ISOs: Limits

The IRS released its long-awaited final regulations for incentive stock options (ISOs) on August 2, 2004. A number of changes to the rules are based on comments the IRS received in response to proposed regulations of June 9, 2003. 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.

Part 1 addresses the following changes and clarifications:

• Maximum number of shares to be specified in the plan
• Early exercise and disqualifying dispositions
• Income limitation rule for disqualifying dispositions: treatment of brokerage fees
• Income limitation rule denied for wash sales, gifts, and sales to related parties
• Shareholder approval for changes to the granting corporation or shares to be issued
• Corporate transactions and shareholder approval

Maximum Number Of Shares

ISOs must be issued by a plan "which includes the aggregate number of shares which may be issued under options." The proposed regulations of 2003 provided that an omnibus plan (providing for grants of ISOs and other types of equity awards) satisfied this condition only if the maximum aggregate limit applied to all awards under a plan, rather than just ISOs. Comments suggested that an omnibus plan should be allowed to have either an overall plan limit or an ISO-specific limit. Adopting these comments, the final regulations provide that a plan must have an aggregate limit for ISOs, but it is not required to have separate limits for other types of awards.

When the regulations were issued, some uncertainty existed about whether they let an omnibus plan have a single, overall limit or whether they required a separate ISO-specific limit. The IRS has confirmed in discussions that a single plan-wide limit is enough (assuming it otherwise complies with the requirements for maximum aggregate limits) and has indicated that a technical correction to clarify this point will be made.

Early Exercise And Disqualifying Dispositions

In some cases, ISOs provide an option to buy restricted stock. Many pre-public companies (and a number of public companies) have used this type of ISO as a way to minimize alternative minimum tax (AMT). With this type of ISO, you can exercise the option while the stock's fair market value is equal to the exercise price, or is low relative to its expected value in the future, and receive unvested shares. Within 30 days of exercise, you then make a Section 83(b) election to have the tax consequences determined at the time of exercise (as opposed to vesting), minimizing AMT.

While many employers and tax professionals have argued that the election should be effective for both AMT and, in the case of a disqualifying disposition, regular income taxes, the IRS's position over the past several years has been that the election is not effective for regular income taxes.

The final regulations carry a number of points on receipt of unvested stock at the exercise of an option. They confirm the IRS's position with respect to the calculation of ordinary income upon a subsequent disqualifying disposition.

• The final regulations clarify that, for purposes of the ISO holding period, a "transfer" occurs when the option is exercised, even if you receive unvested shares. Under Section 422(a)(1), you must hold the stock for more than one year after the date of transfer and two years after the grant of the option to avoid a disqualifying disposition and to receive favorable ISO treatment. (However, see the paragraph below about the holding period for long-term capital gains in a disqualifying disposition.)

• The final regulations clarify the effect of 83(b) elections when you receive restricted stock. An 83(b) election has no effect for "regular" income tax purposes but will be recognized for AMT purposes. As a result, if there is a subsequent disqualifying disposition, the amount of compensation income you are required to recognize is based on the value of the stock at the date it vests rather than at the date it was transferred. For shares that appreciate between the date of exercise and the vesting date, this will cause you to recognize more compensation income and less capital gain.

• The final regulations clarify that the company is allowed a deduction upon a disqualifying disposition provided that the requirements of Section 83(h) and Reg. 1.83-6(a) are satisfied (e.g., generally applicable reporting requirements for nonqualified stock options).

• The regulations do not specifically address the application of the holding period requirements for long-term capital gains when a disqualifying disposition occurs on shares for which a Section 83(b) election was made. The ISO rules specify the tax treatment when the holding period of Section 422 is satisfied but do not change the generally applicable rules about the holding periods for long and short-term capital gains. The discussion in the preamble and the example in the regulations make clear that the amount of capital gain on a subsequent disposition is calculated according to the value on vesting, rather than exercise, suggesting that the holding period for capital gain runs from vesting, not from option exercise, in the case of a disqualifying disposition. This result is also consistent with the determination of the holding period for restricted stock with respect to which no Section 83(b) election is made. We understand that technical corrections may clarify this issue as well.

Income Limitation Rule For Disqualifying Dispositions

A special rule at Section 422(c)(2) limits the amount of compensation that is taken into income upon a sale of ISO stock in a disqualifying disposition to the amount realized on the sale over the basis of the stock. This rule protects those who sell their ISO stock at less than exercise value from having to recognize both ordinary income and a capital loss on the same transaction.

Treatment Of Brokerage Fees

In the past, many companies reduced the ordinary income by the brokerage fees according to the normal use of the tax term "amount realized."

Both the proposed and the final regulations state that the amount of ordinary income is calculated without reduction for brokerage fees or other costs paid in connection with the disposition. As a result, individuals who dispose of their stock in a disqualifying disposition when the sales price is less than the value of the stock on the date of exercise have compensation measured based on the difference between the gross selling price and the exercise price. The amount of compensation is added to the cost basis, resulting in a capital loss for any brokerage fees or other selling costs.

Wash Sales, Gifts, And Sales To Related Parties

The final regulations confirm that the special rule at Section 422(c)(2) (discussed directly above) does not apply to limit the compensation income upon a disqualifying disposition if the transaction is one in which a loss, if sustained, would not ordinarily be recognized for tax purposes. A disposition of stock as part of a wash sale transaction, a gift of the stock, or a sale of the stock to a related party, as described in §267(a)(1), are situations in which a loss would not be recognized for tax purposes. Generally speaking, a wash sale is any sale that results in a loss if you acquire or enter into a contract or option to acquire substantially identical shares within 30 days before or after the sale.

Example (from the IRS regulations): You exercise an ISO for $100 when the stock is worth $200 and sell it in a disqualifying disposition for $150. If the gain limitation rule applies, you will recognize only $50 of ordinary income and will not have any capital gain or loss (except for broker fees or commissions, as noted above). If, however, you buy the stock back within 30 days (before or after the sale) so that the wash sale rules under Section 1091 apply, you will have to recognize the full $100 (equal to the amount of the spread on the date of exercise) as ordinary income and realize a capital loss of $50, the recognition of which will be deferred under the wash sale rules.

The 2003 proposed regulations added a rule requiring that changes to a plan which concern either the granting corporation or the shares to be issued (i.e., shares of a different corporation) required shareholder approval (in addition to changes increasing the number of shares to be issued or the classes of employees). In particular, the application of this requirement raised questions for mergers and acquisitions. For example, as a result of a consolidation, a new corporation may assume an ISO plan maintained by its target and issue options on its own shares after the transaction.

The final regulations do not eliminate the requirement of shareholder approval for options that are granted after the sponsor or the stock issued under the plan is changed. However, the regulations clearly state that the approval process may be incorporated into the process of approving the transaction. For example, the regulations include an example in which the shareholder approval requirement is deemed to be satisfied if the consolidation agreement describes the plan and is approved by the shareholders.

Corporate Transactions And Shareholder Approval

The 2003 proposed regulations required that ISOs (and options issued under an employee stock purchase plan, or ESPP) outstanding at the time of a transaction be substituted or assumed under a plan approved by the shareholders of the acquiring company in order to retain their status after a corporate transaction. However, the final regulations provide that in a corporate transaction, ISOs (and ESPPs) outstanding at the time of the transaction that are substituted or assumed by the acquiring company are not required to be submitted to additional approval by the shareholders of the acquiring company. However, as discussed above, future option grants under the plan qualify only if the acquiring company's shareholders approve the plan.

Part 2

For discussion of other areas affected by the final regulations, see the second part of our article.

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.