Source: http://www.aicpastore.com/Content/media/PRODUCER_CONTENT/Newsletters/Articles_2010/CPA/Dec/StockOptions.jsp
Timestamp: 2017-05-30 01:59:08
Document Index: 381377832

Matched Legal Cases: ['§ 421', '§ 6039', '§ 1', '§ 422', '§ 1', '§ 1', '§ 422', '§ 1', '§ 421', '§ 421', '§ 422', '§ 424', '§ 1', '§ 1', '§ 1', '§ 1', '§ 1', '§ 1', '§ 1', '§ 1', '§ 1']

> The Tricky Rules on Incentive Stock Options
In contrast to the favorable tax consequences enjoyed by individuals, employers receive no deduction upon exercise of ISOs. I.R.C. § 421(a)(2). Commencing in 2010, employers have to file Form 3921 with the IRS providing information regarding the transfer of shares to their employees upon exercise of their ISOs and give employees copies of Form 3921. I.R.C. § 6039 & Treas.Reg. § 1.6039-1(a) & (2)(a). Employer-Employee Relationships
There are certain exceptions to this rule. If individuals terminate employment because of a disability, they have one year from termination to exercise their ISO. I.R.C. § 422(c)(6). If they die while employed or within three months of termination of employment, additional time is allowed for the exercise of the ISOs provided the ISO plan and agreement allow for additional time. Treas. Reg. § 1.421-2(c). Certain breaks in the employment relationship, e.g., military leave, will not be considered breaks in continuous employment. Treas. Reg. § 1.421-1(h)(2). In addition to the “continuous employment” requirement, individuals must satisfy a holding-period requirement to obtain tax-free treatment upon exercise of their ISOs. Under the holding period requirement, the individual must hold the stock for at least two years from the date the option was granted and one year from the date the stock was transferred to them. I.R.C. § 422(a)(1). If the individual makes a disposition of their ISO stock within this time period, they have made a “disqualifying disposition” of the stock. A “disqualifying disposition” generally means that the individual must recognize ordinary income under Code Section 83 in the year of disposition equal to the spread. Treas. Reg. § 1.421-2(b). Such ordinary income is added to the stock basis to determine the capital gain resulting from a disqualifying disposition. The employer corporation will be entitled to a deduction equal to the spread. I.R.C. § 421(b). Even though there has been a “disqualifying disposition,” the ordinary income generated by such disposition is not subject to employment tax or income tax withholding. I.R.C. § 421(b).
Note, however, if the disposition price is less than the stock price on the date of exercise and the disposition is a transaction in which a loss, if sustained, would be recognized, e.g., the disposition is not a sale or exchange to a related party under Code Section 267(a)(1), then the amount of ordinary income recognized by individuals (and the deduction taken by the employer corporation) is not the spread, but the difference between the amount realized on the sale or exchange and the basis of the stock. I.R.C. § 422(c)(2). ISOs That Are Modified or Transferred
Transfers, which do not constitute “dispositions,” are listed in Code Section 424(c). For example, a transfer of ISO stock incident to a divorce will not constitute a “disposition,” and the spouse receiving the ISO stock will be entitled to the same tax treatment as the employee. I.R.C. § 424(c)(4); Treas. Reg. § 1.424-1(c)(1)(iv). Note, however, if the ISO itself is transferred incident to a divorce, the option loses its ISO status as of the day of such transfer. Treas. Reg. § 1.421-1(b)(2).
An ISO may cease to be a statutory option if it is modified. The rules on when an ISO is considered “modified” are very tricky. Subject to certain exceptions set forth in Code Section 424(h)(3), a “modification” is defined to be a change, which provides an additional benefit. I.R.C. 424(h)(3) & Treas. Reg. § 1.424-1(e)(4)(i). If the ISO is considered modified, extended, or renewed under Code Section 424(h) and Treasury Regulation § 1.424-1(e), then individuals are considered to have been granted a new option, which may or may not meet the definition of an ISO. For example, say an employee exercising their ISO wants to take advantage of a spread and use previously acquired stock to pay the exercise price. While, their ISO agreement does not state that using previously acquired stock is a method of payment, it does provide that the exercise price may be paid by any other method approved by the option committee. If the employee uses previously acquired stock, their ISO will have been “modified.” Treas.Reg. § 1.424-1(e)(4)(i).
In contrast, if previously acquired stock were listed as a method of payment, which could be used at the discretion of the option committee, there would be no modification. Treas. Reg. § 1.424-1(e)(4)(iii). If, in fact, the employee uses previously acquired stock, their “new option” will not satisfy the definition of an ISO because of the spread, which will cause the employee to have ordinary income upon exercise and be subject to withholding and employment tax. “Modification” issues also arise when there has been an assumption or substitution of an ISO in a “corporate transaction,” as defined in Treasury Regulation § 1.424-1(a)(3), e.g., a merger or reorganization. Provided rules set forth in Code Section 424(a) and Treasury Regulation § 1.424-1(a) are met, a “corporate transaction” will not cause “modification” of an assumed or substituted ISO. Note that the rules on modification of an ISO under Code Section 409A, set forth in Treasury Regulation Section 1.409A-1(b)(5)(v), are not identical to those set forth in Code Section 424 and Treasury Regulation § 1.424-1(e).