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Date:   Thu, 7 Jan 2010
From:   Jack

Dear Mr. Gray

If I exercise an ISO for private company stock with a stated fair market value of $565 and an option price of $65 and sell the stock during the year of exercise to a relative for $70, will I pay income taxes based on the fair market value or the sales price for the disqualified disposition?

I look forward to your advice!

Sincerely yours,
Jack

Answer

Date:   8 Jan 2010

Hello Jack,

According to Section 422(c)(2), reporting income for a disqualified disposition based on the selling price of the stock is only permitted if a loss (if sustained) would be allowed for the transaction. Under Section 267, losses for sales to certain related parties are disallowed, including siblings, ancestors and descendants.

Even if you make a sale to a "qualifying" relative or friend, the IRS might find the transaction to be part sale, part gift because of the sale being made substantially below the fair market value reported by the company.

Therefore, I don’t recommend such a sale to avoid the alternative minimum tax. A sale to a person with whom you have no personal relationship with no strings attached and some stated rationale for the discounted selling price, such as lack of marketability and financial hardship, is a possibility. Most private companies won’t permit sales of the shares under these circumstances.

Good luck!

Mike Gray

For more information about incentive stock options, request our free report, Incentive Stock Options - Executive Tax and Financial Planning Strategies.

IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this answer was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.