The Tricky Rules on Incentive Stock Options
Holders of incentive stock options: beware or you will lose your favorable income tax treatment.
December 20, 2010
The detailed rules regarding incentive stock options also referred to as ISOs, statutory options or qualified options must be carefully followed for individuals to obtain the favorable income tax treatment they offer. The favorable treatment is that the individual has no income in the year of exercise even though the fair market value of the stock at the time of exercise exceeds the exercise price of the ISO (“spread”). I.R.C. § 421(a)(1). The deferred compensation rules under Code Section 409A are not applicable to ISOs. Treas. Reg. § 1.409A-1(b)(5)(ii). Furthermore, the individual will not be subject to Federal Insurance Contributions Act (FICA) or Federal Unemployment Tax Act (FUTA) taxes. I.R.C. §§ 3121(a)(22) & 3306(b)(19). However, this favorable income tax treatment is disregarded for purposes of the alternative minimum tax. I.R.C. § 56(b)(3).
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).
Even though an option satisfies the ISO requirements set forth in Code Section 422(b) on the date of grant, many requirements must be satisfied after the date of grant to enjoy the benefits provided by ISOs. First, subject to certain exceptions, the transfer of stock to the individual upon exercise of their ISO will not be tax free unless at all times during the period beginning on the date of the ISO grant and ending on the day three months before the date of exercise of the ISO, the individual was an employee of either the corporation granting the option or a “related corporation,” i.e., a parent or subsidiary of the employer corporation, as defined in Sections 424(e) and (f). I.R.C. § 422(a)(2). Thus, if the individual terminated continuous employment on June 30, they must exercise their ISOs on or before September 30 in order to satisfy the continuous employment rule. (The date of termination of employment is excluded and the last day of the period is included. Rev. Rul. 66-5, 1966-1 C.B. 91.) If the “continuous employment” rule is not satisfied, the spread will constitute wages subject to income and employment taxes and associated income tax withholding.
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).
ISOs provide excellent tax advantages to the employee. To get those tax advantages, however, the ISO rules must be carefully followed. This article has emphasized only some of those rules and has certainly not discussed all of them.
Janice Eiseman, JD, LLM, is a principal at Cummings & Lockwood in Stamford, Conn. office where she focuses on the taxation of closely held businesses and tax planning for owners and investors. Eiseman has broad-based experience counseling clients on the formation, ownership and structuring of various business entities, as well as drafting and negotiating tax-based and transactional documentation for both individual and business clients. She has also done controversy work before the Internal Revenue Service and the New York State Department of Taxation and Finance. Prior to joining Cummings & Lockwood, she served as senior tax and benefits counsel at the New York City-based law firm Morrison & Cohen LLP.