations, in the taxable year of
the disqualifying disposition, E is only required to include \$50 (the
excess of the amount realized on the sale, \$150, over the adjusted
basis of the share, \$100) in gross income as compensation attributable
to the exercise of the option. For its taxable year in which the
disqualifying disposition occurs, X is allowed a compensation deduction
of \$50 attributable to E's exercise of the option, if otherwise
allowable under sections 83(h) and 162 and if the requirements of
§1.83-6(a) are met.

In this example, however, if 10 days after the sale to M, E purchases
substantially identical stock, under section 1091, a loss would not be
recognized on the sale to M. Thus, under §1.422-1(b)(2)(ii) of these
proposed regulations, the special rule in § 1.422-1(b)(2)(i) does not
apply. Instead of including \$50 in gross income in the taxable year of
the disqualifying disposition, E must include \$100 (the difference
between the fair market value of X stock on the date of transfer, \$200,
and the exercise price, \$100) in gross income as compensation
attributable to the exercise of the option. In the taxable year in which
the disqualifying disposition occurs, X is allowed a compensation
deduction of \$100 attributable to E's exercise of the option if
otherwise allowable under sections 83(h) and 162 and if the requirements
of §1.83-6(a) are met.

Since the 1984 proposed regulations were issued, there have been no
changes in section 422(c)(2) (other than the redesignation of section
422A(c)(2) as 422(c)(2) by OBRA 89), and these proposed regulations do
not make any substantive changes to the 1984 proposed regulations.

[2. Stockholder approval of incentive stock option plan]{.underline}

Among other requirements, to qualify as an incentive stock option, the
option must be granted pursuant to a plan which is approved by the
stockholders of the granting corporation within 12 months before or
after the date the plan is adopted. See section 422(b). These proposed
regulations would provide the same basic requirements for stockholder
approval as those included in the 1984 proposed regulations.

These proposed regulations, however, would provide additional guidance
concerning the circumstances in which stockholder approval is required.
As under the 1984 proposed regulations, stockholder approval is required
if there is a change in the aggregate number of shares or in the
employees (or class or classes of employees) eligible to be granted
options under the plan. In addition, while the standard for determining
when stockholder approval is required is the same as under the 1984
proposed regulations, these proposed regulations clarify these
requirements and provide a more complete list of situations that require
new stockholder approval of the plan by specifically including a change
in the shares with respect to which options are issued or a change in
the granting corporation. Thus, for example, assume that S, a subsidiary
of P, adopts an incentive stock option plan under which incentive stock
options for S stock will be granted to S employees, and the plan is
approved by the stockholders of S (in this case, P) within the
applicable 24-month period. If S later amends the plan to provide for
the grant of incentive stock options to acquire P stock (rather than S
stock), S must obtain approval from the stockholders of S within 12
months before or after the date of the amendment to the plan because the
amendment of the plan to allow the grant of options for P stock is
considered the adoption of a new plan.

These proposed regulations also would provide additional guidance
regarding the application of the stockholder approval requirements in
the context of the substitution or assumption of an option by reason of
a corporate transaction. For a discussion of these rules, see the
"Substitution, assumption, and modification of options" portion of the
preamble.

[3. \$100,000 limitation]{.underline}

Section 422(d)(1) provides that to the extent that the aggregate fair
market value of stock with respect to which incentive stock options
(determined without regard to section 422(d)) are exercisable for the
first time by any individual during the calendar year (under all of
plans of the employer corporation and any related corporation) exceeds
\$100,000, such options are not treated as incentive stock options.
Under section 422(d)(2), options are taken into account in the order in
which they are granted. Section 422(d)(3) provides that the fair market
value of stock is determined at the time the option is granted.

The 1984 proposed regulations provided no rules concerning the operation
of the \$100,000 limitation because these provisions were enacted in
1986. However, Notice 87-49 (1987-2 C.B. 355) provides general guidance
about the operation of the \$100,000 limitation, including examples
illustrating the application of this limitation.

Section 1.422-4 of these proposed regulations provides guidance on the
operation of the \$100,000 limitation that incorporates and expands on
the guidance provided in Notice 87-49. Section 1.422-4(a)(1) of these
proposed regulations provides that an option that otherwise qualifies as
an incentive stock option nevertheless fails to be an incentive stock
option to the extent the \$100,000 limitation is exceeded.

To determine whether the \$100,000 limitation has been exceeded, the
rules provided in §1.422-4(b) of these proposed regulations would apply.
Under these proposed regulations, an option that does not qualify as an
incentive stock option when granted (including an option which contains
terms providing that it will not be treated as an incentive stock
option) is disregarded. Additionally, the fair market value of stock is
determined on the date of grant of the option. Except as described in
the following paragraph, options are taken into account in the order in
which they are granted.

An option is considered to be first exercisable during a calendar year
if the option will first become exercisable at any time during the year,
assuming that any condition on the optionee's ability to exercise the
option related to the performance of services is satisfied. If an
optionee is able to exercise the option in a year only if an
acceleration provision is satisfied, then the option is exercisable in
that year only if the acceleration provision is triggered prior to the
end of that year. After an acceleration provision is triggered, for
purposes of applying the \$100,000 limitation, the options subject to
such provision and all other options first exercisable during a calendar
year are then taken into account in the order in which granted. However,
because an acceleration provision is not taken into account prior to its
triggering, an incentive stock option that becomes exercisable for the
first time during a calendar year by operation of such a provision does
not affect the application of the \$100,000 limitation with respect to
an option (or portion thereof) exercised prior to such acceleration. An
acceleration provision includes, for example, a provision that
accelerates the exercisability of an option on a change in ownership or
control or a provision that conditions exercisability on the attainment
of a performance goal. See §1.422-4(d), [Example 4]{.underline} of these
proposed regulations.

For example, assume that in 2006, E, an employee of Y Corporation, is
granted Option 1 for stock of Y with a fair market value on the date of
grant of \$75,000. Option 1 is first exercisable in 2008, except that
the option provides that it will become immediately exercisable in the
event of a change in control. In 2007, E is granted Option 2 for stock
of Y with a fair market value on the date of grant of \$50,000. Option 2
is immediately exercisable, and E exercises Option 2. A change in
control of Y occurs in 2007, after E has exercised Option 2, and Option
1 becomes immediately exercisable. Notwithstanding the fact that Option
1 was granted prior to Option 2, because the acceleration clause is not
taken into account until it is triggered and because E exercised Option
2 prior to the change in control, Option 2 is an incentive stock option
in its entirety. Option 1 is bifurcated into an incentive stock option
to acquire stock with a fair market value of \$50,000 on the date of
grant and a nonstatutory option to acquire stock with a fair market
value of \$25,000 on the date of grant.

If the change in control instead occurred prior to E's exercise of
Option 2, then Option 1, which was granted first, is treated as an
incentive stock option in its entirety, and Option 2 is bifurcated into
an incentive stock option to acquire stock with a fair market value of
\$25,000 on the date of grant and a nonstatutory option to acquire stock
with a fair market value of \$25,000 on the date of grant.

These proposed regulations also would provide that an option is
disregarded for purposes of the \$100,000 limitation if, prior to the
calendar year during which it would have otherwise become exercisable
for the first time, the option is modified and thereafter ceases to be
an incentive stock option, is transferred in violation of the
nontransferability requirements, or is canceled. In all other
situations, a modified, transferred, or canceled option (or portion
thereof) is treated as outstanding until the end of the calendar year
during which it would otherwise have become exercisable for the first
time.

Finally, under these proposed regulations, a disqualifying disposition
has no effect on the determination of whether an option exceeds the
\$100,000 limitation. Thus, for example, assume Corporation X grants E,
an employee of X, Option 1 to acquire X stock with a fair market value
on the date of grant of \$75,000. Option 1 is exercisable on January 1,
2005. On January 5, 2005, E exercises the option and sells the stock in
a disqualifying disposition. On January 15, 2005, X grants E Option 2 to
acquire X stock with a fair market value on the date of grant of
\$50,000. Option 2 is immediately exercisable. Under §1.422-4(b)(6) of
the proposed regulations, the disqualifying disposition of Option 1 has
no effect on the application of the \$100,000 limitation. Thus, Option 2
is bifurcated into an incentive stock option to acquire stock with a
fair market value of \$25,000 on the date of grant and a nonstatutory
option to acquire stock with a fair market value of \$25,000 on the date
of grant.

[4. Permissible provisions]{.underline}

These proposed regulations also provide guidance on additional
provisions that may be included in an incentive stock option. Because
these provisions are not part of the requirements for an incentive stock
option, they are addressed separately in §1.422-5 of these proposed
regulations (many of these rules were previously in §1.422A-2(i) of the
1984 proposed regulations). Section 1.422-5 of these proposed
regulations addresses provisions permitting cashless exercise, providing
the right to receive additional compensation, and providing alternative
rights. In each case, these proposed regulations essentially retain the
rules described in the 1984 proposed regulations.

[Section 424: Definitions and Special Rules]{.underline}

These proposed regulations re-designate the regulations under section
425 as regulations under section 424 and update the regulations. For
example, these proposed regulations amend the definition of
[disposition]{.underline} to exclude a transfer of a share of stock
acquired pursuant to the exercise of a statutory option if the transfer
is described in section 1041(a) (concerning transfers between spouses or
former spouses incident to divorce).

[Substitution, Assumption, and Modification of Options]{.underline}

Section 424(h)(1) provides that if the terms of an option are modified,
extended, or renewed, such modification, renewal, or extension is
treated as the grant of a new option. Under section 424(h)(3), the term
[modification]{.underline} (with certain exceptions) means any change in
the terms of an option which gives the optionee additional benefits
under the option. One exception to this definition is that a change in
the terms of an option attributable to a substitution or an assumption
that meets the requirements of section 424(a) is not a modification of
an option.

These proposed regulations would provide that an [eligible
corporation]{.underline} (as defined in §1.424-1(a)(2) of these proposed
regulations) may by reason of a [corporate transaction]{.underline} (as
defined in §1.424-1(a)(3) of these proposed regulations) substitute a
new statutory option (new option) for an outstanding statutory option
(old option) or assume an old option without the substitution or
assumption being considered a modification of the old option under
section 424(h).

An [eligible corporation]{.underline} is defined as a corporation that
is the employer of an optionee or a related corporation of such
corporation. The determination of whether a corporation is the employer
of the optionee or a related corporation of such corporation is based
upon the circumstances existing immediately after the corporate
transaction.

Under the proposed regulations, a [corporate transaction]{.underline} is
(i) a corporate merger, consolidation, acquisition of property or stock,
separation, reorganization, or liquidation; (ii) a distribution
(excluding ordinary dividends), or change in the terms or number of
outstanding shares of such corporation, such as a stock split or stock
dividend (a change in capital structure); (iii) a change in the name of
a corporation whose stock is purchasable under the old option; and (iv)
such other corporate events as may be prescribed by the Commissioner in
published guidance.

The definitions of [eligible corporation]{.underline} and [corporate
transaction]{.underline} would be expanded under these proposed
regulations. Specifically, these proposed regulations permit
corporations with outstanding options to substitute or assume an option
under §1.424-1(a) if there is a corporate transaction. Additionally, the
definition of [corporate transaction]{.underline} includes events, such
as a stock dividend or stock split, that were previously addressed in
§1.425-1(e) of the final regulations, and is otherwise expanded so that
events or transactions with similar consequences are treated the same.
Because of these changes, the rules in §1.425-1(e)(5)(ii) of the current
regulations would be removed.

These proposed regulations also would eliminate the requirement
contained in §1.425-1(a)(1)(ii) of the final regulations that the
corporate transaction result in a significant number of employees being
transferred to a new employer or discharged or in the creation or
severance of a parent-subsidiary relationship. However, §1.424-1(a)(4)
of these proposed regulations would continue to impose, and provide
additional guidance concerning, the requirement that the substitution or
assumption be "by reason of" the corporate transaction.

Under these proposed regulations, a change in an option or issuance of a
new option is considered to be by reason of a corporate transaction
unless the relevant facts and circumstances demonstrate that such change
or issuance is made for reasons unrelated to such corporate transaction.
For example, a change in an option or issuance of a new option is
considered to be made for reasons unrelated to such a corporate
transaction if there is an unreasonable delay between the corporate
transaction and such change in the option or issuance of a new option or
if the corporate transaction serves no substantial corporate business
purpose independent of the change in options. A change in an option or
issuance of a new option is not by reason of a distribution or change in
the terms or number of outstanding shares unless the option as changed,
or the new option, is issued on the stock of the same corporation, or if
such class of stock is eliminated by the change in capital structure, on
other stock of the same corporation. For purposes of a change in name of
the corporation, the issuance of a new option is by reason of the change
in name of the corporation only if the option issued is on stock of the
successor corporation.

These proposed regulations do not otherwise revise the requirements that
must be met for a change in an option to qualify as a substitution or an
assumption. For example, no changes are proposed with respect to the
requirements that no additional benefits be granted to the optionee in
connection with a substitution or assumption or that certain spread and
ratio tests must be met.

These proposed regulations also continue to impose the requirement
contained in the final regulations that the new or assumed option must
otherwise qualify as a statutory option. See §1.424-1(a)(5)(vi) of these
proposed regulations. Thus, except as necessary to comply with the
specific requirements regarding substitution or assumption, such as the
restrictions on ratio and spread, the option must comply with the
requirements of §1.422-2 of these proposed regulations or 1.423-2, as
applicable. Accordingly, for example, the new option must be granted, or
the old option must be assumed, under a plan approved by the
stockholders of the corporation substituting or assuming the option.

The proposed regulations do not impose any additional stockholder
approval requirement, however, merely because there is a corporate
transaction. In Rev. Rul. 71-474 (1971-2 C.B. 215) involving qualified
stock options,[^1] the IRS held that qualified stock options assumed by
a corporation in a merger with the granting corporation retained their
status as qualified stock options without approval of the assuming
corporation's stockholders. In the ruling, the IRS indicated that
approval of the persons who owned stock of the granting corporation at
the time the plan was approved was sufficient to satisfy the stockholder
approval requirements. Similarly, the 1984 proposed regulations provided
that the stockholders of the granting corporation must approve the plan
within 12 months before or after its adoption without additional
requirements.

Section 1.422-2(b)(2) of these proposed regulations would provide that
the plan must be approved during the applicable 24-month period by the
stockholders of the corporation granting the incentive stock option.
There is no requirement that additional stockholder approval be obtained
because of post-approval changes in the stockholders. For example,
assume S, a subsidiary of P, adopts a plan under which incentive stock
options for S stock will be granted to S employees. Under the proposed
regulations, the stockholders of S must approve the plan within 12
months before or after the adoption of the plan. If P later completely
disposes of its interest in S, outstanding S options and new grants of S
options under the plan are treated as options granted under a plan that
meets the stockholder approval requirement of §1.422-2(b)(2) of these
proposed regulations without regard to whether S seeks approval of the
plan from the stockholders of S after the spin-off. Assuming all other
applicable requirements are met, the outstanding S options and new
options granted by S pursuant to the plan with respect to S stock will
be treated as incentive stock options.

These proposed regulations also would provide additional guidance with
respect to when a change to an option constitutes a modification. Under
these proposed regulations, as under the 1984 proposed regulations, both
a provision under an option that provides that the optionee may receive
an additional benefit at the future discretion of the granting
corporation and the exercise of that discretion are considered
modifications of the option. However, under these proposed regulations,
it is not a modification for the granting corporation to exercise
discretion related to the payment of a bonus at the time of the exercise
of the option, the availability of a loan at exercise, or the right to
tender previously-owned stock for the stock purchasable under the
option. A change to an option adding such discretion, however, would be
a modification.

In addition, these proposed regulations address more clearly changes
related to an option, including changes not only to the option or the
option plan, but also changes to any other related agreements. In the
case of a change to the stock on which the option is granted that
affects the value of the stock, there would be a modification unless a
new option is substituted for the old option by reason of the change in
the terms of the stock in accordance with the requirements of
§1.424-1(a) of these proposed regulations.

[Section 6039]{.underline}

These proposed regulations also would provide guidance on the statements
required under section 6039 of the Code. Under these proposed
regulations, §1.6039-1 of the final regulations would be deleted, and
§1.6039-2 would be re-designated as §1.6039-1. These proposed
regulations take the same approach toward providing notice as that taken
in the 1984 proposed regulations.

Section 1.6039‑1(f) of these proposed regulations states that the matter
of furnishing statements in electronic form is reserved. Temporary and
proposed regulations have been issued under sections 6041 and 6051
(relating to voluntary electronic furnishing of payee statements on Form
W‑2) and section 6050S (relating to voluntary electronic furnishing of
statements to individuals for whom Forms 1098‑T, "Tuition Payments
Statement," and 1098‑E, "Student Loan Interest Statement" are filed).
See 66 FR 10191 and 10247 (Feb. 14, 2001). The preamble to those
temporary and proposed regulations requested comments regarding, among
other things, the extent to which the proposed method of electronic
filing is appropriate for information statements required under other
sections of the Code. In addition, section 401 of the Job Creation and
Worker Assistance Act of 2002 authorized all statements required by
sections 6041 through 6050T of the Code to be furnished electronically
under certain conditions. The issue of electronic statements in general
is under review, and comments are requested.

**Proposed Effective Date**

The regulations under sections 421, 422, and 424 are proposed to apply
as of the date that is 180 days after publication of final regulations
in the **Federal Register** and apply to any statutory option that is
granted on or after that date. The regulations under section 6039 are
proposed to apply to transfers on or after the date that is 180 days
after publication of final regulations in the **Federal Register** of
stock acquired pursuant to a statutory option. The 1984 proposed
regulations are withdrawn. Taxpayers may rely on these proposed
regulations for the treatment of any statutory option granted after June
9, 2003**.**

**Special Analyses**

It has been determined that this notice of proposed rulemaking is not a
significant regulatory action as defined in Executive Order 12866.
Therefore, a regulatory assessment is not required. Section 1.6039-1 of
these proposed regulations provides for the collection of information.
It is hereby certified that the collection of information in these
regulations will not have a significant economic impact on a substantial
number of small entities. This certification is based on the fact that
the provision of employee statements provided under these proposed
regulations will impose a minimal paperwork burden on most small
entities (see the discussion under the heading "Paperwork Reduction Act"
earlier in this preamble). Therefore, an analysis under the Regulatory
Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to
section 7805(f) of the Code, this notice of proposed rulemaking is being
submitted to the Chief Counsel for Advocacy of the Small Business
Administration for comment on its impact on small business.

**Comments and Public Hearing**

Before these proposed regulations are adopted as final regulations,
consideration will be given to any written or electronic comments (a
signed original and eight (8) copies) that are submitted timely to the
IRS. All comments will be available for public inspection and copying.

A public hearing has been scheduled for September 2, 2003, beginning at
10 a.m. in the IRS Auditorium of the Internal Revenue Building, 1111
Constitution Avenue, NW., Washington, DC. All visitors must come to the
Constitution Avenue entrance and present photo identification to enter
the building. Because of access restrictions, visitors will not be
admitted beyond the immediate entrance area more than 30 minutes before
the hearing starts. For information about having your name placed on the
building access list to attend the hearing, see the "FOR FURTHER
INFORMATION CONTACT" section of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who wish
to present oral comments at the hearing must submit written comments and
an outline of the topics to be discussed and the time to be devoted to
each topic (signed original and eight (8) copies) by August 12, 2003. A
period of 10 minutes will be allotted to each person for making
comments. An agenda showing the schedule of speakers will be prepared
after the deadline for receiving outlines has passed. Copies of the
agenda will be available free of charge at the hearing.

**Drafting Information**

The principal author of these proposed regulations is Erinn Madden,
Office of

the Division Counsel/Associate Chief Counsel (Tax Exempt and Government
Entities). However, other personnel from the IRS and Treasury Department
participated in their development.

**List of Subjects in 26 CFR Parts 1** **and 14a**

Income taxes, Reporting, and recordkeeping requirements.

**Proposed Amendments to the Regulations**

Accordingly, 26 CFR parts 1 and 14a is proposed to be amended as
follows:

PART 1 \-- INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in part
as follows:

Authority: 26 U.S.C. 7805 \* \* \*

**§§1.421-1 through 1.421-6 \[Removed\]**

Par. 2. Sections 1.421-1 through 1.421-6 are removed.

Par. 3. Section 1.421-7 is re-designated as §1.421-1 and is amended as
follows:

1\. In paragraph (a)(1), first sentence, the language "sections 421
through 425\" is removed and "§§1.421-1 through 1.424-1\" is added in
its place.

2\. In paragraph (a)(1), first sentence, the language "includes" is
removed, and "means" is added in its place.

3\. In paragraph (a)(1), removing the second sentence.

4\. Removing the last sentence of paragraph (a)(1) and adding two
sentences in its place.

5\. Revising paragraph (a)(3).

6\. Revising paragraphs (b)(1) and (b)(2).

7\. In paragraph (b)(3)(i), third sentence, removing the language
"1.425-1\" and inserting "1.424-1\" in its place.

8\. In the list below, for each section indicated in the left column,
remove the language in the middle column and add the language in the
right column:

Newly Designated Section

Remove

Add

1.421-1(b)(3)(ii), [Example 1]{.underline}, first, second, third and
fourth sentences

S-1

X

1.421-1(b)(3)(ii), [Example 1]{.underline}, second sentence

1964

2004

1.421-1(b)(3)(ii), [Example 1]{.underline}, third and fourth sentences

1965

2005

1.421-1(b)(3)(ii), [Example 2]{.underline}, first and second sentences

1964

2004

1.421-1(b)(3)(ii), [Example 2,]{.underline} first, third, and fourth
sentences

S-1

X

1..421-1(b)(3)(ii), [Example 2]{.underline}, third and fourth sentences

1965

2005

9\. Revising the last sentence of paragraph (b)(3)(ii), [Example
1]{.underline}.

10\. Removing the last sentence of paragraph (b)(3)(ii), [Example
2]{.underline} and adding two sentences in its place.

11\. Removing the first sentence of paragraph (c)(1) and adding two new
sentences in its place.

12\. In paragraph (c)(2), second sentence, the language "425\" is
removed and "424\" is added in its place.

13\. In paragraph (c)(3), second and last sentences, the language
"1964\" is removed and "2004\" is added in its place.

14\. In paragraph (c)(3), second sentence, the language "1965\" is
removed and "2005\" is added in its place.

15\. Revising paragraphs (d) and (e).

16\. In paragraph (f), in the first sentence, the language "sections 421
through 425\" is removed and "this section and §§1.421-2 through
1.424-1\" is added in its place.

17\. Revising the last sentence of paragraph (f).

18\. In paragraph (g), first sentence, the language "sections 421
through 425\" is removed and "this section and §§1.421-2 through
1.424-1\" is added in its place.

19\. Adding a new third sentence to paragraph (g).

20\. Revising the first, second, and third sentences of paragraph
(h)(1).

21\. Revising paragraph (h)(2).

22\. In paragraph (h)(3), first sentence, the language "425" is removed
and "424" is added in its place.

23\. In paragraph (h)(3), last sentence, the language "or assuming" is
removed and "the option or substituting or assuming the option" is added
in its place.

24\. In the list below, for each section indicated in the left column,
remove the language in the middle column and add the language in the
right column:

Newly Designated Section

Remove

Add

1.421-1(h)(4), [Example 1]{.underline}, first sentence

1964

2004

1.421-1(h)(4), [Example 1]{.underline}, second and last sentences

1965

2005

1.421-1(h)(4), [Example 2]{.underline}, first sentence

425

424

1.421-1(h)(4), [Example 2]{.underline}, first sentence

issuing

substituting

1.424-1(h)(4), [Example 2]{.underline}, last sentence

1965

2005

1.421-1(h)(4), [Example 2]{.underline}, last sentence

for A is then employed by a corporation which issued an option under
section 425(a).

to the transfer of the M stock because, at all times during the period
beginning with the date of grant of the X option and ending with the
date of exercise of the M option, A was an employee of the corporation
granting the option or substituting or assuming the option under
§1.424-1(a).

1.421-1(h)(4), [Example 3]{.underline}, second sentence

1964

2004

1.421-1(h)(4), [Example 3]{.underline}, third, fourth, and fifth
sentences

1965

2005

1.421-1(h)(4), [Example 4]{.underline}, first sentence

425(a)

424(a)

1.421-1(h)(4), [Example 5]{.underline}, first sentence

qualified stock

statutory

1.421-1(h)(4), [Example 6]{.underline}, first sentence

an employment contract with M which provides that upon the termination
of any military duty E may be required to serve, E will be entitled to
reemployment with M or a parent or subsidiary of M.

a right to reemploymnet with M or a related corporation on the
termination of any military duty E may be required to serve.

1.421-1(h)(4), [Example 6]{.underline}, third sentence

of M

of M or a related corporation

1.421-1(h)(4), [Example 6]{.underline}, last sentence

can apply

applies

1.421-1(h)(4), [Example 7]{.underline}, first and last sentences

a qualified stock

an incentive

1.421-1(h)(4), [Example 7]{.underline}, first sentence

parent or subsidiary

related corporation

1.421-1(h)(4), [Example 7]{.underline}, last sentence

its parent and subsidiary corporation

related corporations

1.421-1(h)(4), [Example 7]{.underline}, last sentence

terminated

deemed terminated

25\. Revising paragraph (i).

26\. Adding paragraph (j).

The additions and revisions read as follows:

[§1.421-1 Meaning and use of certain terms.]{.underline}

\(a\) \* \* \* (1) \* \* \* While no particular form of words is
necessary, the option must express, among other things, an offer to sell
at the option price, the maximum number of shares purchasable under the
option, and the period of time during which the offer remains open. The
term [option]{.underline} includes a warrant that meets the requirements
of this paragraph (a)(1).

\* \* \* \* \*

\(3\) An option must be in writing (in paper or electronic form),
provided that such writing is adequate to establish an option right or
privilege that is enforceable under applicable law.

\(b\) [Statutory options]{.underline}. (1) The term [statutory
option]{.underline}, for purposes of this section and §§1.421-2 through
1.424-1, means an [incentive stock option]{.underline}, as defined in
§1.422-2(a), or an option granted under an [employee stock purchase
plan]{.underline}, as defined in §1.423-2.

\(2\) An option qualifies as a statutory option only if the option is
not transferable (other than by will or by the laws of descent and
distribution) by the individual to whom the option was granted, and is
exercisable, during the lifetime of such individual, only by such
individual. See §§1.422-2(a)(2)(v) and 1.423-2(j). Accordingly, an
option which is transferable or transferred by the individual to whom
the option is granted during such individual's lifetime, or is
exercisable during such individual's lifetime by another person, is not
a statutory option. However, if the option or the plan under which the
option was granted contains a provision permitting the individual to
designate the person who may exercise the option after such individual's
death, neither such provision, nor a designation pursuant to such
provision, disqualifies the option as a statutory option. A pledge of
the stock purchasable under an option as security for a loan that is
used to pay the option price does not cause the option to violate the
nontransferability requirements of this paragraph (b). Also, the
transfer of an option to a trust does not disqualify the option as a
statutory option if, under section 671 and applicable State law, the
individual is considered the sole beneficial owner of the option while
it is held in the trust. If an option is transferred incident to divorce
(within the meaning of section 1041) or pursuant to a qualified domestic
relations order (within the meaning of section 414(p)), the option does
not qualify as a statutory option as of the day of such transfer. For
the treatment of nonstatutory options, see §1.83-7.

(3)(ii) \* \* \* \* \*

[Example 1]{.underline}. \* \* \* Because X was a subsidiary of P on the
date of the grant of the statutory option, the option does not fail to
be a statutory option even though X ceases to be a subsidiary of P.

[Example 2]{.underline}. \* \* \* Because X was not a subsidiary of P on
the date of the grant of the option, the option is not a statutory
option even though S later becomes a subsidiary of P. See
§§1.422-2(a)(2) and 1.423-2(b).

\(c\) [Time and date of granting option]{.underline}. (1) For purposes
of this section and §§1.421-2 through 1.424-1, the language "the date of
the granting of the option" and "the time such option is granted," and
similar phrases refer to the date or time when the granting corporation
completes the corporate action constituting an offer of stock for sale
to an individual under the terms and conditions of a statutory option. A
corporate action constituting an offer of stock for sale is not
considered complete until the date on which the maximum number of shares
that can be purchased under the option and the minimum option price are
fixed or determinable. \* \* \*

\* \* \* \* \*

\(d\) [Stock and voting stock]{.underline}*.* (1) For purposes of this
section and §§1.421-2 through 1.424-1, the term [stock]{.underline}
means capital stock of any class, including voting or nonvoting common
or preferred stock. Except as otherwise provided, the term includes both
treasury stock and stock of original issue. Special classes of stock
authorized to be issued to and held by employees are within the scope of
the term [stock]{.underline} as used in such sections, provided such
stock otherwise possesses the rights and characteristics of capital
stock.

\(2\) For purposes of determining what constitutes voting stock in
ascertaining whether a plan has been approved by stockholders under
§1.422-2(b) or 1.423-2(c) or whether the limitations pertaining to
voting power contained in sections §§1.422-2(f) and 1.423-2(d) have been
met, stock which does not have voting rights until the happening of an
event, such as the default in the payment of dividends on preferred
stock, is not voting stock until the happening of the specified event.
Generally, stock which does not possess a general voting power, and may
vote only on particular questions, is not voting stock. However, if such
stock is entitled to vote on whether a stock option plan may be adopted,
it is voting stock.

\(3\) In general, for purposes of this section and §§1.421‑2 through
1.424‑1, ownership interests other than capital stock are considered
stock.

\(e\) [Option price]{.underline}. (1) For purposes of this section and
§§1.421-2 through 1.424-1, the term [option price]{.underline}, [price
paid under the option]{.underline}, or [exercise price]{.underline}
means the consideration in cash or property which, pursuant to the terms
of the option, is the price at which the stock subject to the option is
purchased. The term [option price]{.underline} does not include any
amounts paid as interest under a deferred payment arrangement or treated
as interest.

\(2\) Any reasonable valuation method may be used to determine whether,
at the time the option is granted, the option price satisfies the
pricing requirements of sections 422(b)(4), 422(c)(5), 422(c)(7), and
423(b)(6) with respect to the stock subject to the option. Such methods
include, for example, the valuation method described in §20.2031-2 of
this chapter (Estate Tax Regulations).

\(f\) [Exercise]{.underline}. \* \* \* An agreement or undertaking by
the employee to make payments under a stock purchase plan does not
constitute the exercise of an option to the extent the payments made
remain subject to withdrawal by or refund to the employee.

\(g\) [Transfer]{.underline}*.* \* \* \* A transfer does not fail to
occur merely because, under the terms of the arrangement, the individual
may not dispose of the share for a specified period of time or the share
is subject to a right of first refusal at the share's fair market value
at the time of sale.

\(h\) [Employment relationship]{.underline}*.* (1) An option is a
statutory option only if, at the time the option is granted, the
optionee is an employee of the corporation granting the option, or a
related corporation of such corporation. If the option has been assumed
or a new option has been substituted in its place under §1.424-1(a), the
optionee must, at the time of such substitution or assumption, be an
employee of the corporation so substituting or assuming the option, or a
related corporation of such corporation. The determination of whether
the optionee is an employee at the time the option is granted (or at the
time of the substitution or assumption under §1.424-1(a)) is made in
accordance with section 3401(c) and the regulations thereunder. \* \* \*

\(2\) In addition, §1.421-2(a) is applicable to the transfer of a share
pursuant to the exercise of the statutory option only if the optionee
is, at all times during the period beginning with the date of the
granting of such option and ending on the day 3 months before the date
of such exercise, an employee of either the corporation granting such
option, a related corporation of such corporation, or a corporation (or
a related corporation of such corporation) substituting or assuming a
stock option in a transaction to which §1.424-1(a) applies. For purposes
of the preceding sentence, the employment relationship is treated as
continuing intact while the individual is on military leave, sick leave,
or other bona fide leave of absence (such as temporary employment by the
Government) if the period of such leave does not exceed 90 days, or if
longer, so long as the individual\'s right to reemployment with the
corporation granting the option (or a related corporation of such
corporation) or a corporation (or a related corporation of such
corporation) substituting or assuming a stock option in a transaction to
which §1.424-1(a) applies, is guaranteed either by statute or by
contract. If the period of leave exceeds 90 days and the individual\'s
right to reemployment is not guaranteed either by statute or by
contract, the employment relationship is deemed to terminate on the 91st
day of such leave. Thus, if the option is not exercised before such
deemed termination of employment, §1.421-2(a) applies to the transfer of
a share pursuant to an exercise of the option only if the exercise
occurs within 3 months from the date the employment relationship is
deemed terminated.

\* \* \* \*

\(i\) [Additional definitions]{.underline}. (1)
[Corporation]{.underline}. For purposes of this section and §§1.421-2
through 1.424-1, the term [corporation]{.underline} has the meaning
prescribed by section 7701(a)(3) and §301.7701-2(b) of this chapter. For
example, a [corporation]{.underline} for purposes of the preceding
sentence includes an S corporation (as defined in section 1361), a
foreign corporation (as defined in section 7701(a)(5)), and a limited
liability company that is treated as a corporation for all Federal tax
purposes.

\(2\) [Parent corporation and subsidiary corporation]{.underline}. For
the definition of the terms [parent corporation]{.underline} (and
[parent]{.underline}) and [subsidiary corporation]{.underline} (and
[subsidiary]{.underline}), for purposes of this section and §§1.421-2
through 1.424-1, see §1.424-1(f)(i) and (ii), respectively. [Related
corporation]{.underline} as used in this section and in §§1.421-2
through 1.424-1 means either a parent corporation or subsidiary
corporation.

\(j\) [Effective date]{.underline}. This section applies to any
statutory option granted on or after the date that is 180 days after
publication of final regulations in the **Federal Register**. Taxpayers
can rely on these regulations for the treatment of any statutory option
granted on or after June 9, 2003.

Par. 4. Section 1.421-8 is re-designated as 1.421-2 and is amended by:

1\. Revising paragraphs (a)(1), (b), and (c)(1).

2\. In the list below, for each section indicated in the left column,
remove the language in the middle column and add the language in the
right column:

[Newly Designated Section]{.underline}

1.421-2(c)(2), second sentence

[Remove]{.underline}

, or 424(c)(1)

[Add]{.underline}

1.421-2(c)(2), third sentence

or 424(c)(1)

1.421-2(c)(3)(i), first, second, and third sentences

422(c)(1), 423(c), or 424(c)(1)

423(c)

1.421-2(c)(3)(ii), [Example]{.underline}, first sentence

1964

2004

1.421-2(c)(3)(ii), [Example]{.underline}, third, fifth, and sixth
sentences

1966

2006

3\. In paragraph (c)(2), first sentence, add the phrase "for purposes of
section 423(c)" at the end of the first sentence.

4\. Removing paragraph (c)(4)(i) and redesignating paragraphs (c)(4)(ii)
through (c)(4)(iv) as paragraphs (c)(4)(i) through (c)(4)(iii),
respectively.

5\. In newly designated paragraph (c)(4)(i)([a]{.underline}), first
sentence, removing the phrase "In the case of an employee dying after
December 31, 1956" and adding "In the case of the death of an optionee"
in its place.

6\. Removing [Example (1)]{.underline} in newly designated paragraph
(c)(4)(iii) and redesignating [Examples (2)]{.underline} through (5) as
[Examples (1)]{.underline} through (4), respectively.

7\. In the list below, for each section indicated in the left column,
remove the language in the middle column and add the language in the
right column:

[Newly Designated Section]{.underline}

1.421-2(c)(4)(i)([a]{.underline}), last sentence

[Remove]{.underline}

422(c)(1), 423(c), or 424(c)(1)

[Add]{.underline}

423(c)

1.421-2(c)(4)(i)([b]{.underline}), first, second, and last sentences

422(c)(1), 423(c), or 424(c)(1)

423(c)

1.421-2(c)(4)(i)([c]{.underline}), first sentence

422(c)(1), 423(c), or 424(c)(1)

423(c)

1.421-2(c)(4)(iii), [Example 1]{.underline}, first sentence

1964

2005

1.421-2(c)(4)(iii), [Example 1]{.underline}, eighth sentence

subdivision (ii)([b]{.underline}) of this subparagraph

paragraph (c)(4)(i)([b]{.underline}) of this section

1.421-2(c)(4)(iii), [Example 1]{.underline}, third and fifth sentences

1966

2006

1.421-2(c)(4)(iii), [Example 1]{.underline}, ninth sentence

subdivision (ii)([c]{.underline}) of this subparagraph

paragraph (c)(4)(i)([c]{.underline}) of this section

1.421-2(c)(4)(iii), [Example 2]{.underline}, second and fifth sentences

subdivision (ii)([a]{.underline}) of this subparagraph

paragraph (c)(4)(i)([a]{.underline}) of this section

1.421-2(c)(4)(iii), [Example 2]{.underline}, fifth sentence

subdivision (ii)([b]{.underline}) of this subparagraph

paragraph (c)(4)(i)([b]{.underline}) of this section

1.421-2(c)(4)(iii), [Example 2]{.underline}, first sentence

[example (2)]{.underline}

[Example 1]{.underline}

1.421-2(c)(4)(iii), [Example 3]{.underline}, first sentence

[example (2)]{.underline}

[Example 1]{.underline}

1.421-2(c)(4)(iii), [Example 3]{.underline}, second and fourth sentences

subdivision (ii)([a]{.underline}) of this subparagraph

paragraph (c)(4)(i)([a]{.underline}) of this section

1.421-2(c)(4)(iii), [Example 3]{.underline}, fourth sentence

subdivision (ii)([c]{.underline}) of this subparagraph

paragraph (c)(4)(i)([c]{.underline}) of this section

1.421-2(c)(4)(iii), [Example 4]{.underline}, first sentence

[example (2)]{.underline}

[Example 1]{.underline}

1.421-2(c)(4)(iii), [Example 4]{.underline}, first sentence

1966

2006

1.421-2(c)(4)(iii), [Example 4]{.underline}, first and second sentences

1967

2007

1.421-2(c)(iii), [Example 4]{.underline}, third, fifth, and sixth
sentences

subdivision (ii)([a]{.underline}) of this subparagraph

paragraph (c)(4)(i)([a]{.underline}) of this section

1.421-2(c)(4)(iii), [Example 4]{.underline}, fifth and sixth sentences

subdivision (ii)([b]{.underline}) of this subparagraph

paragraph (c)(4)(i)([b]{.underline}) of this section

1.421-2(c)(4)(iii), [Example 4]{.underline}, sixth sentence

subdivision (ii)([c]{.underline}) of this subparagraph

paragraph (c)(4)(i)([c]{.underline}) of this section

8\. Revising paragraph (d).

9\. Adding paragraph (f).

The revisions read as follows:

[§ 1.421-2 General rules]{.underline}.

\(a\) [Effect of qualifying transfer]{.underline}. (1) If a share of
stock is transferred to an individual pursuant to the individual's
exercise of a statutory option, and if the requirements of §1.422-1(a)
(relating to incentive stock options) or §1.423-1(a) (relating to
employee stock purchase plans) whichever is applicable, are met, then\--

\(i\) No income results at the time of the transfer of such share to the
individual upon the exercise of the option with respect to such share
(in addition, no income results upon grant of the option, see §1.83-7);

\(ii\) No deduction under section 162 or the regulations thereunder
(relating to trade or business expenses) is allowable at any time with
respect to the share so transferred; and

\(iii\) No amount other than the price paid under the option is
considered as received by the employer corporation, a related
corporation of such corporation, or a corporation substituting or
assuming a stock option in a transaction to which §1.424-1(a) (relating
to corporate reorganizations, liquidations, etc.) applies, for the share
so transferred.

\* \* \* \* \*

\(b\) [Effect of disqualifying disposition]{.underline}*.* (1)(i) The
disposition (as defined in §1.424-1(c)) of a share of stock acquired by
the exercise of a statutory option before the expiration of the
applicable holding periods as determined under §1.422-1(a) or 1.423-1(a)
is a disqualifying disposition and makes paragraph (a) of this section
inapplicable to the transfer of such share. See §1.83-7 for the
treatment of nonstatutory options. The income attributable to such
transfer (determined without reduction for any brokerage fees or other
costs paid in connection with the disposition) is treated by the
individual as compensation income received in the taxable year in which
such disqualifying disposition occurs. Similarly, if otherwise allowable
under sections 83(h) and 162, a deduction attributable to such transfer
is allowable for the taxable year in which such disqualifying
disposition occurs to the employer corporation, or a related corporation
of such corporation, or a corporation substituting or assuming an option
in a transaction to which §1.424-1(a) applies. Additionally, an amount
is allowed as a deduction only if the requirements of §1.83-6(a) are
satisfied. No amount is treated as income, and no amount is allowed as a
deduction, for any taxable year other than the taxable year in which the
disqualifying disposition occurs. If the amount realized on the
disposition exceeds (or is less than) the sum of the amount paid for the
share and the amount of compensation income recognized as a result of
such disposition, the extent to which the difference is treated as gain
(or loss) is determined under the rules of section 302 or 1001, as
applicable.

\(ii\) The following examples illustrate the principles of this
paragraph (b):

[Example 1]{.underline}. On June 1, 2006, X Corporation grants an
incentive stock option to A, an employee of X, entitling A to purchase
100 shares of X stock at \$10 per share. On August 1, 2006, A exercises
the option when the fair market value of X stock is \$20 per share, and
100 shares of X stock are transferred to A on that date. On December 15,
2007, A sells the stock. Because A disposed of the stock before June 2,
2008, A did not satisfy the holding period requirements of §1.422-1(a).
Under paragraph (b)(1)(i) of this section, A made a disqualifying
disposition of the stock. Thus, paragraph (a) of this section is
inapplicable to the transfer of the shares, and A must include the
compensation income attributable to the transfer of the shares in gross
income. The amount of compensation income A must include in income under
§1.83-7 in the year of the disqualifying disposition is \$1,000 ((\$20,
the fair market value of X stock on transfer less \$10, the exercise
price per share) times 100 shares)). If otherwise allowable under
sections 83(h) and 162 and if the requirements of §1.83-6(a) are met, X
is allowed a deduction of \$1,000 for its taxable year in which the
disqualifying disposition occurs.

[Example 2]{.underline}. Y Corporation grants an incentive stock option
for 100 shares of its stock to E, an employee of Y. The option has an
exercise price of \$10 per share. E exercises the option and is
transferred the shares when the fair market value of a share of Y stock
is \$30. Before the applicable holding periods expire, Y redeems the
shares for \$70 per share. Because the holding period requirements of
§1.422-1(a) are not met, the redemption of the shares is a disqualifying
disposition of the shares. Under paragraph (b)(1)(i) of this section, A
made a disqualifying disposition of the stock. Thus, paragraph (a) of
this section is inapplicable to the transfer of the shares, and E must
include the compensation income attributable to the transfer of the
shares in gross income. Under §1.83-7, the amount of compensation income
attributable to E's purchase of the share that E must include in gross
income in the year of the disqualifying disposition is \$2,000 (\$3,000,
the fair market value of Y stock on transfer, less \$1,000, the exercise
price paid by E). The character of the additional gain that is
includible in E's income as a result of the redemption is determined
under the rules of section 302. If otherwise allowable under sections
83(h) and 162 and if the requirements of §1.83-6(a) are met, Y is
allowed a deduction for the taxable year in which the disqualifying
disposition occurs for the compensation income of \$2,000. Y is not
allowed a deduction for the additional gain includible in E's income as
a result of the redemption.

\(2\) If an optionee transfers stock acquired through the optionee's
exercise of a statutory option prior to the expiration of the applicable
holding periods, paragraph (a) of this section continues to apply to the
transfer of the stock pursuant to the exercise of the option if such
transfer is not a disposition of the stock as defined in §1.424-1(c)
(for example, a transfer from a decedent to the decedent's estate or a
transfer by bequest or inheritance). Similarly, a subsequent transfer by
the executor, administrator, heir, or legatee is not a disqualifying
disposition by the decedent. If a statutory option is exercised by the
estate of the optionee or by a person who acquired the option by bequest
or inheritance or by reason of the death of such optionee, see paragraph
(c) of this section. If a statutory option is exercised by the
individual to whom the option was granted and the individual dies before
the expiration of the holding periods, see paragraph (d) of this
section.

\(3\) For special rules relating to the disqualifying disposition of a
share of stock acquired by exercise of an incentive stock option, see
§§1.422-5(b)(2) and 1.424-1(c)(3).

\(c\) [Exercise by estate]{.underline}. (1) If a statutory option is
exercised by the estate of the individual to whom the option was granted
(or by any person who acquired such option by bequest or inheritance or
by reason of the death of such individual), paragraph (a) of this
section applies to the transfer of stock pursuant to such exercise in
the same manner as if the option had been exercised by the deceased
optionee. Consequently, neither the estate nor such person is required
to include any amount in gross income as a result of a transfer of stock
pursuant to the exercise of the option. Paragraph (a) of this section
applies even if the executor, administrator, or such person disposes of
the stock so acquired before the expiration of the applicable holding
periods as determined under §1.422-1(a) or 1.423-1(a). This special rule
does not affect the applicability of section 423(c), relating to the
estate's or other qualifying person's recognition of compensation
income, or section 1222, relating to what constitutes a short-term and
long-term capital gain or loss. Paragraph (a) of this section also
applies even if the executor, administrator, or such person does not
exercise the option within three months after the death of the
individual or is not employed as described in §1.421-1(h), either when
the option is exercised or at any time. However, paragraph (a) of this
section does not apply to a transfer of shares pursuant to an exercise
of the option by the estate or by such person unless the individual met
the employment requirements described in §1.421-1(h) either at the time
of the individual's death or within three months before such time (or,
if applicable, within the period described in §1.422-1(a)(3)).
Additionally, paragraph (a) of this section does not apply if the option
is exercised by a person other than the executor or administrator, or
other than a person who acquired the option by bequest or inheritance or
by reason of the death of such deceased individual. For example, if the
option is sold by the estate, paragraph (a) of this section does not
apply to the transfer of stock pursuant to an exercise of the option by
the buyer, but if the option is distributed by the administrator to an
heir as part of the estate, paragraph (a) of this section applies to the
transfer of stock pursuant to an exercise of the option by such heir.

\* \* \* \* \*

\(d\) [Option exercised by the individual to whom the option was granted
if the individual dies before expiration of the applicable holding
periods]{.underline}. If a statutory option is exercised by the
individual to whom the option was granted and such individual dies
before the expiration of the applicable holding periods as determined
under §1.422-1(a) or 1.423-1(a), paragraph (a) of this section does not
become inapplicable if the executor or administrator of the estate of
such individual, or any person who acquired such stock by bequest or
inheritance or by reason of the death of such individual, disposes of
such stock before the expiration of such applicable holding periods.
This rule does not affect the applicability of section 423(c), relating
to the individual's recognition of compensation income, or section 1222,
relating to what constitutes a short-term and long-term capital gain or
loss.

\* \* \* \* \*

\(f\) [Effective date]{.underline}. This section is applies to any
statutory option granted on or after the date that is 180 days after
publication of final regulations in the **Federal Register**. Taxpayers
can rely on these regulations for the treatment of any statutory option
granted on or after June 9, 2003.

Par. 5. Section 1.422-1 is added to read as follows:

[§1.422-1 Incentive stock options; general rules]{.underline}.

\(a\) [Applicability of section 421(a)]{.underline}. (1)(i) Section
1.421-2(a) applies to the transfer of a share of stock to an individual
pursuant to the individual's exercise of an incentive stock option if
the following conditions are satisfied\--

\(A\) The individual makes no disposition of such share before the later
of the expiration of the 2-year period from the date of grant of the
option pursuant to which such share was transferred, or the expiration
of the 1-year period from the date of transfer of such share to the
individual; and

\(B\) At all times during the period beginning on the date of grant of
the option and ending on the day 3 months before the date of exercise,
the individual was an employee of either the corporation granting the
option, a related corporation of such corporation, or a corporation (or
a related corporation of such corporation) substituting or assuming a
stock option in a transaction to which §1.424-1(a) applies.

\(ii\) For rules relating to the disposition of shares of stock acquired
pursuant to the exercise of a statutory option, see §1.424-1(c). For
rules relating to the requisite employment relationship, see
§1.421-1(h).

(2)(i) The holding period requirement of section 422(a)(1), described in
paragraph (a)(1)(i)(A) of this section, does not apply to the transfers
of shares by an insolvent individual described in this paragraph (a)(2).
If an insolvent individual holds a share of stock acquired pursuant to
the individual's exercise of an incentive stock option, and if such
share is transferred to a trustee, receiver, or other similar fiduciary
in any proceeding under the Bankruptcy Act or any other similar
insolvency proceeding, neither such transfer, nor any other transfer of
such share for the benefit of the individual\'s creditors in such
proceeding is a disposition of such share for purposes of this paragraph
(a). For purposes of this paragraph (a)(2), an individual is insolvent
only if the individual's liabilities exceed the individual's assets or
the individual is unable to satisfy the individual's liabilities as they
become due. See section 422(c)(3).

\(ii\) A transfer by the trustee or other fiduciary that is not treated
as a disposition for purposes of this paragraph (a) may be a sale or
exchange for purposes of recognizing capital gain or loss with respect
to the share transferred. For example, if the trustee transfers the
share to a creditor in an insolvency proceeding, capital gain or loss
must be recognized by the insolvent individual to the extent of the
difference between the amount realized from such transfer and the
adjusted basis of such share.

\(iii\) If any transfer by the trustee or other fiduciary (other than a
transfer back to the insolvent individual) is not for the exclusive
benefit of the creditors in an insolvency proceeding, then whether such
transfer is a disposition of the share by the individual for purposes of
this paragraph (a) is determined under §1.424-1(c). Similarly, if the
trustee or other fiduciary transfers the share back to the insolvent
individual, any subsequent transfer of the share by such individual
which is not made in respect of the insolvency proceeding may be a
disposition of the share for purposes of this paragraph (a).

\(3\) If the employee exercising an option ceased employment because of
permanent and total disability, within the meaning of section 22(e)(3),
1 year is used instead of 3 months in the employment period requirement
of paragraph (a)(1)(i)(B) of this section.

\(b\) [Failure to satisfy holding period requirements]{.underline}\--(1)
[General rule]{.underline}. For general rules concerning a disqualifying
disposition of a share of stock acquired pursuant to the exercise of an
incentive stock option, see §1.421-2(b)(1).

(2)(i) [Special rule]{.underline}. If an individual makes a
disqualifying disposition of a share of stock acquired by the exercise
of an incentive stock option, and if such disposition is a sale or
exchange with respect to which a loss (if sustained) would be recognized
to the individual, then, under this paragraph (b)(2)(i), the amount
includible in the gross income of such individual, and deductible from
the income of the employer corporation (or a related corporation of such
corporation, or of a corporation substituting or assuming the option in
a transaction to which §1.424-1(a) applies) as compensation attributable
to the exercise of such option, shall not exceed the excess (if any) of
the amount realized on such sale or exchange over the adjusted basis of
such share. Subject to the special rule provided by this paragraph
(b)(2)(i), the amount of compensation attributable to the exercise of
the option is determined under §1.83-7; see §1.421-2(b)(1)(i).

\(ii\) [Limitation to special rule]{.underline}. The special rule
described in paragraph (b)(2)(i) of this section does not apply if the
disposition is a sale or exchange with respect to which a loss (if
sustained) would not be recognized to the individual. Thus, for example,
if a disqualifying disposition is a sale described in section 1091
(relating to loss from wash sales of stock or securities), a gift (or
any other transaction which is not at arm's length), or a sale described
in section 267(a)(1) (relating to sales between related persons), the
special rule described in paragraph (b)(2)(i) of this section does not
apply because a loss sustained in any such transaction would not be
recognized.

\(3\) [Examples]{.underline}. The following examples illustrate the
principles of this paragraph (b):

[Example 1]{.underline}*.* On June 1, 2006, X Corporation grants an
incentive stock option to A, an employee of X Corporation, entitling A
to purchase one share of X Corporation stock. On August 1, 2006, A
exercises the option and the share of X Corporation stock is transferred
to A on that date. The option price is \$100 (the fair market value of a
share of X Corporation stock on June 1, 2006) and the fair market value
of a share of X Corporation stock on August 1, 2006 (the date of
transfer) is \$200. The share transferred to A is transferable and not
subject to a substantial risk of forfeiture. A makes a disqualifying
disposition by selling the share on June 1, 2007, for \$250. Under
§1.83-7(a) (relating to options to which section 421 does not apply),
the amount of compensation attributable to A\'s exercise is \$100 (the
difference between the fair market value of the share at the date of
transfer, \$200, and the amount paid for the share, \$100). Because the
amount realized (\$250) is greater than the value of the share at
transfer (\$200), paragraph (b)(2)(i) of this section does not apply and
thus does not affect the amount includible as compensation in A\'s gross
income and deductible by X. A must include in gross income for the
taxable year in which the sale occurred \$100 as compensation and \$50
as capital gain (\$250, the amount realized from the sale, less A\'s
basis of \$200 (the \$100 paid for the share plus the \$100 increase in
basis resulting from the inclusion of that amount in A\'s gross income
as compensation attributable to the exercise of the option)). For its
taxable year in which the disqualifying disposition occurs, if otherwise
allowable under sections 83(h) and 162 and if the requirements of
§1.83-6(a) are met, X Corporation is allowed a deduction of \$100 for
compensation attributable to A\'s exercise of the incentive stock
option.

[Example 2]{.underline}*.* Assume the same facts as in [Example
1]{.underline}, except that the share of X Corporation stock transferred
to A is subject to a substantial risk of forfeiture and not transferable
for a period of six months after such transfer. Assume further that the
fair market value of X Corporation stock is \$225 on February 1, 2005,
the date on which the six-month restriction lapses. Under section 83(a)
and §1.83-7(a), the amount of compensation attributable to A\'s exercise
of the option and disqualifying disposition of the share is \$125 (the
difference between the fair market value of the share on the date that
the restriction lapsed, \$225, and the amount paid for the share,
\$100). A must include \$125 of compensation income and \$25 of capital
gain in gross income for the taxable year in which the disposition
occurs (\$250, the amount realized from the sale, less A\'s basis of
\$225 (the \$100 paid for the share plus the \$125 increase in basis
resulting from the inclusion of that amount of compensation in A\'s
gross income)). For its taxable year in which the disqualifying
disposition occurs, if otherwise allowable under sections 83(h) and 162
and if the requirements of §1.83-6(a) are met, X Corporation is allowed
a deduction of \$125 for the compensation attributable to A\'s exercise
of the option.

[Example 3]{.underline}. (i) Assume the same facts as in [Example
1]{.underline}, except that A sells the share for \$150 to M.

\(ii\) If the sale to M is a disposition that meets the requirements of
paragraph (b)(2)(i) of this section, instead of \$100 which otherwise
would have been includible as compensation under §1.83-7, under
paragraph (b)(2)(i) of this section, A must include only \$50 (the
excess of the amount realized on such sale, \$150, over the adjusted
basis of the share, \$100) in gross income as compensation attributable
to the exercise of the incentive stock option. Because A\'s basis for
the share is \$150 (the \$100 which A paid for the share, plus the \$50
increase in basis resulting from the inclusion of that amount in A\'s
gross income as compensation attributable to the exercise of the
option), A realizes no capital gain or loss as a result of the sale. For
its taxable year in which the disqualifying disposition occurs, if
otherwise allowable under sections 83(h) and 162 and if the requirements
of §1.83-6(a) are met, X Corporation is allowed a deduction of \$50 for
the compensation attributable to A\'s exercise of the option.

\(iii\) Assume the same facts as in paragraph (i) of this [Example
3]{.underline}, except that 10 days after the sale to M, A purchases
substantially identical stock. Because under section 1091(a) a loss (if
it were sustained on the sale) would not be recognized on the sale,
under paragraph (b)(2)(ii) of this section, the special rule described
in paragraph (b)(2)(i) of this section does not apply. Under §1.83-7, A
must include \$100 (the difference between the fair market value of the
share on the date of transfer, \$200, and the amount paid for the share,
\$100) in gross income as compensation attributable to the exercise of
the option for the taxable year in which the disqualifying disposition
occurred. A recognizes no capital gain or loss on the transaction. For
its taxable year in which the disqualifying disposition occurs, if
otherwise allowable under sections 83(h) and 162 and if the requirements
of §1.83-6(a) are met, X Corporation is allowed a \$100 deduction for
compensation attributable to A's exercise of the option.

\(iv\) Assume the same facts as in paragraph (ii) of this [Example
3]{.underline}, except that A sells the share for \$50. Under paragraph
(b)(2)(i) of this section, A is not required to include any amount in
gross income as compensation attributable to the exercise of the option.
A is allowed a capital loss of \$50 (the difference between the amount
realized on the sale, \$50, and the adjusted basis of the share, \$100).
X Corporation is not allowed any deduction attributable to A\'s exercise
of the option and disqualifying disposition of the share.

\(c\) [Failure to satisfy employment requirement]{.underline}. Section
1.421-2(a) does not apply to the transfer of a share of stock pursuant
to the exercise of an incentive stock option if the employment
requirement, as determined under paragraph (a)(1)(i)(B) of this section,
is not met at the time of the exercise of such option. Consequently, the
effects of such a transfer are determined under the rules of §1.83-7.
For rules relating to the employment relationship, see §1.421-1(h).

Par. 6. Section 1.422-2 is added to read as follows:

[§1.422-2 Incentive stock options defined]{.underline}.

\(a\) [Incentive stock option defined]{.underline}\--(1) [In
general]{.underline}. The term [incentive stock option]{.underline}
means an option that meets the requirements of paragraph (a)(2) of this
section on the date of grant. An incentive stock option is also subject
to the \$100,000 limitation described in §1.422-4. An incentive stock
option may contain a number of permissible provisions that do not affect
the status of the option as an incentive stock option. See §1.422-5 for
rules relating to permissible provisions of an incentive stock option.

\(2\) [Option requirements]{.underline}. To qualify as an incentive
stock option under this section, an option must be granted to an
individual in connection with the individual's employment by the
corporation granting such option (or by a related corporation), and
granted only for stock of any of such corporations. In addition, the
option must meet all of the following requirements \--

\(i\) It must be granted pursuant to a plan that meets the requirements
described in paragraph (b) of this section;

\(ii\) It must be granted within 10 years from the date of the adoption
of the plan or the date such plan is approved by the stockholders,
whichever is earlier (see paragraph (c) of this section);

\(iii\) It must not be exercisable after the expiration of 10 years from
the date of grant (see paragraph (d) of this section);

\(iv\) It must provide that the option price per share is not less than
the fair market value of the share on the date of grant (see paragraph
(e) of this section);

\(v\) By its terms, it must not be transferrable by the individual to
whom the option is granted other than by will or the laws of descent and
distribution, and must be exercisable, during such individual's
lifetime, only by such individual (see §§1.421-1(b)(2) and 1.421-2(c));
and

\(vi\) Except as provided in paragraph (f) of this section, it must be
granted to an individual who, at the time the option is granted, does
not own stock possessing more than 10 percent of the total combined
voting power of all classes of stock of the corporation employing such
individual or of any related corporation of such corporation.

\(3\) [Amendment of option terms]{.underline}. Except as otherwise
provided in §1.424-1, the amendment of the terms of an incentive stock
option may cause it to cease to be an option described in this section.
If the terms of an option that has lost its status as an incentive stock
option are subsequently changed with the intent to re-qualify the option
as an incentive stock option, such change results in the grant of a new
option on the date of the change. See §1.424-1(e).

\(4\) [Terms provide option not an incentive stock option]{.underline}.
If the terms of an option, when granted, provide that it will not be
treated as an incentive stock option, such option is not treated as an
incentive stock option.

\(b\) [Option plan]{.underline}\--(1) [In general]{.underline}. An
incentive stock option must be granted pursuant to a plan that meets the
requirements of this paragraph (b). The authority to grant other stock
options or other stock-based awards pursuant to the plan, where the
exercise of such other options or awards does not affect the exercise of
incentive stock options granted pursuant to the plan, does not
disqualify such incentive stock options. The plan must be in writing or
electronic form, provided that such writing or electronic form is
adequate to establish the terms of the plan. See §1.422-5 for rules
relating to permissible provisions of an incentive stock option.

\(2\) [Stockholder approval]{.underline}. (i) The plan required by this
paragraph (b) must be approved by the stockholders of the corporation
granting the incentive stock option within 12 months before or after the
date such plan is adopted. Ordinarily, a plan is adopted when it is
approved by the granting corporation's board of directors, and the date
of the board's action is the reference point for determining whether
stockholder approval occurs within the applicable 24-month period.
However, if the board\'s action is subject to a condition (such as
stockholder approval) or the happening of a particular event, the plan
is adopted on the date the condition is met or the event occurs, unless
the board\'s resolution fixes the date of approval as the date of the
board\'s action.

\(ii\) For purposes of paragraph (b)(2)(i) of this section, the
stockholder approval must comply with the rules described in §1.422-3.

\(iii\) The provisions relating to the maximum aggregate number of
shares to be issued under the plan (described in paragraph (b)(3) of
this section) and the employees (or class or classes of employees)
eligible to receive options under the plan (described in paragraph
(b)(4) of this section) are the only provisions of a stock option plan
that must be approved by stockholders for purposes of section 422(b)(1).
Any increase in the maximum aggregate number of shares that may be
issued under the plan (other than an increase merely reflecting a change
in the number of outstanding shares, such as a stock dividend or stock
split), or change in the designation of the employees (or class or
classes of employees) eligible to receive options under the plan is
considered the adoption of a new plan requiring stockholder approval
within the prescribed 24-month period. In addition, a change in the
granting corporation or the stock available for purchase or award under
the plan is considered the adoption of a new plan requiring new
stockholder approval within the prescribed 24-month period. Any other
changes in the terms of an incentive stock option plan are not
considered the adoption of a new plan and, thus, do not require
stockholder approval.

\(3\) [Maximum aggregate number of shares]{.underline}. (i) The plan
required by this paragraph (b) must designate the maximum aggregate
number of shares that may be issued under the plan through incentive
stock options, nonstatutory options, and all other stock-based awards to
be granted thereunder. If nonstatutory options or other stock-based
awards may be granted, the plan may separately designate terms for each
type of option and other stock-based award and designate the maximum
number of shares that may be issued under such option or other
stock-based award. Unless otherwise specified, all terms of the plan
apply to all options and other stock-based awards that may be granted
under the plan.

\(ii\) A plan that merely provides that the number of shares that may be
issued under options and other stock-based awards granted under such
plan may not exceed a stated percentage of the shares outstanding at the
time of each offering or grant under such plan does not satisfy the
requirement that the plan state the maximum aggregate number of shares
that may be issued under the plan. However, the maximum aggregate number
of shares that may be issued under the plan may be stated in terms of a
percentage of the authorized, issued or outstanding shares at the date
of the adoption of the plan. The plan may specify that the maximum
aggregate number of shares available for grants under the plan may
increase annually by a specified percentage of the authorized, issued or
outstanding shares at the date of the adoption of the plan. A plan which
provides that the maximum aggregate number of shares that may be issued
under the plan may change based on any other specified circumstances
satisfies the requirements of this paragraph (b)(3) only if the
stockholders approve an immediately determinable maximum aggregate
number of shares that may be issued under the plan in any event.

\(iii\) It is permissible for the plan to provide that shares
purchasable under the plan may be supplied to the plan through
acquisitions of stock on the open market, that shares purchased under
the plan and forfeited back to the plan are available for re-issuance
under the plan, or that shares surrendered in payment of the exercise
price of an option are available for re-issuance under the plan.

\(iv\) If there is more than one plan under which incentive stock
options may be granted and stockholders of the granting corporation
merely approve a maximum aggregate number of shares that are available
for issuance under such plans, the stockholder approval requirements
described in paragraph (b)(2) of this section are not satisfied. A
separate maximum aggregate number of shares must be approved for each
plan.

\(4\) [Designation of employees]{.underline}. The plan described in this
paragraph (b), as adopted and approved, must indicate the employees (or
class or classes of employees) eligible to receive the options or other
stock-based awards to be granted under the plan. This requirement is
satisfied by a general designation of the classes of employees eligible
to receive options or other stock-based awards under the plan.
Designations such as "key employees of the grantor corporation"; "all
salaried employees of the grantor corporation and its subsidiaries,
including subsidiaries which become such after adoption of the plan;" or
"all employees of the corporation" meet this requirement. This
requirement is considered satisfied even though the board of directors,
another group, or an individual is given the authority to select the
particular employees who are to receive options or other stock-based
awards from a described class and to determine the number of shares to
be optioned or granted to each such employee. If individuals other than
employees may be granted options or other stock-based awards under the
plan, the plan must separately designate the employees or classes of
employees eligible to receive incentive stock options.

\(5\) [Conflicting option terms]{.underline}. An option on stock
available for purchase or grant under the plan is treated as having been
granted pursuant to a plan even if the terms of the option conflict with
the terms of the plan, unless such option is granted to an employee who
is ineligible to receive options under the plan, options have been
granted on stock in excess of the aggregate number of shares which may
be issued under the plan, or the option provides otherwise.

> \(6\) The following examples illustrate the principles of this
> paragraph (b):

[Example 1]{.underline}. [Stockholder approval]{.underline}. (i) S
Corporation is a subsidiary of P Corporation, a publicly traded
corporation. On January 1, 2006, S adopts a plan under which incentive
stock options for S stock are granted to S employees.

\(ii\) To meet the requirements of paragraph (b)(2) of this section, the
plan must be approved by the stockholders of S (in this case, P) within
12 months before or after January 1, 2004.

\(iii\) Assume the same facts as in paragraph (i) of this [Example
1]{.underline}. Assume further that the plan was approved by the
stockholders of S (in this case, P) on March 1, 2006. On January 1,
2008, S changes the plan to provide that incentive stock options for P
stock will be granted to S employees under the plan. Because there is a
change in the stock available for grant under the plan, the change is
considered the adoption of a new plan that must be approved by the
stockholders within 12 months before or after January 1, 2008.

[Example 2]{.underline}. [Stockholder approval]{.underline}. (i) Assume
the same facts as in paragraph (i) of [Example 1]{.underline}, except
that on March 15, 2007, P completely disposes of its interest in S.
Thereafter, S continues to grant options for S stock to S employees
under the plan.

\(ii\) The new S options are granted under a plan that meets the
stockholder approval requirements of paragraph (b)(2) of this section
without regard to whether S seeks approval of the plan from the
stockholders of S after P disposes of its interest in S.

> \(iii\) Assume the same facts as in paragraph (i) of this [Example
> 2]{.underline}, except that under the plan as adopted on January 1,
> 2006, only options for P stock are granted to S employees. Assume
> further that after P disposes of its interest in S, S changes the plan
> to provide for the grant of options for S stock to S employees.
> Because there is a change in the stock available for purchase or grant
> under the plan, under paragraph (b)(2)(iii) of this section, the
> stockholders of S must approve the plan within 12 months before or
> after the change to the plan to meet the stockholder approval
> requirements of paragraph (b) of this section.

[Example 3]{.underline}. [Maximum aggregate number of
shares]{.underline}. X Corporation maintains a plan under which
statutory options and nonstatutory options may be granted. The plan
designates the number of shares that may be used for incentive stock
options. Because the maximum aggregate number of shares that will be
used for both statutory and nonstatutory options is not designated in
the plan, the requirements of paragraph (b)(3) of this section are not
satisfied.

[Example 4]{.underline}. [Maximum aggregate number of
shares.]{.underline} Y Corporation adopts an incentive stock option plan
on November 1, 2006. On that date there are two million outstanding
shares of Y Corporation stock. The plan provides that the maximum
aggregate number of shares that may be issued under the plan may not
exceed 15% of the outstanding number of shares of Y Corporation on
November 1, 2006. Because the maximum aggregate number of shares under
the plan is designated in the plan, the requirements of paragraph (b)(3)
of this section are met.

[Example 5]{.underline}. [Maximum aggregate number of
shares]{.underline}. (i) B Corporation adopts an incentive stock option
plan on March 15, 2005. The plan provides that the maximum aggregate
number of shares available under the plan is 50,000, increased on each
anniversary date of the adoption of the plan by 5 percent of the
then-outstanding shares.

\(ii\) Because the maximum aggregate number of shares is not designated
under the plan, the requirements of paragraph (b)(3) of this section are
not met.

\(iii\) Assume the same facts as in paragraph (i) of this [Example
5]{.underline}, except that the plan provides that the maximum aggregate
number of shares available under the plan is the lesser of (a) 50,000
shares increased each anniversary date of the adoption of the plan by 5
percent of the then‑outstanding shares or (b) 200,000 shares. Because
the maximum aggregate number of shares under the plan is designated as
the lesser of one of two numbers, one of which provides an immediately
determinable maximum aggregate number of shares that may be issued under
the plan in any event, the requirements of paragraph (b)(3) of this
section are met.

\(c\) [Duration of option grants under the plan.]{.underline} An
incentive stock option must be granted within 10 years from the date
that the plan under which it is granted is adopted or the date such plan
is approved by the stockholders, whichever is earlier. To grant
incentive stock options after the expiration of the 10-year period, a
new plan must be adopted and approved.

\(d\) [Period for exercising options]{.underline}. An incentive stock
option, by its terms, must not be exercisable after the expiration of 10
years from the date such option is granted, or 5 years from the date
such option is granted to an employee described in paragraph (f) of this
section. An option that does not contain such a provision when granted
is not an incentive stock option.

\(e\) [Option price.]{.underline} (1) Except as provided by paragraph
(e)(2) of this section, the option price of an incentive stock option
must not be less than the fair market value of the stock subject to the
option at the time the option is granted. The option price may be
determined in any reasonable manner, including the valuation methods
permitted under §20.2031-2 of this chapter (Estate Tax Regulations), so
long as the minimum price possible under the terms of the option is not
less than the fair market value of the stock on the date of grant. For
general rules relating to the option price, see §1.421-1(e). For rules
relating to the determination of when an option is granted, see
§1.421-1(c).

(2)(i) If a share of stock is transferred to an individual pursuant to
the exercise of an option which fails to qualify as an incentive stock
option merely because there was a failure of an attempt, made in good
faith, to meet the option price requirements of paragraph (e)(1) of this
section, the requirements of such paragraph are considered to have been
met. Whether there was a good-faith attempt to set the option price at
not less than the fair market value of the stock subject to the option
at the time the option was granted depends on the relevant facts and
circumstances.

\(ii\) For publicly held stock that is actively traded on an established
market at the time the option is granted, determining the fair market
value of such stock by the appropriate method described in §20.2031-2 of
this chapter (Estate Tax Regulations) establishes that a good-faith
attempt to meet the option price requirements of this paragraph (e) was
made.

\(iii\) For non-publicly traded stock, if it is demonstrated, for
example, that the fair market value of the stock at the date of grant
was based upon an average of the fair market values as of such date set
forth in the opinions of completely independent and well-qualified
experts, such a demonstration generally establishes that there was a
good-faith attempt to meet the option price requirements of this
paragraph (e). If the stock is non-publicly traded, the optionee's
status as a majority or minority stockholder may be taken into
consideration.

\(iv\) Regardless of whether the stock offered under an option is
publicly traded, a good-faith attempt to meet the option price
requirements of this paragraph (e) is not demonstrated unless the fair
market value of the stock on the date of grant is determined with regard
to [nonlapse restrictions]{.underline} (as defined in §1.83-3(h)) and
without regard to [lapse restrictions]{.underline} (as defined in
§1.83-3(i)).

\(v\) Amounts treated as interest and amounts paid as interest under a
deferred payment arrangement are not includible as part of the option
price. See §1.421-1(e)(1). An attempt to set the option price at not
less than fair market value is not regarded as made in good faith where
an adjustment of the option price to reflect amounts treated as interest
results in the option price being lower than the fair market value on
which the option price was based.

\(3\) Notwithstanding that the option price requirements of paragraphs
(e)(1) and (2) of this section are satisfied by an option granted to an
employee whose stock ownership exceeds the limitation provided by
paragraph (f) of this section, such option is not an incentive stock
option when granted unless it also complies with paragraph (f) of this
section. If the option, when granted, does not comply with the
requirements described in paragraph (f) of this section, such option can
never become an incentive stock option, even if the employee's stock
ownership does not exceed the limitation of paragraph (f) of this
section when such option is exercised.

\(f\) [Options granted to certain stockholders]{.underline}. (1) If,
immediately before an option is granted, an individual owns (or is
treated as owning) stock possessing more than 10 percent of the total
combined voting power of all classes of stock of the corporation
employing the optionee or of any related corporation of such
corporation, then an option granted to such individual cannot qualify as
an incentive stock option unless the option price is at least 110
percent of the stock\'s fair market value on the date of grant and such
option by its terms is not exercisable after the expiration of 5 years
from the date of grant. For purposes of determining the minimum option
price for purposes of this paragraph (f), the rules described in
paragraph (e)(2) of this section, relating to the good-faith
determination of the option price, do not apply.

\(2\) For purposes of determining the stock ownership of the optionee,
the stock attribution rules of §1.424-1(d) apply. Stock that the
optionee may purchase under outstanding options is not treated as stock
owned by the individual. The determination of the percentage of the
total combined voting power of all classes of stock of the employer
corporation (or of its related corporations) that is owned by the
optionee is made with respect to each such corporation in the related
group by comparing the voting power of the shares owned (or treated as
owned) by the optionee to the aggregate voting power of all shares of
each such corporation actually issued and outstanding immediately before
the grant of the option to the optionee. The aggregate voting power of
all shares actually issued and outstanding immediately before the grant
of the option does not include the voting power of treasury shares or
shares authorized for issue under outstanding options held by the
individual or any other person.

\(3\) [Examples]{.underline}. The rules of this paragraph (f) are
illustrated by the following examples:

[Example 1]{.underline}. (i) E, an employee of M Corporation, owns
15,000 shares of M Corporation common stock, which is the only class of
stock outstanding. M has 100,000 shares of its common stock outstanding.
On January 1, 2005, when the fair market value of M stock is \$100, E is
granted an option with an option price of \$100 and an exercise period
of 10 years from the date of grant.

\(ii\) Because E owns stock possessing more than 10 percent of the total
combined voting power of all classes of M Corporation stock, M cannot
grant an incentive stock option to E unless the option is granted at an
option price of at least 110 percent of the fair market value of the
stock subject to the option and the option, by its terms, expires no
later than 5 years from its date of grant. The option granted to E fails
to meet the option-price and term requirements described in paragraph
(f)(1) of this section and, thus, the option is not an incentive stock
option.

\(iii\) Assume the same facts as in paragraph (i) of this [Example
1]{.underline}, except that E\'s father and brother each owned 7,500
shares of M Corporation stock, and E owned no M stock in E\'s own name.
Because under the attribution rules of §1.424-1(d), E is treated as
owning stock held by E's parents and siblings, M cannot grant an
incentive stock option to E unless the option price is at least 110
percent of the fair market value of the stock subject to the option, and
the option, by its terms, expires no later than 5 years from the date of
grant.

[Example 2]{.underline}*.* Assume the same facts as in paragraph (i) of
this [Example 1]{.underline}. Assume further that M is a subsidiary of P
Corporation. Regardless of whether E owns any P stock and the number of
P shares outstanding, if P Corporation grants an option to E which
purports to be an incentive stock option, but which fails to meet the
110-percent-option-price and 5-year-term requirements, the option is not
an incentive stock option because E owns more than 10 percent of the
total combined voting power of all classes of stock of a related
corporation of P Corporation (i.e., M Corporation). An individual who
owns (or is treated as owning) stock in excess of the ownership
specified in paragraph (f)(1) of this section, in any corporation in a
group of corporations consisting of the employer corporation and its
related corporations, cannot be granted an incentive stock option by any
corporation in the group unless such option meets the
110-percent-option-price and 5-year-term requirements of paragraph
(f)(1) of this section.

[Example 3]{.underline}*.* (i) F is an employee of R Corporation. R has
only one class of stock, of which 100,000 shares are issued and
outstanding. F owns no stock in R Corporation or any related corporation
of R Corporation. On January 1, 2005, R grants a 10-year incentive stock
option to F to purchase 50,000 shares of R stock at \$3 per share, the
fair market value of R stock on the date of grant of the option. On
April 1, 2005, F exercises half of the January option and receives
25,000 shares of R stock that previously were not outstanding. On July
1, 2005, R grants a second 50,000 share option to F which purports to be
an incentive stock option. The terms of the July option are identical to
the terms of the January option, except that the option price is \$3.25
per share, which is the fair market value of R stock on the date of
grant of the July option.

\(ii\) Because F did not own more than 10% of the total combined voting
power of all classes of stock of R Corporation or any related
corporation on the date of the grant of the January option and the
pricing requirements of paragraph (e) of this section are satisfied on
the date of grant of such option, the unexercised portion of the January
option remains an incentive stock option regardless of the changes in
F's percentage of stock ownership in R after the date of grant. However,
the July option is not an incentive stock option because, on the date
that it was granted, F owned 20 percent (25,000 shares owned by F
divided by 125,000 shares of R stock issued and outstanding) of the
total combined voting power of all classes of R Corporation stock and,
thus the pricing requirements of paragraph (f)(1) of this section were
not met.

\(iii\) Assume the same facts as in paragraph (i) of this [Example
3]{.underline} except that the partial exercise of the January incentive
stock option on April 1, 2003, is for only 10,000 shares. Under these
circumstances, the July option is an incentive stock option, because, on
the date of grant of the July option, F does not own more than 10
percent of the total combined voting power (10,000 shares owned by F
divided by 110,000 shares of R issued and outstanding) of all classes of
R Corporation stock.

**§1.422-4 \[Removed\]**

Par. 7. Section 1.422-4 is removed.

**§1.422-5 \[Redesignated\]**

Par. 8. Section 1.422-5 is re-designated as §1.422-3.

Par. 9. New §1.422-4 is added to read as follows:

[§1.422-4 \$100,000 limitation for incentive stock options]{.underline}.

\(a\) [\$100,000 per year limitation]{.underline}\--(1) [General
rule]{.underline}. An option that otherwise qualifies as an incentive
stock option nevertheless fails to be an incentive stock option to the
extent that the \$100,000 limitation described in paragraph (a)(2) of
this section is exceeded.

\(2\) [\$100,000 per year limitation]{.underline}. To the extent that
the aggregate fair market value of stock with respect to which an
incentive stock option (determined without regard to this section) is
exercisable for the first time by any individual during any calendar
year (under all plans of the employer corporation and related
corporations) exceeds \$100,000, such option is treated as a
nonstatutory option. See §1.83-7 for rules applicable to nonstatutory
options.

\(b\) [Application]{.underline}. To determine whether the limitation
described in paragraph (a)(2) of this section has been exceeded, the
following rules apply.

\(1\) An option that does not meet the requirements of §1.422-2 when
granted (including an option which, when granted, contains terms
providing that it will not be treated as incentive stock option) is
disregarded. See §1.422-2(a)(4).

\(2\) The fair market value of stock is determined as of the date of
grant of the option for such stock.

\(3\) Except as otherwise provided in paragraph (b)(4) of this section,
options are taken into account in the order in which they are granted.

\(4\) For purposes of this section, an option is considered to be first
exercisable during a calendar year if the option will become exercisable
at any time during the year assuming that any condition on the
optionee's ability to exercise the option related to the performance of
services is satisfied. If the optionee's ability to exercise the option
in the year is subject to an acceleration provision, then the option is
considered first exercisable in the calendar year in which the
acceleration provision is triggered. After an acceleration provision is
triggered, the options subject to such provision are then taken into
account in accordance with paragraph (b)(3) of this section for purposes
of applying the limitation described in paragraph (a)(2) of this section
to all options first exercisable during a calendar year. However,
because an acceleration provision is not taken into account prior to its
triggering, an incentive stock option that becomes exercisable for the
first time during a calendar year by operation of such a provision does
not affect the application of the \$100,000 limitation with respect to
any option (or portion thereof) exercised prior to such acceleration.
For purposes of this paragraph (b)(4), an acceleration provision
includes, for example, a provision that accelerates the exercisability
of an option on a change in ownership or control or a provision that
conditions exercisability on the attainment of a performance goal. See
paragraph (d), [Example 4]{.underline} of this section.

(5)(i) An option (or portion thereof) is disregarded if, prior to the
calendar year during which it would otherwise have become exercisable
for the first time, the option (or portion thereof) is modified and
thereafter ceases to be an incentive stock option described in §1.422-2,
is canceled, or is transferred in violation of §1.421-1(b)(2).

\(ii\) If an option (or portion thereof) is modified, canceled, or
transferred at any other time, such option (or portion thereof) is
treated as outstanding according to its original terms until the end of
the calendar year during which it would otherwise have become
exercisable for the first time.

\(6\) A disqualifying disposition has no effect on the determination of
whether an option exceeds the \$100,000 limitation.

\(c\) [Bifurcation of options]{.underline}. The application of the rules
described in paragraph (b) of this section may result in an option being
treated, in part, as an incentive stock option and, in part, as a
nonstatutory option. In such a case, a corporation can issue a separate
certificate for incentive option stock and designate such stock as
incentive stock option stock in the corporation's transfer records. In
the absence of such a designation, a pro rata portion of each share of
stock purchased under the option is treated as incentive stock option
stock and nonstatutory option stock. See §1.83-7 for the treatment of
nonstatutory options.

\(d\) [Examples]{.underline}. The following examples illustrate the
principles of this section. In each of the following examples E is an
employee of X Corporation. The examples are as follows:

[Example 1]{.underline}. [General rule]{.underline}. Effective January
1, 2004, X Corporation adopts a plan under which incentive stock options
may be granted to its employees. On January 1, 2004, and each succeeding
January 1 through January 1, 2013, E is granted immediately exercisable
options for X Corporation stock with a fair market value of \$100,000
determined on the date of grant. The options qualify as incentive stock
options (determined without regard to this section). On January 1, 2014,
E exercises all of the options. Because the \$100,000 limitation has not
been exceeded during any calendar year, all of the options are treated
as incentive stock options.

[Example 2]{.underline}. [Order of grant]{.underline}. X Corporation is
a parent corporation of Y Corporation, which is a parent corporation of
Z Corporation. Each corporation has adopted its own separate plan, under
which an employee of any member of the corporate group may be granted
options for stock of any member of the group. On January 1, 2004, X
Corporation grants E an incentive stock option (determined without
regard to this section) for stock of Y Corporation with a fair market
value of \$100,000 on the date of grant. On December 31, 2004, Y
Corporation grants E an incentive stock option (determined without
regard to this section) for stock of Z Corporation with a fair market
value of \$75,000 as of the date of grant. Both of the options are
immediately exercisable. For purposes of this section, options are taken
into account in the order in which granted using the fair market value
of stock as of the date on the option is granted. During calendar year
2004, the aggregate fair market value of stock with respect to which E's
options are exercisable for the first time exceeds \$100,000. Therefore,
the option for Y Corporation stock is treated as an incentive stock
option, and the option for Z Corporation stock is treated as a
nonstatutory option.

[Example 3]{.underline}. [Acceleration provision]{.underline}. (i) In
2004, X Corporation grants E three incentive stock options (determined
without regard to this section) to acquire stock with an aggregate fair
market value of \$150,000 on the date of grant. The dates of grant, the
fair market value of the stock (as of the applicable date of grant) with
respect to which the options are exercisable, and the years in which the
options are first exercisable (without regard to acceleration
provisions) are as follows:

Option 1

Option 2

Option 3

[Date of Grant]{.underline}

April 1, 2004

May 1, 2004

June 1, 2004

[Fair Market]{.underline}

[Value of Stock]{.underline}

\$60,000

\$50,000

\$40,000

[First]{.underline}

[Exercisable]{.underline}

2004

2006

2004

\(ii\) In July of 2004, a change in control of X Corporation occurs,
and, under the terms of its option plan, all outstanding options become
immediately exercisable. Under the rules of this section, Option 1 is
treated as an incentive stock option in its entirety; Option 2 exceeds
the \$100,000 aggregate fair market value limitation for calendar year
2004 by \$10,000 (Option 1\'s \$60,000 + Option 2\'s \$50,000 =
\$110,000) and is, therefore, bifurcated into an incentive stock option
for stock with a fair market value of \$40,000 as of the date of grant
and a nonstatutory option for stock with a fair market value of \$10,000
as of the date of grant. Option 3 is treated as a nonstatutory option in
its entirety.

[Example 4]{.underline}*.* [Exercise of option and acceleration
provision]{.underline}. (i) In 2004, X Corporation grants E three
incentive stock options (determined without regard to this section) to
acquire stock with an aggregate fair market value of \$120,000 on the
date of grant. The dates of grant, the fair market value of the stock
(as of the applicable date of grant) with respect to which the options
are exercisable, and the years in which the options are first
exercisable (without regard to acceleration provisions) are as follows:

Option 1

Option 2

Option 3

[Date of Grant]{.underline}

April 1, 2004

May 1, 2004

June 1, 2004

[Fair Market]{.underline}

[Value of Stock]{.underline}

\$60,000

\$40,000

\$20,000

[First]{.underline}

[Exercisable]{.underline}

2005

2006

2005

\(ii\) On June 1, 2005, E exercises Option 3. At the time of exercise of
Option 3, the fair market value of X stock (at the time of grant) with
respect to which options held by E are first exercisable in 2005 does
not exceed \$100,000. On September 1, 2005, a change of control of X
Corporation occurs, and, under the terms of its option plan, Option 2
becomes immediately exercisable. Under the rules of this section,
because E's exercise of Option 3 occurs before the change of control and
the effects of an acceleration provision are not taken into account
until it is triggered, Option 3 is treated as an incentive stock option
in its entirety. Option 1 is treated as an incentive stock option in its
entirety. Option 2 is bifurcated into an incentive stock option for
stock with a fair market value of \$20,000 on the date of grant and a
nonstatutory option for stock with a fair market value of \$20,000 on
the date of grant because it exceeds the \$100,000 limitation for 2003
by \$20,000 (Option 1 for \$60,000 + Option 3 for \$20,000 + Option 2
for \$40,000 = \$120,000).

\(iii\) Assume the same facts as in paragraph (ii) of this [Example
4]{.underline}, except that the change of control occurs on May 1, 2005.
Because options are taken into account in the order in which they are
granted, Option 1 and Option 2 are treated as incentive stock options in
their entirety. Because the exercise of Option 3 (on June 1, 2005) takes
place after the acceleration provision is triggered, Option 3 is treated
as a nonstatutory option in its entirety.

[Example 5]{.underline}*.* [Cancellation of option]{.underline}. (i) In
2004, X Corporation grants E three incentive stock options (determined
without regard to this section) to acquire stock with an aggregate fair
market value of \$140,000 as of the date of grant. The dates of grant,
the fair market value of the stock (as of the applicable date of grant)
with respect to which the options are exercisable, and the years in
which the options are first exercisable (without regard to acceleration
provisions) are as follows:

Option 1

Option 2

Option 3

[Date of Grant]{.underline}

April 1, 2004

May 1, 2004

June 1, 2004

[Fair Market]{.underline} [Value of Stock]{.underline}

\$60,000

\$40,000

\$40,000

[First]{.underline}

[Exercisable]{.underline}

2005

2005

2005

\(ii\) On December 31, 2004, Option 2 is canceled. Because Option 2 is
canceled before the calendar year during which it would have become
exercisable for the first time, it is disregarded. As a result, Option 1
and Option 3 are treated as incentive stock options in their entirety.

\(iii\) Assume the same facts as in paragraph (ii) of this [Example
5]{.underline}, except that Option 2 is canceled on January 1, 2005.
Because Option 2 is not canceled prior to the calendar year during which
it would have become exercisable for the first time (2005), it is
treated as an outstanding option for purposes of determining whether the
\$100,000 requirement for 2005 has been exceeded. Because options are
taken into account in the order in which granted, Option 1 is treated as
an incentive stock option in its entirety. Because Option 3 exceeds the
\$100,000 limitation by \$40,000 (Option 1 for \$60,000 + Option 2 for
\$40,000 + Option 3 for \$40,000 = \$140,000), it is treated as a
nonstatutory options in its entirety.

\(iv\) Assume the same facts as in paragraph (i) of this [Example
5]{.underline}, except that on January 1, 2005, E exercises Option 2 and
immediately sells the stock in a disqualifying disposition. A
disqualifying disposition has no effect on the determination of whether
the underlying option is considered outstanding during the calendar year
during which it is first exercisable. Because options are taken into
account in the order in which granted, Option 1 is treated as an
incentive stock option in its entirety. Because Option 3 exceeds the
\$100,000 limitation by \$40,000 (Option 1 for \$60,000 + Option 2 for
\$40,000 + Option 3 for \$40,000 = \$140,000), it is treated as a
nonstatutory option in its entirety.

[Example 6]{.underline}. [Designation of stock]{.underline}. On January
1, 2004, X grants E an immediately exercisable incentive stock option
(determined without regard to this section) to acquire X stock with a
fair market value of \$150,000 on that date. Under the rules of this
section, the option is bifurcated and treated as an incentive stock
option for X stock with a fair market value of \$100,000 and a
nonstatutory option for X stock with a fair market value of \$50,000. In
these circumstances, X may designate the stock that is treated as stock
acquired pursuant to the exercise of an incentive stock option by
issuing a separate certificate (or certificates) for \$100,000 of stock
and identifying such certificates as Incentive Stock Option Stock in its
transfer records. In the absence of such a designation, two-thirds
(\$100,000 / \$150,000) of each share of stock is treated as acquired
pursuant to the exercise of an incentive stock option and one-third
(\$50,000 / \$150,000) as stock acquired pursuant to the exercise of a
nonstatutory option.

Par. 10. Section 1.422-5 is added to read as follows:

[§1.422-5 Permissible provisions]{.underline}.

\(a\) [General rule]{.underline}. An option that otherwise qualifies as
an incentive stock option does not fail to be an incentive stock option
merely because such option contains one or more of the provisions
described in paragraphs (b), (c), and (d) of this section.

\(b\) [Cashless exercise]{.underline}. (1) An option does not fail to be
an incentive stock option merely because the optionee may exercise the
option with previously acquired stock of the corporation that granted
the option or stock of the corporation whose stock is being offered for
purchase under the option. For special rules relating to the use of
statutory option stock to pay the option price of an incentive stock
option, see §1.424-1(c)(3).

\(2\) All shares acquired through the exercise of an incentive stock
option are individually subject to the holding period requirements
described in §1.422-1(a) and the disqualifying disposition rules of
§1.422-1(b), regardless of whether the option is exercised with
previously acquired stock of the corporation that granted the option or
stock of the corporation whose stock is being offered for purchase under
the option. If an incentive stock option is exercised with such shares,
and the exercise results in the basis allocation described in paragraph
(b)(3) of this section, the optionee's disqualifying disposition of any
of the stock acquired through such exercise is treated as a
disqualifying disposition of the shares with the lowest basis.

\(3\) If the exercise of an incentive stock option with previously
acquired shares is comprised in part of an exchange to which section
1036 (and so much of section 1031 as relates to section 1036) applies,
then:

\(i\) The optionee's basis in the incentive stock option shares received
in the section 1036 exchange is the same as the optionee's basis in the
shares surrendered in the exchange, increased, if applicable, by any
amount included in gross income as compensation pursuant to sections 421
through 424 or section 83. Except for purposes of §1.422-1(a), the
holding period of the shares is determined under section 1223. For
purposes of §1.422-1 and sections 421(b) and 83 and the regulations
thereunder, the amount paid for the shares purchased under the option is
the fair market value of the shares surrendered on the date of the
exchange.

\(ii\) The optionee's basis in the incentive stock option shares not
received pursuant to the section 1036 exchange is zero. For all
purposes, the holding period of such shares begins as of the date that
such shares are transferred to the optionee. For purposes of §1.422-1(b)
and sections 421(b) and 83 and the regulations thereunder, the amount
paid for the shares is considered to be zero.

\(c\) [Additional compensation]{.underline}. An option does not fail to
be an incentive stock option merely because the optionee has the right
to receive additional compensation, in cash or property, when the option
is exercised, provided such additional compensation is includible in
income under section 61 or section 83. The amount of such additional
compensation may be determined in any manner, including by reference to
the fair market value of the stock at the time of exercise or to the
option price.

\(d\) [Option subject to a condition]{.underline}. (1) An option does
not fail to be an incentive stock option merely because the option is
subject to a condition, or grants a right, that is not inconsistent with
the requirements of §§1.422-2 and 1.422-4.

\(2\) An option that includes an alternative right is not an incentive
stock option if the requirements of §1.422-2 are effectively avoided by
the exercise of the alternative right. For example, an alternative right
extending the option term beyond ten years, setting an option price
below fair market value, or permitting transferability prevents an
option from qualifying as an incentive stock option. If either of two
options can be exercised, but not both, each such option is a
disqualifying alternative right with respect to the other, even though
one or both options would individually satisfy the requirements of
§§1.422-2, 1.422-4, and this section.

\(3\) An alternative right to receive a taxable payment of cash and/or
property in exchange for the cancellation or surrender of the option
does not disqualify the option as an incentive stock option if the right
is exercisable only when the then fair market value of the stock exceeds
the exercise price of the option and the option is otherwise
exercisable, the right is transferable only when the option is otherwise
transferable, and the exercise of the right has the same economic and
tax consequences as the exercise of the option followed by an immediate
sale of the stock. For this purpose, the exercise of the alternative
right does not have the same economic and tax consequences if the
payment exceeds the difference between the then fair market value of the
stock and the exercise price of the option.

\(e\) [Examples]{.underline}. The principles of this section are
illustrated by the following examples:

[Example 1]{.underline}*.* On June 1, 2004, X Corporation grants an
incentive stock option to A, an employee of X Corporation, entitling A
to purchase 100 shares of X Corporation common stock at \$10 per share.
The option provides that A may exercise the option with previously
acquired shares of X Corporation common stock. X Corporation has only
one class of common stock outstanding. Under the rules of section 83,
the shares transferable to A through the exercise of the option are
transferable and not subject to a substantial risk of forfeiture. On
June 1, 2005, when the fair market value of an X Corporation share is
\$25, A uses 40 shares of X Corporation common stock, which A had
purchased on the open market on June 1, 2002, for \$5 per share, to pay
the full option price. After exercising the option, A owns 100 shares of
incentive stock option stock. Under section 1036 (and so much of section
1031 as relates to section 1036), 40 of the shares have a \$200
aggregate carryover basis (the \$5 purchase price x 40 shares) and a
three-year holding period for purposes of determining capital gain, and
60 of the shares have a zero basis and a holding period beginning on
June 1, 2005, for purposes of determining capital gain. All 100 shares
have a holding period beginning on June 1, 2005, for purposes of
determining whether the holding period requirements of §1.422-1(a) are
met.

[Example 2]{.underline}. Assume the same facts as in [Example
1]{.underline}. Assume further that, on September 1, 2005, A sells 75 of
the shares that A acquired through exercise of the incentive stock
option for \$30 per share. Because the holding period requirements were
not satisfied, A made a disqualifying disposition of the 75 shares on
September 1, 2005. Under the rules of paragraph (b)(3) of this section,
A has sold all 60 of the non-section-1036 shares and 15 of the 40
section-1036 shares. Therefore, under paragraph (b)(3) of this section
and section 83(a), the amount of compensation attributable to A\'s
exercise of the option and subsequent disqualifying disposition of 75
shares is \$1,500 (the difference between the fair market value of the
stock on the date of transfer, \$1,875 (75 shares at \$25 per share),
and the amount paid for the stock, \$375 (60 shares at \$0 per share
plus 15 shares at \$25 per share)). In addition, A must recognize a
capital gain of \$675. Accordingly, A must include in gross income for
the taxable year in which the sale occurs \$1,500 as compensation and
\$675 as capital gain. For its taxable year in which the disqualifying
disposition occurs, if otherwise allowable under section 162 and if the
requirements of §1.83-6(a) are met, X Corporation is allowed a deduction
of \$1,500 for the compensation paid to A.

[Example 3]{.underline}. Assume the same facts as in [Example
2]{.underline}, except that, instead of selling the 75 shares of
incentive stock option stock on September 1, 2005, A uses those shares
to exercise a second incentive stock option. The second option was
granted to A by X Corporation on January 1, 2005, entitling A to
purchase 100 shares of X Corporation common stock at \$22.50 per share.
As in [Example 2]{.underline}, A has made a disqualifying disposition of
the 75 shares of stock pursuant to §1.424-1(c). Under paragraph (b)(1)
of this section, A has disposed of all 60 of the non-section-1036 shares
and 15 of the 40 section-1036 shares. Therefore, pursuant to paragraph
(b)(3) of this section and section 83(a), the amount of compensation
attributable to A\'s exercise of the first option and subsequent
disqualifying disposition of 75 shares is \$1,500 (the difference
between the fair market value of the stock on the date of transfer,
\$1,875 (75 shares at \$25 per share), and the amount paid for the
stock, \$375 (60 shares at \$0 per share plus 15 shares at \$25 per
share)). Unlike [Example 2]{.underline}, A does not recognize any
capital gain as a result of exercising the second option because, for
all purposes other than the determination of whether the exercise is a
disposition pursuant to section 424(c), the exercise is considered an
exchange to which section 1036 applies. Accordingly, A must include in
gross income for the taxable year in which the disqualifying disposition
occurs \$1,500 as compensation. For its taxable year in which the
disqualifying disposition occurs, if otherwise alllowable under sections
83(h) and 162 and if the requirements of §1.83-6(a) are met, X
Corporation is allowed a deduction of \$1,500 for the compensation paid
to A. After exercising the second option, A owns a total of 125 shares
of incentive stock option stock. Under section 1036 (and so much of
section 1031 as relates to section 1036), the 100 \"new\" shares of
incentive stock option stock have the following bases and holding
periods: 15 shares have a \$75 carryover basis and a
three-year-and-three-month holding period for purposes of determining
capital gain, 60 shares have a \$1,500 basis resulting from the
inclusion of that amount in income as compensation and a three-month
holding period for purposes of determining capital gain, and 25 shares
have a zero basis and a holding period beginning on September 1, 2005,
for purposes of determining capital gain. All 100 shares have a holding
period beginning on September 1, 2005, for purposes of determining
whether the holding period requirements of §1.422-1(a)are met.

[Example 4]{.underline}*.* Assume the same facts as in [Example
2]{.underline}, except that, instead of selling the 75 shares of
incentive stock option stock on September 1, 2005, A uses those shares
to exercise a nonstatutory option. The nonstatutory option was granted
to A by X Corporation on January 1, 2005, entitling A to purchase 100
shares of X Corporation common stock at \$22.50 per share. Unlike
[Example 3]{.underline}, A has not made a disqualifying disposition of
the 75 shares of stock. After exercising the nonstatutory option, A owns
a total of 100 shares of incentive stock option stock and 25 shares of
nonstatutory stock option stock. Under section 1036 (and so much of
section 1031 as relates to section 1036), the 75 new shares of incentive
stock option stock have the same basis and holding period as the 75 old
shares used to exercise the nonstatutory option. The additional 25
shares of stock received upon exercise of the nonstatutory option are
taxed under the rules of section 83(a). Accordingly, A must include in
gross income for the taxable year in which the transfer of such shares
occurs \$750 (25 shares at \$30 per share) as compensation. A\'s basis
in such shares is the same as the amount included in gross income. For
its taxable year in which the transfer occurs, X Corporation is allowed
a deduction of \$750 for the compensation paid to A to the extent
allowable under sections 83(h) and 162 and if the requirements of
§1.83-6(a) are satisfied.

[Example 5]{.underline}*.* Assume the same facts in [Example
1]{.underline}, except that the shares transferred pursuant to the
exercise of the incentive stock option are subject to a substantial risk
of forfeiture and not transferable (substantially nonvested) for a
period of six months after such transfer. Assume further that the shares
that A uses to exercise the incentive stock option are similarly
restricted. Such shares were transferred to A on January 1, 2005,
through A's exercise of a nonstatutory stock option which was granted to
A on January 1, 2004. A paid \$5 per share for the stock when its fair
market value was \$22.50 per share. A did not file a section 83(b)
election to include the \$700 spread (the difference between the option
price and the fair market value of the stock on date of exercise of the
nonstatutory option) in gross income as compensation. After exercising
the incentive stock option with the 40 substantially-nonvested shares, A
owns 100 shares of substantially-nonvested incentive stock option stock.
Section 1036 (and so much of section 1031 as relates to section 1036)
applies to the 40 shares exchanged in exercise of the incentive stock
option. However, pursuant to section 83(g), the stock received in such
exchange, because it is incentive stock option stock, is not subject to
restrictions and conditions substantially similar to those to which the
stock given in such exchange was subject. For purposes of section 83(a)
and §1.83-1(b)(1), therefore, A has disposed of the 40 shares of
substantially-nonvested stock on June 1, 2005, and must include in gross
income as compensation \$800 (the difference between the amount realized
upon such disposition, \$1,000, and the amount paid for the stock,
\$200). Accordingly, 40 shares of the incentive stock option stock have
a \$1,000 basis (the \$200 original basis plus the \$800 included in
income as compensation) and 60 shares of the incentive stock option
stock have a zero basis. For its taxable year in which the disposition
of the substantially-nonvested stock occurs, X Corporation is allowed a
deduction of \$800 for the compensation paid to A, provided that the
requirements of §1.83-6 are satisfied.

\(f\) [Effective date]{.underline}. This section applies to any
statutory option granted on or after the date that is 180 days after
publication of final regulations in the **Federal Register**. Taxpayers
can rely on these regulations for the treatment of any statutory option
granted on or after June 9, 2003.

**§1.423-1 \[Amended\]**

Par. 11. Section 1.423-1 is amended as follows:

1\. In paragraph (a)(2), the language "425(a)" is removed and "424(a)"
is added in its place.

2\. In paragraph (b), first sentence, the language "§1.421-7\" is
removed and "§1.421-1\" is added in its place.

3\. In paragraph (b), second sentence, the language "§1.421-8\" is
removed and §1.421-2\" is added in its place.

4\. In paragraph (b), last sentence, the language "425(c)" is removed
and "424(c)" is added in its place.

5\. In paragraph (b), last sentence, the language "§1.425-1\" is removed
and "§1.424-1\" is added in its place.

**§1.423-2 \[Amended\]**

Par. 12. Section 1.423-2 is amended by:

1\. In paragraph (b), last sentence, the language "§1.421-7\" is removed
and "§1.421-1\" is added in its place.

2\. In paragraph (d)(1), second sentence, the language "425(d)" is
removed and "424(d)" is added in its place.

3\. In paragraph (d)(3), [Example 3]{.underline}, fourth sentence, the
language "425(d)" is removed and "424(d)" is added in its place.

4\. In paragraph (e)(2), the language "§1.421-7\" is removed and
"§1.421-1\" is added in its place.

5\. In paragraph (g)(1), the first sentence of the concluding text, the
language "§1.421-7\" is removed and "§1.421-1\" is added in its place.

6\. In paragraph (g)(1), the third sentence of the concluding text, the
language "§1.421-7\" is removed and "§1.421-1\" is added in its place.

7\. In paragraph (j), second sentence, the language "§1.421-7\" is
removed and "§1.421-1\" is added in its place.

8\. In paragraph (j), last sentence, the language "425\" is removed and
"424\" is added in its place.

9\. In paragraph (k)(2), second sentence, the language "§1.421-8\" is
removed and "§1.421-2\" is added in its place.

**§1.425-1 \[Redesignated\]**

Par. 13. Section 1.425-1 is redesignated as §1.424-1 and is amended by:

1\. Revising paragraphs (a)(1) through (a)(6).

2\. Redesignating paragraph (a)(7) as paragraph (a)(9).

3\. Adding paragraph (a)(7).

4\. Revising paragraph (a)(8).

5\. Adding paragraph (a)(10).

6\. In paragraph (b)(1), first, second, and last sentences, the language
"425\" is removed wherever it appears, and "424\" is added in their
places.

7\. In paragraph (c)(1), first sentence, the language "425\" is removed
and "424\" is added in its place.

8\. In paragraph (c)(1), first sentence, the language
"[disposition]{.underline}" is removed and "[disposition of
stock]{.underline}" is added in its place.

9\. Adding paragraph (c)(1)(iv).

10\. Redesignating paragraph (c)(3) as (c)(4).

11\. Adding new paragraph (c)(3).

12\. Adding newly designated paragraph (c)(4), [Examples 7]{.underline}
through [9]{.underline}.

13\. In the list below, for each section indicated in the left column,
remove the language in the middle column and add the language in the
right column:

Newly Designated Section

Remove

Add

1.424-1(c)(4), [Example 1]{.underline}, first sentence

1964

2004

1.424-1(c)(4), [Example 1]{.underline}, first sentence

qualified stock option

statutory option

1.424-1(c)(4), [Example 1]{.underline}, second and fourth sentences

1965

2005

1.424-1(c)(4), [Example 1]{.underline}, third sentence

1968

2006

1.424-1(c)(4), [Example 2]{.underline}, first sentence

1968

2006

1.424-1(c)(4), [Example 2]{.underline}, last sentence

long-term

1.424-1(c)(4), [Example 3]{.underline}, first sentence

1968

2006

1.424-1(c)(4), [Example 4]{.underline}, first sentence

1968, two years and 11 months after the transfer of shares to him

2006

1.424-1(c)(4), [Example 4,]{.underline} last sentence

three years from the date

two years from the date the options were granted and within one year of
the date that

1.424-1(c)(4), [Example 5]{.underline}, first sentence

1965

2005

1.424-1(c)(4), [Example 5]{.underline}, first sentence

qualified stock option

statutory option

1.424-1(c)(4), [Example 6]{.underline}, first sentence

1965

2005

1.424-1(c)(4), [Example 6]{.underline}, third sentence

three years

2 years

1.424-1(c)(4), [Example 6]{.underline}, last sentence

income

compensation income

1.424-1(c)(4), [Example 6]{.underline}, third sentence

a qualified stock option

the option

1.424-1(c)(4), [Example 6]{.underline}, last sentence

paragraph (b)(2) of §1.421-8

§1.421-2(b)(2)

14\. Revising paragraph (d).

15\. Revising paragraphs (e)(1) and (e)(2).

16\. In paragraph (e)(3), first sentence, remove the phrase "Except as
otherwise provided in subparagraph (4)" and add "If section 423(c)
applies to an option then,".

17\. In paragraph (e)(3), first sentence, remove the language ", and
424(b)(1)."

18\. Removing paragraph (e)(4).

19\. Redesignating paragraph (e)(5) as paragraph (e)(4).

20\. Revising newly designated paragraph (e)(4).

21\. Redesignating paragraph (e)(6) as paragraph (e)(5) and removing the
second and third sentences.

22\. Adding a new paragraph (e)(6).

23\. In list below, for each section indicated in the left column,
remove the language in the middle column and add the language in the
right column:

Section

Remove

Add

1.424-1(e)(7) [Example 1]{.underline}, first sentence

1964

2004

1.424-1(e)(7) [Example 1]{.underline}, first sentence

1966

2006

1.424-1(e)(7) [Example 1]{.underline}, third, fourth, fifth, sixth and
last sentences

1965

2005

1.424-1(e)(7) [Example 1]{.underline}, fifth sentence

425(h)

424(h)

1.424-1(e)(7) [Example 1]{.underline}, last sentence

The exercise of such

Because the requirements of §1.424-1(e)(3) and §1.423-2(g) have not been
met, the exercise of such

1.424-1(e)(7) [Example 2]{.underline}, first, second, and fifth
sentences

1964

2004

1.424-1(e)(7) [Example 2]{.underline}, first, third, fourth, and fifth
sentences, wherever it appears

1965

2005

1.424-1(e)(7) [Example 2]{.underline}, first and third sentences

1966

2006

1.424-1(e)(7) [Example 2]{.underline}, fifth sentence

425(h)

424(h)

1.424-1(e)(7) [Example 2]{.underline}, last sentence

The exercise of such

Because the requirements of §1.424-1(e)(3) and §1.423-2(g) have not been
met, the exercise of such

1.424-1(e)(7) [Example 3]{.underline}, first, second, and last sentences

1965

2005

24\. In paragraph (e)(7), remove [Example 4]{.underline}.

25\. Adding paragraphs (f) and (g).

The additions and revisions are as follows:

[§ 1.424-1 Definitions and special rules applicable to statutory
options]{.underline}.

\(a\) [Substitutions and assumptions of options]{.underline}\--(1) [In
general.]{.underline} (i) This paragraph (a) provides rules under which
an [eligible corporation]{.underline} (as defined in paragraph (a)(2) of
this section) may, by reason of a [corporate transaction]{.underline}
(as defined in paragraph (a)(3) of this section), substitute a new
statutory option (new option) for an outstanding statutory option (old
option) or assume an old option without such substitution or assumption
being considered a modification of the old option. For the definition of
[modification]{.underline}, see paragraph (e) of this section.

\(ii\) For purposes of §§1.421-1 through 1.424-1, the phrase
"substituting or assuming a stock option in a transaction to which
section 424 applies," "substituting or assuming a stock option in a
transaction to which §1.424-1(a) applies," and similar phrases means a
substitution of a new option for an old option or an assumption of an
old option that meets the requirements of this paragraph (a). For a
substitution or assumption to qualify under this paragraph (a), the
substitution or assumption must meet all of the requirements described
in paragraphs (a)(4) and (a)(5) of this section.

\(2\) [Eligible corporation.]{.underline} For purposes of this paragraph
(a), the term

[eligible corporation]{.underline} means a corporation that is the
employer of the optionee or a related corporation of such corporation.
For purposes of this paragraph (a), the determination of whether a
corporation is the employer of the optionee or a related corporation of
such corporation is based upon all of the relevant facts and
circumstances existing immediately after the corporate transaction.

\(3\) [Corporate transaction]{.underline}. For purposes of this
paragraph (a), the term [corporate transaction]{.underline} includes\--

\(i\) A corporate merger, consolidation, acquisition of property or
stock, separation, reorganization, or liquidation;

\(ii\) A distribution (excluding ordinary dividends) or change in the
terms or number of outstanding shares of such corporation (e.g., a stock
split or stock dividend);

\(iii\) A change in the name of the corporation whose stock is
purchasable under the old option; and

\(iv\) Such other corporate events prescribed by the Commissioner in
published guidance.

\(4\) [By reason of]{.underline}. (i) For a change in an option or
issuance of a new option to qualify as a substitution or assumption
under this paragraph (a), the change must be made by an [eligible
corporation]{.underline} (as defined in paragraph (a)(2) of this
section) and occur by reason of a [corporate transaction]{.underline}
(as defined in paragraph (a)(3) of this section).

\(ii\) Generally, a change in an option or issuance of a new option is
considered to be by reason of a corporate transaction, unless the
relevant facts and circumstances demonstrate that such change or
issuance is made for reasons unrelated to such corporate transaction.
For example, a change in an option or issuance of a new option will be
considered to be made for reasons unrelated to a corporate transaction
if there is an unreasonable delay between the corporate transaction and
such change in the option or issuance of a new option, or if the
corporate transaction serves no substantial corporate business purpose
independent of the change in options. Similarly, a change in the number
or price of shares purchasable under an option merely to reflect market
fluctuations in the price of the stock purchasable under an option is
not by reason of a corporate transaction.

\(iii\) A change in an option or issuance of a new option is by reason
of a distribution or change in the terms or number of the outstanding
shares of a corporation (as described in paragraph (a)(3)(ii) of this
section) only if the option as changed or the new option issued is an
option on the same stock as under the old option (or if such class of
stock is eliminated in the change in capital structure, on other stock
of the same corporation).

\(iv\) A change in an option or issuance of a new option is by reason of
a change in the name of a corporation (as defined in paragraph
(a)(3)(iii) of this section) only if the option as changed or the new
option issued is an option on stock of the successor corporation.

\(5\) [Other requirements]{.underline}. For a change in an option or
issuance of a new option to qualify as a substitution or assumption
under this paragraph (a), all of the requirements described in this
paragraph (a)(5) must be met.

\(i\) In the case of an issuance of a new option (or a portion thereof)
in exchange for an old option (or portion thereof), the optionee's
rights under the old option (or portion thereof) must be canceled, and
the optionee must lose all rights under the old option (or portion
thereof). There cannot be a substitution of a new option for an old
option within the meaning of this paragraph (a) if the optionee may
exercise both the old option and the new option. It is not necessary to
have a complete substitution of a new option for the old option.
However, any portion of such option which is not substituted or assumed
in a transaction to which this paragraph (a) applies is an outstanding
option to purchase stock or, to the extent paragraph (e) of this section
applies, a modified option.

\(ii\) The excess of the aggregate fair market value of the shares
subject to the new or assumed option immediately after the change in the
option or issuance of a new option over the aggregate option price of
such shares must not exceed the excess of the aggregate fair market
value of all shares subject to the old option (or portion thereof)
immediately before the change in the option or issuance of a new option
over the aggregate option price of such shares.

\(iii\) On a share by share comparison, the ratio of the option price to
the fair market value of the shares subject to the option immediately
after the change in the option or issuance of a new option must not be
more favorable to the optionee than the ratio of the option price to the
fair market value of the stock subject to the old option (or portion
thereof) immediately before the change in the option or issuance of a
new option. The number of shares subject to the new or assumed option
may be adjusted to compensate for any change in the aggregate spread
between the aggregate option price and the aggregate fair market value
of the shares subject to the option immediately after the change in the
option or issuance of the new option as compared to the aggregate spread
between the option price and the aggregate fair market value of the
shares subject to the option immediately before the change in the option
or issuance of the new option.

\(iv\) The new or assumed option must contain all terms of the old
option, except to the extent such terms are rendered inoperative by
reason of the corporate transaction.

\(v\) The new option or assumed option must not give the optionee
additional benefits that the optionee did not have under the old option.

\(vi\) The new or assumed option must otherwise comply with the
requirements of §1.422-2 or §1.423-2. Thus, for example, the old option
must be assumed or the new option must be issued under a plan approved
by the stockholders of the corporation changing the option or issuing
the new option as described in §1.422-2(b)(2) or §1.423-2(c), as
applicable.

\(6\) [Obligation to substitute or assume not necessary]{.underline}.
For a change in the option or issuance of a new option to meet the
requirements of this paragraph (a), it is not necessary to show that the
corporation changing an option or issuing a new option is under any
obligation to do so. In fact, this paragraph (a) may apply even when the
option that is being replaced or assumed expressly provides that it will
terminate upon the occurrence of certain corporate transactions.
However, this paragraph (a) cannot be applied to revive a statutory
option which, for reasons not related to the corporate transaction,
expires before it can properly be replaced or assumed under this
paragraph (a).

\(7\) [Issuance of stock without meeting the requirements of this
paragraph (a)]{.underline}. A change in the terms of an option resulting
in a modification of such option occurs if an optionee's new employer
(or a related corporation of the new employer) issues its stock (or
stock of a related corporation) upon exercise of such option without
satisfying all of the requirements described in paragraphs (a)(4) and
(5) of this section.

\(8\) [Date of grant]{.underline}. For purposes of applying the rules of
this paragraph (a), a substitution or assumption is considered to occur
on the date that the optionee would, but for this paragraph (a), be
considered to have been granted the option that the eligible corporation
is substituting or assuming. A substitution or an assumption that occurs
by reason of a corporate transaction may occur before or after the
corporate transaction.

\* \* \* \* \*

\(10\) [Examples]{.underline}. The principles of this paragraph (a) are
illustrated by the following examples:

[Example 1]{.underline}. [Eligible corporation]{.underline}. X
Corporation acquires a new subsidiary, Y Corporation, and transfers some
of its employees to Y. Y Corporation wishes to grant to its new
employees and to the employees of X Corporation new options for Y shares
in exchange for old options for X shares that were previously granted by
X Corporation. Because Y Corporation is an employer with respect to its
own employees and a related corporation of X Corporation, Y Corporation
is an eligible corporation under paragraph (a)(2) of this section with
respect to both the employees of X and Y Corporations.

[Example 2]{.underline}. [Corporate transaction]{.underline}. (i) On
January 1, 2004, Z Corporation grants E, an employee of Z, an option to
acquire 100 shares of Z stock. At the time of grant, the fair market
value of Z stock is \$200 per share. E's option price is \$200 per
share. On July 1, 2005, when the fair market value of Z stock is \$400,
Z declares a stock dividend that causes the fair market value of Z stock
to decrease to \$200 per share. On the same day, Z grants to E a new
option to acquire 200 shares of Z stock in exchange for E's old option.
The new option has an exercise price of \$100 per share.

\(ii\) A stock dividend is a corporate transaction under paragraph
(a)(3)(ii) of this section. Generally, the issuance of a new option is
considered to be by reason of a corporate transaction. None of the facts
in this [Example 2]{.underline} indicate that the new option is not
issued by reason of the stock dividend. In addition, the new option is
issued on the same stock as the old option. Thus, the substitution
occurs by reason of the corporate transaction. Assuming the other
requirements of this section are met, the issuance of the new option is
a substitution that meets the requirements of this paragraph (a) and is
not a modification of the option.

\(iii\) Assume the same facts as in paragraph (i) of this [Example
2]{.underline}. Assume further that on December 1, 2005, Z declares an
ordinary cash dividend. On the same day, Z grants E an new option to
acquire Z stock in substitution for E's old option. Under paragraph
(a)(3)(ii) of this section, an ordinary cash dividend is not a corporate
transaction. Thus, the exchange of the new option for the old option
does not meet the requirements of this paragraph (a) and is a
modification of the option.

[Example 3]{.underline}. [Corporate transaction]{.underline}. On March
15, 2004, A Corporation grants E, an employee of A, an option to acquire
100 shares of A stock at \$50 per share, the fair market value of A
stock on the date of grant. On May 2, 2005, A Corporation transfers
several employees, including E, to B Corporation, a related corporation.
B Corporation arranges to purchase some assets from A on the same day as
E\'s transfer to B. Such purchase is without a substantial business
purpose independent of making the exchange of E\'s old options for the
new options appear to be by reason of a corporate transaction. The
following day, B Corporation grants to E, one of its new employees, an
option to acquire shares of B stock in exchange for the old option held
by E to acquire A stock. Under paragraph (a)(3)(i) of this section, the
purchase of assets is a corporate transaction. Generally, the
substitution of an option is considered to occur by reason of a
corporate transaction. However, in this case, the relevant facts and
circumstances demonstrate that the issuance of the new option in
exchange for the old option occurred by reason of the change in E\'s
employer rather than a corporate transaction and that the sale of assets
is without a substantial corporate business purpose independent of the
change in the options. Thus, the exchange of the new option for the old
option is not by reason of a corporate transaction that meets the
requirements of this paragraph (a) and is a modification of the old
option.

[Example 4]{.underline}. [Additional benefit]{.underline}. On June 1,
2004, P Corporation acquires 100 percent of the shares of S Corporation
and issues a new option to purchase P shares in exchange for an old
option to purchase S shares that is held by E, an employee of S. On the
date of the exchange, E\'s old option is exercisable for 3 more years,
and, after the exchange, E's new option is exercisable for 5 years.
Because the new option is exercisable for an additional period of time
beyond the time allowed under the old option, the effect of the exchange
of the new option for the old option is to give E an additional benefit
that E did not enjoy under the old option. Thus, the requirements of
paragraph (a)(5) of this section are not met, and this paragraph (a)
does not apply to the exchange of the new option for the old option.
Therefore, the exchange is a modification of the old options.

[Example 5]{.underline}. [Spread and ratio tests]{.underline}. E is an
employee of S Corporation. E holds an old option that was granted to E
by S to purchase 60 shares of S at \$12 per share. On June 1, 2005, S
Corporation is merged into P Corporation, and on such date P issues a
new option to purchase P shares in exchange for E\'s old option to
purchase S shares. Immediately before the exchange, the fair market
value of an S share is \$32; immediately after the exchange, the fair
market value of a P share is \$24. The new option entitles E to buy P
shares at \$9 per share. Because, on a share-by-share comparison, the
ratio of the new option price (\$9 per share) to the fair market value
of a P share immediately after the exchange (\$24 per share) is not more
favorable to E than the ratio of the old option price (\$12 per share)
to the fair market value of an S share immediately before the exchange
(\$32 per share) (9/24 = 12/32), the requirements of paragraph
(a)(5)(iii) of this section are met. The number of shares subject to
E\'s option to purchase P stock is set at 80. Because the excess of the
aggregate fair market value over the aggregate option price of the
shares subject to E\'s new option to purchase P stock, \$1,200 (80 x
\$24 minus 80 x \$9), is not greater than the excess of the aggregate
fair market value over the aggregate option price of the shares subject
to E\'s old option to purchase S stock, \$1,200 (60 x \$32 minus 60 x
\$12), the requirements of paragraph (a)(5)(ii) of this section are met.

[Example 6]{.underline}. [Ratio test and partial
substitution]{.underline}. Assume the same facts as in [Example
5]{.underline}, except that the fair market value of an S share
immediately before the exchange of the new option for the old option is
\$8, that the option price is \$10 per share, and that the fair market
value of a P share immediately after the exchange is \$12. P sets the
new option price at \$15 per share. Because, on a share-by-share
comparison, the ratio of the new option price (\$15 per share) to the
fair market value of a P share immediately after the exchange (\$12) is
not more favorable to E than the ratio of the old option price (\$10 per
share) to the fair market value of an S share immediately before the
substitution (\$8 per share) (15/12 = 10/8), the requirements of
paragraph (a)(5)(iii) of this section are met. Assume further that the
number of shares subject to E\'s P option is set at 20, as compared to
60 shares under E\'s old option to buy S stock. Immediately after the
exchange, 2 shares of P are worth \$24, which is what 3 shares of S were
worth immediately before the exchange (2 x \$12 = 3 x \$8). Thus, to
achieve a complete substitution of a new option for E\'s old option, E
would need to receive a new option to purchase 40 shares of P (*i.e.*, 2
shares of P for each 3 shares of S that E could have purchased under the
old option (2/3 = 40/60)). Because E\'s new option is for only 20 shares
of P, P has replaced only ½ of E\'s old option, and the other ½ is still
outstanding.

[Example 7]{.underline}. [Partial substitution]{.underline}. X
Corporation forms a new corporation, Y Corporation, by a transfer of
certain assets and, in a spin-off, distributes the shares of Y
Corporation to the stockholders of X Corporation. E, an employee of X
Corporation, is thereafter an employee of Y. Y wishes to substitute a
new option to purchase some of its stock for E's old option to purchase
100 shares of X. E's old option to purchase shares of X, at \$50 a
share, was granted when the fair market value of an X share was \$50,
and an X share was worth \$100 just before the distribution of the Y
shares to X's stockholders. Immediately after the spin-off, which is
also the time of the substitution, each share of X and each share of Y
is worth \$50. Based on these facts, a new option to purchase 200 shares
of Y at an option price of \$25 per share could be granted to E in
complete substitution of E's old option. It would also be permissible to
grant E a new option to purchase 100 shares of Y, at an option price of
\$25 per share, in substitution for E's right to purchase 50 of the
shares under the old option.

[Example 8]{.underline}. [Stockholder approval
requirements]{.underline}. (i) X Corporation, a publicly traded
corporation, adopts an incentive stock option plan that meets the
requirements of §1.422-2. Under the plan, options to acquire X stock are
granted to X employees. X Corporation is acquired by Y Corporation and
becomes a subsidiary corporation of Y Corporation. Y Corporation
maintains an incentive stock option plan that meets the requirements of
§1.422-2. Under the plan, options for Y stock may be granted to
employees of Y or its related corporations. After the acquisition, X
employees remain employees of X. In connection with the acquisition, Y
Corporation substitutes new options for Y stock for old options for X
stock that were previously granted to the employees of X. As a result of
this substitution, on exercise of the new options, X employees receive Y
Corporation stock.

\(ii\) Because Y Corporation has a plan that meets the requirements of
§1.422-2 in existence on the date it acquires X, the new options for Y
stock are granted under a plan approved by the stockholders of Y. The
stockholders of Y do not need to approve the X plan. If the other
requirements of paragraphs (a)(4) and (5) of this section are met, the
issuance of new options for Y stock in exchange for the old options for
X stock meets the requirements of this paragraph (a) and is not a
modification of the old options.

\(iii\) Assume the same facts as in paragraph (i) of this [Example
8]{.underline}, except that Y Corporation does not maintain an incentive
stock option plan on the date of the acquisition of X. The Y options
will only be incentive stock options if they are granted under a plan
that meets the requirements of §1.422-2(b). Therefore, Y must adopt a
plan that provides for the grant of incentive stock options, and the
plan must be approved by the stockholders of Y in accordance with
§1.422-2(b). If the stockholders of Y approve the incentive stock option
plan within 12 months before or after the date of the adoption of a plan
by Y and the other requirements of §1.422-2 and the requirements of this
paragraph (a) are met, the issuance of the new options for Y stock in
exchange for the old options for X stock meets the requirements of this
paragraph (a) and is not treated as a modification of the old options
for X stock. The result is the same if Y Corporation assumes the old
options instead of issuing new options.

\(iv\) Assume the same facts as in paragraph (i) of this [Example
8]{.underline}, except that there is no exchange of options. Instead, as
part of the acquisition, X amends its plan to allow future grants under
the plan to be grants to acquire Y stock. Because the amendment of the
plan to allow options on a different stock is considered the adoption of
the new plan, the stockholders of X must approve the plan within 12
months before or after the date of the amendment of the plan. If the
stockholders of X timely approve the plan, the future grants to acquire
Y stock will be incentive stock options (assuming the other requirements
of §1.422-2 have been met).

[Example 9]{.underline}. [Modification]{.underline}. X Corporation
merges into Y Corporation. Y Corporation retains employees of X who hold
old options to acquire X Corporation stock. When the former employees of
X exercise the old options, Y Corporation issues Y stock to the former
employees of X. Under paragraph (a)(7) of this section, because Y issues
its stock on exercise of the old options for X stock, there is a change
in the terms of the old options for X stock. Thus, the issuance of Y
stock on exercise of the old options is a modification of the old
options.

\* \* \* \* \*

\(c\) \* \* \* (1) \* \* \*

\(iv\) A transfer between spouses or incident to divorce (described in
section 1041(a)). The special tax treatment of §1.421-2(a) with respect
to the transferred stock applies to the transferee. However, see
§1.421-1(b)(2) for the treatment of the transfer of a statutory option
incident to divorce.

\* \* \* \* \*

\(3\) If an optionee exercises an incentive stock option with statutory
option stock and the applicable holding period requirements (under
§1.422-1(a) or §1.423-1(a)) with respect to such statutory option stock
are not met before such transfer, then sections 354, 355, 356, or 1036
(or so much of 1031 as relates to 1036) do not apply to determine
whether there is a disposition of those shares. Therefore, there is a
disposition of the statutory option stock, and the special tax treatment
of § 1.421-2(a) does not apply to such stock.

\(4\) \* \* \*

[Example 7]{.underline}. On January 1, 2004, X Corporation grants to E,
an employee of X Corporation, an incentive stock option to purchase 100
shares of X Corporation stock at \$100 per share (the fair market value
of an X Corporation share on that date). On January 1, 2005, when the
fair market value of a share of X Corporation stock is \$200, E
exercises half of the option, pays X Corporation \$5,000 in cash, and is
transferred 50 shares of X Corporation stock with an aggregate fair
market value of \$10,000. E makes no disposition of the shares before
January 2, 2006. Under §1.421-2(a), no income is recognized by E on the
transfer of shares pursuant to the exercise of the incentive stock
option, and X Corporation is not entitled to any deduction at any time
with respect to its transfer of the shares to E. E\'s basis in the
shares is \$5,000.

[Example 8]{.underline}. Assume the same facts as in [Example
7]{.underline}, except that on December 1, 2005, one year and 11 months
after the grant of the option and 11 months after the transfer of the 50
shares to E, E uses 25 of those shares, with a fair market value of
\$5,000, to pay for the remaining 50 shares purchasable under the
option. On that day, X Corporation transfers 50 of its shares, with an
aggregate fair market value of \$10,000, to E. Because E disposed of the
25 shares before the expiration of the applicable holding periods,
§1.421-2(a) does not apply to the January 1, 2005, transfer of the 25
shares used by E to exercise the remainder of the option. As a result of
the disqualifying disposition of the 25 shares, E recognizes
compensation income under the rules of §1.421-2(b).

[Example 9]{.underline}. On January 1, 2005, X Corporation grants an
incentive stock option to E, an employee of X Corporation. The exercise
price of the option is \$10 per share. On June 1, 2005, when the fair
market value of an X Corporation share is \$20, E exercises the option
and purchases 5 shares with an aggregate fair market value of \$100. On
January 1, 2006, when the fair market value of an X Corporation share is
\$50, X Corporation is acquired by Y Corporation in a section
368(a)(1)(A) reorganization. As part of the acquisition, all X
Corporation shares are converted into Y Corporation shares. After the
conversion, if an optionee holds a fractional share of X Corporation
stock, Y Corporation will purchase the fractional share for cash equal
to its fair market value. After applying the conversion formula to the
shares held by E, E has 10 Y Corporation shares and one-half of a share
of X Corporation stock. Y Corporation purchases E's one-half share for
\$25, the fair market value of one-half of an X Corporation share on the
conversion date. Because E sells the one-half share prior to expiration
of the holding periods described in §1.422-1(a), the sale is a
disqualifying disposition of the one-half share. Thus, in 2006, E must
recognize compensation income of \$5 (one-half of the fair market value
of an X Corporation share on the date of exercise of the option, or
\$10, less one-half of the exercise price per share, or \$5). For
purposes of computing any additional gain, E's basis in the one-half
share increases to \$10 (reflecting the \$5 included in income as
compensation). E recognizes an additional gain of \$15 (\$25, the fair
market value of the one-half share, less \$10, the basis in such share).
The extent to which the additional \$15 of gain is treated as a
redemption of X Corporation stock is determined under section 302.

\(d\) [Attribution of stock ownership]{.underline}. To determine the
amount of stock owned by an individual for purposes of applying the
percentage limitations relating to certain stockholders described in
§§1.422-2(f) and 1.423-2(d), shares of the employer corporation or of a
related corporation that are owned (directly or indirectly) by or for
the individual\'s brothers and sisters (whether by the whole or half
blood), spouse, ancestors, and lineal descendants, are considered to be
owned by the individual. Also, for such purposes, if a domestic or
foreign corporation, partnership, estate, or trust owns (directly or
indirectly) shares of the employer corporation or of a related
corporation, the shares are considered to be owned proportionately by or
for the stockholders, partners, or beneficiaries of the corporation,
partnership, estate, or trust. The extent to which stock held by the
optionee as a trustee of a voting trust is considered owned by the
optionee is determined under all of the facts and circumstances.

\(e\) [Modification, extension, or renewal of option]{.underline}. (1)
This paragraph (e) provides rules for determining whether a share of
stock transferred to an individual upon the individual's exercise of an
option after the terms of the option have been changed is transferred
pursuant to the exercise of a statutory option.

\(2\) Any modification, extension, or renewal of the terms of an option
to purchase shares is considered the granting of a new option. The new
option may or may not be a statutory option. To determine the date of
grant of the new option for purposes of section 422 or 423, see
§1.421-1(c).

\* \* \* \* \*

(4)(i) For purposes of §§1.421-1 through 1.424-1 the term
[modification]{.underline} means any change in the terms of the option
(or change in the terms of the plan pursuant to which the option was
granted or in the terms of any other agreement governing the
arrangement) that gives the optionee additional benefits under the
option regardless of whether the optionee in fact benefits from the
change in terms. In contrast, for example, a change in the terms of the
option shortening the period during which the option is exercisable is
not a modification. However, a change providing an extension of the
period during which an option may be exercised (such as after
termination of employment) or a change providing an alternative to the
exercise of the option (such as a stock appreciation right) is a
modification regardless of whether the optionee in fact benefits from
such extension or alternative right. Similarly, a change providing an
additional benefit upon exercise of the option (such as the payment of a
cash bonus) or a change providing more favorable terms for payment for
the stock purchased under the option (such as the right to tender
previously acquired stock) is a modification.

\(ii\) If an option is not immediately exercisable in full, a change in
the terms of the option to accelerate the time at which the option (or
any portion thereof) may be exercised is not a modification for purposes
of this section. Additionally, no modification occurs if a provision
accelerating the time when an option may first be exercised is removed
prior to the year in which it would otherwise be triggered. For example,
if an acceleration provision is timely removed to avoid exceeding the
\$100,000 limitation described in §1.422-4, a modification of the option
does not occur.

\(iii\) A change to an option which provides, either by its terms or in
substance, that the optionee may receive an additional benefit under the
option at the future discretion of the grantor, is a modification at the
time that the option is changed to provide such discretion. In addition,
the exercise of discretion to provide an additional benefit is a
modification of the option. However, it is not a modification for the
grantor to exercise discretion reserved under an option with respect to
the payment of a cash bonus at the time of exercise, the availability of
a loan at exercise, or the right to tender previously acquired stock for
the stock purchasable under the option. An option is not modified merely
because an optionee is offered a change in the terms of an option if the
change to the option is not made.

\(iv\) A change in the terms of the stock purchasable under the option
that affects the value of the stock is a modification of such option,
except to the extent that a new option is substituted for such option by
reason of the change in the terms of the stock in accordance with
paragraph (a) of this section.

\(v\) If an option is amended solely to increase the number of shares
subject to the option, the increase is not considered a modification of
the option but is treated as the grant of a new option for the
additional shares.

\(vi\) Any change in the terms of an option made in an attempt to
qualify the option as a statutory option grants additional benefits to
the optionee and is, therefore, a modification.

\(vii\) An extension of an option refers to the granting by the
corporation to the optionee of an additional period of time within which
to exercise the option beyond the time originally prescribed. A renewal
of an option is the granting by the corporation of the same rights or
privileges contained in the original option on the same terms and
conditions. The rules of this paragraph apply as well to successive
modifications, extensions, and renewals.

\* \* \* \* \*

\(6\) \[Reserved.\]

\* \* \* \* \*

\(f\) [Definitions]{.underline}. The following definitions apply for
purposes of §§1.421-1 through 1.424-1:

\(1\) [Parent corporation]{.underline}. The term [parent
corporation]{.underline}, or [parent]{.underline}, means any corporation
(other than the employer corporation) in an unbroken chain of
corporations ending with the employer corporation if, at the time of the
granting of the option, each of the corporations other than the employer
corporation owns stock possessing 50 percent or more of the total
combined voting power of all classes of stock in one of the other
corporations in such chain.

\(2\) [Subsidiary corporation]{.underline}. The term [subsidiary
corporation]{.underline}, or [subsidiary]{.underline}, means any
corporation (other than the employer corporation) in an unbroken chain
of corporations beginning with the employer corporation if, at the time
of the granting of the option, each of the corporations other than the
last corporation in an unbroken chain owns stock possessing 50 percent
or more of the total combined voting power of all classes of stock in
one of the other corporations in such chain.

\(g\) [Effective date]{.underline}. This section applies to any
statutory option granted on or after the date that is 180 days after
publication of final regulations in the **Federal Register**. Taxpayers
can rely on these regulations for the treatment of any statutory option
granted on or after June 9, 2003.

**§1.6039-1 \[Removed\]**

Par. 14. Section 1.6039-1 is removed.

**§1.6039-2 \[Redesignated\]**

Par. 15. Section 1.6039-2 is redesignated as 1.6039-1 and revised to
read as follows:

[§1.6039-1 Statements to persons with respect to whom information is
furnished]{.underline}.

\(a\) [Requirement of statement with respect to incentive stock options
under section 6039(a)(1)]{.underline}. Every corporation which transfers
stock to any person pursuant to such person\'s exercise of an incentive
stock option described in section 422(b) must furnish to such
transferee, for each calendar year in which such a transfer occurs, a
written statement with respect to the transfer or transfers made during
such year. This statement must include the following information\--

\(1\) The name, address, and employer identification number of the
corporation transferring the stock;

\(2\) The name, address, and identifying number of the person to whom
the share or shares of stock were transferred;

\(3\) The name and address of the corporation the stock of which is the
subject of the option (if other than the corporation transferring the
stock);

\(4\) The date the option was granted;

\(5\) The date the shares were transferred to the person exercising the
option;

\(6\) The fair market value of the stock at the time the option was
exercised;

\(7\) The number of shares of stock transferred pursuant to the option;

\(8\) The type of option under which the transferred shares were
acquired; and

\(9\) The total cost of all the shares.

\(b\) [Requirement of statement with respect to stock purchased under an
employee stock purchase plan under section 6039(a)(2)]{.underline}. (1)
Every corporation which records, or has by its agent recorded, a
transfer of the title to stock acquired by the transferor pursuant to
the transferor\'s exercise on or after January 1, 1964, of an option
granted under an employee stock purchase plan which meets the
requirements of section 423(b), and with respect to which the special
rule of section 423(c) applied, must furnish to such transferor, for
each calendar year in which such a recorded transfer of title to such
stock occurs, a written statement with respect to the transfer or
transfers containing the information required by paragraph (b)(2) of
this section.

\(2\) The statement required by paragraph (b)(1) of this section must
contain the following information\--

\(i\) The name and address of the corporation whose stock is being
transferred;

\(ii\) The name, address and identifying number of the transferor;

\(iii\) The date such stock was transferred to the transferor;

\(iv\) The number of shares to which title is being transferred; and

\(v\) The type of option under which the transferred shares were
acquired.

\(3\) If the statement required by this paragraph is made by the
authorized transfer agent of the corporation, it is deemed to have been
made by the corporation. The term [transfer agent]{.underline}, as used
in this section means any designee authorized to keep the stock
ownership records of a corporation and to record a transfer of title of
the stock of such corporation on behalf of such corporation.

\(4\) A statement is required by reason of a transfer described in
section 6039(a)(2) of a share only with respect to the first transfer of
such share by the person who exercised the option. Thus, for example, if
the owner has record title to a share or shares of stock transferred to
a recognized broker or financial institution and the stock is
subsequently sold by such broker or institution (on behalf of the
owner), the corporation is only required to furnish a written statement
to the owner relating to the transfer of record title to the broker or
financial institution. Similarly, a written statement is required when a
share of stock is transferred by the optionee to himself and another
person (or persons) as joint tenants, tenants by the entirety or tenants
in common. However, when stock is originally issued to the optionee and
another person (or persons) as joint tenants, or as tenants by the
entirety, the written statement required by this paragraph shall be
furnished (at such time and in such manner as is provided by this
section) with respect to the first transfer of the title to such stock
by the optionee.

\(5\) Every corporation which transfers any share of stock pursuant to
the exercise of an option described in this paragraph shall identify
such stock in a manner sufficient to enable the accurate reporting of
the transfer of record title to such shares. Such identification may be
accomplished by assigning to the certificates of stock issued pursuant
to the exercise of such options a special serial number or color.

\(c\) [Time for furnishing statements]{.underline} \-- (1) [In
general]{.underline}. Each statement required by this section to be
furnished to any person for a calendar year must be furnished to such
person on or before January 31 of the year following the year for which
the statement is required.

\(2\) [Extension of time]{.underline}. For good cause shown upon written
application of the corporation required to furnish statements under this
section, the Director, Martinsburg Computing Center, may grant an
extension of time not exceeding 30 days in which to furnish such
statements. The application must contain a full recital of the reasons
for requesting an extension to aid the Director in determining the
period of the extension, if any, which will be granted and must be sent
to the Martinsburg Computing Center (Attn: Extension of Time
Coordinator). Such a request in the form of a letter to the Martinsburg
Computing Center signed by the applicant (or its agent) will suffice as
an application. The application must be filed on or before the date
prescribed in paragraph (c)(1) of this section for furnishing the
statements required by this section, and must contain the employer
identification number of the corporation required to furnish statements
under this section.

\(3\) [Last day for furnishing statement]{.underline}. For provisions
relating to the time for performance of an act when the last day
prescribed for performance falls on Saturday, Sunday, or a legal
holiday, see §301.7503-1 of this chapter (Regulations on Procedure and
Administration).

\(d\) [Statements furnished by mail]{.underline}. For purposes of this
section, a statement is considered to be furnished to a person if it is
mailed to such person\'s last known address.

\(e\) [Penalty]{.underline}. For provisions relating to the penalty
provided for failure to furnish a statement under this section, see
section 6722.

\(f\) [Electronic furnishing of statements]{.underline} \[Reserved\]

\(g\) [Effective date]{.underline}. This section applies as of the date
that is 180 days after publication of final regulations in the **FEDERAL
REGISTER** to transfers of stock acquired pursuant to a statutory option
on or after that date. Taxpayers can rely on these regulations with
respect to the transfer of stock acquired pursuant to a statutory option
on or after June 9, 2003.

PART 14a\--TEMPORARY INCOME TAX REGULATIONS RELATING TO INCENTIVE

STOCK OPTIONS

**Part 14a \[Removed\]**

Par. 16. Part 14a is removed.

David A. Mader,

Assistant Deputy Commissioner of Internal Revenue.

[^1]: Qualified stock options are no longer permitted under section 422,
    but the stockholder approval provisions applicable to a plan under
    which qualified stock options were granted were the same as those
    that apply to a plan under which incentive stock options are
    granted.