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Subject:   ISO to NQSO
Date:   Wed, 15 Dec 1999
From:   Sonia

Dear Mr. Gray,

Scenario: An employee is granted an ISO then retires from the Company as an employee, however, continues working for the Company as a consultant and the Company allows him to retain his vested options, no further vesting will take place.

Question: Does the ISO now become a NQSO?

Question: What would be the result if the Company extended his options, to expire at a later date? (I do realize there could be compensation expense to the Company due to a new measurement date.)

Question: If it is determined that this is a NQSO, in the year he exercises his options, should he be issued a 1099 instead of a W-2 since he no longer is an employee and the fact that it is a NQSO?

I would appreciate your response as soon as practicable and appreciate your providing this method obtaining this information.

Thank you,
Sonia

Answer

Date:   20 Dec 1999

Hello Sonia,

In order for a stock option to qualify for ISO treatment, the employee must have been an employee at some time during the three months before the exercise. (Section 422 (a)(2)

If the option does not lapse after this period, it will be a NQSO. (Treasury Regulations Sections 1.421-6, 1.83-7.)

For the company to extend the options, they would have to be converted to NQOs and the tax treatment would follow the NQO rules. Assuming the options did not have an ascertainable value, ordinary income would be recognized when the options were exercised and the stock issued. (Treasury Regulations Section 1.83-7. Also see V.A. Kluesner, 56 TCM 1354, Dec. 45,509(M), TC Memo. 1989-83.)

Since this person will no longer be an employee, it appears to me that Form 1099 should be issued and no withholding is required. (Internal Revenue Code Section 6041. Revenue Ruling 67-257 applies to employees. Note in V.A. Kluesner the former employer issued Form 1099 to the former employee and this was accepted by the IRS and Tax Court.)

Why aren't you working with your CPA firm on this issue?

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.