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Subject:   Rules for inherited ISOs
Date:   Wed, 24 Mar 1999
From:   Sandy

I have a question. I understand that on death an ISO steps up to the fair market value. What is the tax treatment if there is a step up at death, but by the time the ISO is exercised (and immediately sold) the stock price has dropped to a number lower than the date of death value? Is there then a loss on the sale? Or what if they are just exercised and not sold? What is the AMT treatment?

Answer

Date:   May 10, 1999

Hello Sandy,

Your questions about inherited ISOs raise complicated issues that are hard to explain.

As you said, the inherited ISO receives a tax basis equal to the fair market value of the ISO as of the date of death. At one time, this value was deemed to be the excess of the fair market value of the stock over the option price. Now much more involved formulas are applied to value ISOs.

The three-month exercise period and employment requirements that apply when a person leaves his or her employer don’t apply to inherited ISOs. Also, if an ISO is exercised after the death of the employee, the one-year after exercise and two-years after grant holding period requirements to avoid ordinary income treatment don’t apply. (IRC Section 421(c)(1).) However, the executor or trustee for the decedent should immediately determine the requirements under the plan for the exercise of outstanding ISOs to avoid having them lapse, if they are in fact valuable.

When an ISO is exercised after the death of the employee, the holding period of the stock will begin on the date of exercise.

Now, to more directly answer your questions.

Suppose a deceased employee had an incentive stock option to purchase employer stock for $20. The stock value on the date of death was $100. The executor later makes a same day exercise and sale when the fair market value of the stock is $50.

For the sake of simplicity, assume the fair market value of the ISO on the date of death is $100 - $20 = $80.

The estate will have a short-term capital loss as follows:

Sales price		$  50
Cost of sale
Tax basis of option     (FMV at death)	$80
Option price	20
Total		100
Net Loss		($ 50)

No gain or loss will be recognized until the stock is sold. If the option is exercised and the stock is not sold, there will still be an alternative minimum tax preference at exercise for the excess of the fair market value of the stock over the option price. There doesn’t appear to be any adjustment of the preference for the basis adjustment of the option because the preference is determined under the rules for "income with respect of a decedent" as if the option was a non-qualified option. (IRC § 56(b)(3).)

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.