Tax Center: ISO Basics

The IRS released its long-awaited final regulations for incentive stock options (ISOs) on August 2, 2004. The final rules clarify and consolidate a tangle of proposed, temporary, and final regulations, as well as other guidance, that governed the taxation of ISOs.

This article covers the following:

• Stock splits and stock dividends
• Inadvertent modifications and offers to modify
• "Net" shares and the overall plan limit
• Treatment of modifications and cancellations for purposes of the $100,000 limit
• Designation of ISO versus NQSO stock for amounts over the $100,000 limit
• Nonpublic companies and good-faith valuations
• Information reporting under Section 6039 and electronic reporting

Effective dates, an IRS request for comments on employee stock purchase plans, and action steps for companies are also discussed.

Stock Splits And Stock Dividends

The proposed regulations of 2003 expanded the definition of "corporate transaction" to include stock dividends or stock splits. Under this provision, a change to an outstanding option to reflect a stock dividend or stock split would be subject to the ratio and spread tests. Comments noted that sometimes changes in stock price related to stock splits and stock dividends reflected slight shifts, so that ratio and spread would not apply smoothly.

In response, the final regulations do not treat stock dividends or stock splits as corporate transactions. Instead, the regulations simply provide that a proportionate adjustment to an outstanding option as a result of a stock dividend or stock split is not a "modification" of the option.

Inadvertent Modifications And Offers To Modify

In response to comments, the final regulations say that if an ISO or an ISO plan is inadvertently modified in a way that disqualifies the ISOs or the plan, but the modification is canceled before the earlier of either the exercise or the end of the calendar year of the modification, the ISO is not disqualified. The final regulations retain a rule in the 2003 proposed regulations that says your option is not considered modified if you are offered a change in the terms of the option as long as the change is not made. However, the final regulations set a limit for the number of days on which the offer can remain outstanding without triggering a modification. If the offer to change the terms of the option remains outstanding for 30 days or more, the option is considered to have been modified as of the date the offer was made.

"Net" Shares And The Overall Plan Limit

The final regulations make a slight change to the rule in the proposed regulations that allows the reissue of shares that were forfeited to the plan or used to satisfy the purchase price. In addition to allowing the use of these shares, the final regulations also allow the reissue of shares withheld to meet employment tax and withholding obligations. This change seems to be moot, as there are no federal employment and withholding obligations for ISOs and ESPPs.

The regulations provide an example in which an optionholder exercises an option for 100 shares and pays the exercise price with 20 of them, receiving 80 shares. Only the net 80 shares count against the overall plan limit on shares that can be issued under ISOs.

Guidance On The $100,000 Limit

The 2003 regulations provided regulatory guidance on the $100,000 ISO limit. These rules limit ISO grants to $100,000 worth of stock that can first be exercised in any calendar year, according to the fair market value on the grant date. Before this, guidance had been provided under Notice 87-49. The final rules largely follow the 2003 proposed regulations with one notable exception (below) about designation of ISO stock versus stock from nonqualified stock options (NQSOs).

Options are normally taken into account in the order they were granted. Options that are not ISOs at grant are not taken into account. If the ISO is modified, canceled, or transferred and thus becomes disqualified in a year prior to the year in which the option becomes exercisable for the first time, the option is disregarded for the purposes of the $100,000 limit. Options modified, canceled, or transferred in any other situation must be taken into account in the year during which they otherwise would have first become exercisable under their original terms.

An option is taken into account for a year if the option would become exercisable at any time during that year. However, if the ability to exercise an option is accelerated by a triggering event such as a change in control or the attainment of a performance goal, the option is taken into account only after the triggering event, not the entire calendar year.

Designation Of ISO Versus NQSO Stock

If the options first becoming exercisable in a year exceed the $100,000 limit, the company may issue separate certificates for the ISO stock or designate such stock as ISO stock in the corporation's transfer records or plan records. Under prior guidance and the proposed regulations, if the corporation failed to do so, a pro rata portion of each share was to be treated as ISO and non-ISO stock. In response to comments, the final regulations provide that, in the absence of a separate issue or designation, the first $100,000 of stock (based on the value at grant) is treated as ISO stock and the excess shares as NQSO stock.

Nonpublic Companies And Good-Faith Exercise-Price Valuations

The regulations make no change to the requirement that privately held companies make a good-faith attempt to determine fair market value when setting the exercise price of ISOs and state that whether a good-faith attempt was made will depend on the facts and circumstances. Despite requests for additional safe harbors, the final regulations include only one example of a safe harbor: the use of the average of two or more valuations performed by independent and qualified experts. Often companies are not willing to incur the costs of two (or even one) independent valuations. In that case, whether a valuation is in good faith depends on the facts and circumstances. Taxpayers are required to retain adequate books and records to demonstrate that the option-price requirements are satisfied.

Information Reporting Under Section 6039 And Electronic Reporting

The final regulations state that companies must furnish information statements to individuals after the exercise of ISOs and after the first transfer of title to ESPP stock. The statements must be provided by January 31 of the following year, and an extension not exceeding 30 days may be requested. Failure to provide the required statements results in penalties under Section 6722. The basic penalty structure under Section 6722 is $50 per failure to file a payee statement or failure to provide the correct information, with a $100,000 annual limit. However, the penalties may be higher in the case of intentional disregard. The regulations also allow statements related to ISOs and ESPPs to be provided electronically, if the participant consents. The consent procedures should comply with the requirements that are otherwise applicable to electronic statements.

Effective Date

The final regulations are effective from August 3, 2004, but there are transition rules that permit reliance on the 2003 proposed regulations and the old guidance. For ISOs and ESPPs granted on or before June 9, 2003, you may rely on the old 1984 proposed regulations, the 2003 proposed regulations, or the final regulations, until January 1, 2006, or if earlier, the first regularly scheduled shareholders' meeting that occurs six months after August 3, 2004. For options granted after June 9, 2003, and before the earlier of either January 1, 2006, or the first regularly scheduled shareholders' meeting that occurs six months after August 3, 2004 (i.e., after February 3, 2005), you may rely on the 2003 proposed regulations or the final regulations. If you rely on the 2003 proposed rules, you must follow all provisions of those regulations, and all options granted during the reliance period must be treated consistently. You cannot pick and choose which provisions of the proposed regulations to follow.

Employee Stock Purchase Plans

Although the new final regulations also provide some minor guidance on employee stock purchase plans (ESPPs) governed by Section 423, the IRS has also issued Notice 2004-55, requesting comments on certain aspects of ESPPs. In particular, the IRS has requested comments on the following issues:

• Whether any categories of employees can be excluded from participation under the nondiscrimination rule of Section 423(b)(4) and, if so, under what conditions.
• Whether there should be any rules in the regulations that address inadvertent exclusions of employees from ESPPs.
• Whether the calculation of the $25,000 limit under Section 423(b)(8) should be consistent with the $100,000 rule for ISOs.
• Whether the participation and equal rights and privileges rules should include specific rules for new participants.
• Whether shareholder approval should be necessary to add highly compensated employees.
• Whether amounts not used in one purchase period can be carried over to another purchase period.
• Whether individuals should be permitted to increase or decrease contributions to purchase stock under an ESPP.
• Whether there should be special rules about exclusion and equal rights and privileges for foreign employees.

What Should Employers Do Now?

Brokerage Fees In Ordinary Income

A provision with potentially broad application is the disallowance of brokerage fees and other costs when computing the ordinary income to be reported to individuals that sell their ISO shares in a disqualifying disposition. This change will affect only the calculation of income when the shares have declined in value from the date of exercise. However, because the practice of reducing the ordinary income for the brokerage fees was fairly widespread, this change could affect many employers and should be communicated to employees. Of course, the increase in ordinary income recognized by the employee will lead to a corresponding increase in the deduction allowed to the employer.

Early Exercise Options And Disqualifying Dispositions

For employers that allow early exercise, the most significant issue may be addressing the implications of Section 83(b) elections and the tax treatment upon early disposition. The issue arises when an employee has failed to hold the stock for at least two years from grant of the option and one year from exercise. In practice, many employees exercise ISOs soon after grant so that they can make the Section 83(b) election while the value of the stock is as close to the exercise price as possible. As a result, even if the employee has held the shares for at least one year from the date of exercise, the disposition is disqualifying. The final regulations clearly state that the vesting date is used to determine the amount of compensation income. The vesting date also determines whether any gains are long-term or short-term.

Employers need to review their current practices for reporting compensation income on disqualifying dispositions. They should review plan documents for necessary changes. If changes are needed, companies may want to consider alerting employees that have made Section 83(b) elections but have not yet met the ISO holding periods: they should understand that the ordinary income will be higher than expected if they make a disqualifying disposition after the stock has increased in value between the exercise and vesting dates (and is sold for a price in excess of the value on the exercise date).

If companies know that their employees plan to exercise immediately, they should consider issuing NQSOs for restricted stock or granting restricted stock. (Note, however, that unless employees pay the grant date fair market value for the restricted stock, they will have to recognize taxable income when they make the Section 83(b) election.) For both of these types of awards, the Section 83(b) election is clearly effective for regular income tax purposes (the Section 83(b) election is made upon the exercise of NQSOs), and there is no doubt that the holding period for long-term capital gains begins on the exercise date (for options) or on the grant date (for restricted stock) with a properly filed Section 83(b) election. Employees need only satisfy the one-year holding period to achieve long-term capital gains with these awards, as opposed to meeting both the two-year and one-year holding period for ISOs.

Minimal Changes To Plans And Administration

With these exceptions, the final regulations will not require significant changes to many plans or their administration. In addition, the elimination of shareholder approval for options assumed in a corporate transaction will simplify planning. On the other hand, employers who were waiting to address such issues as the application of the $100,000 limit will now need to begin implementing the method that the regulations require; for example, regarding the effect of canceling options.

The regulations now make electronic plan administration an attractive option. The regulations allow the plan and options to be electronic, as long as sufficient records demonstrate compliance with ISO requirements, such as date of grant. The final regulations now also allow electronic reporting, which will ease administration. Companies that have become lax in Section 6039 reporting for ISOs and ESPPs (or have never issued the required reports) should review their procedures to avoid future penalties.

ISO Compliance

Employers should also give attention to ISO compliance as they consider related issues, such as changes that stem from the possible fair-value accounting of options, implementation of new systems for compliance with the Schedule M-3 (expanded reporting of book/tax differences on corporate tax returns), and preparation for increased IRS auditing around executive and equity compensation. For example, preliminary reports on the IRS audit initiative in executive compensation indicate issues with company compliance around stock option taxation and reporting, and that this will be one of the key focus areas for future IRS audits.

Shareholder Approval

Many employers have shareholder meetings in the spring or early summer. As a result, employers need to adopt a plan by then so that options can be granted under that plan, with shareholder approval obtained either at that time or at the next meeting, provided it occurs within 12 months of plan adoption. For an employer that has a meeting only once a year, it will be important to carefully consider presenting a revised plan for approval at next year's meeting.

Ellie Kehmeier (San José, California) and Elizabeth Drigotas (Washington, DC) work for Deloitte Tax LLP, a division of Deloitte & Touche. The authors would like to thank Thomas Pevarnik, a tax director, and Diane McGowan, a tax senior manager, for their assistance with this article. This article does not constitute tax, legal, or other advice from Deloitte Tax LLP, which assumes no responsibility with respect to assessing or advising the reader as to tax, legal, or other consequences arising from the reader's particular situation. This article was published solely for its content and quality. Neither the authors nor their firm compensated us in exchange for its publication.