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By Michael Gray

Table of Contents

• Early exercise guidance in final ISO regulations.
• ISO explanation updated.
• Related party sales don't stop ordinary income for NQOs.
• Consult with a tax advisor.
• Subscribe to Michael Gray, CPA's Option Alert.

Early exercise guidance in final ISO regulations

The IRS has issued final regulations for incentive stock options (ISOs), effective August 3, 2004. The regulations mostly incorporate rules previously issued in proposed regulations and rulings. There is an important clarification relating to early exercises of ISOs.

Employers that are planning an initial public offering will often allow their employees to exercise their employee stock options before they are vested. Before the IRS issued these regulations, it was unclear how these transactions should be handled.

The regulations make it clear that, since Section 83 (explained below) does not apply for regular tax purposes when an ISO is exercised, no Section 83(b) election can be made at that time for the exercise of a non-vested ISO.

The employee receives a tax benefit, because the holding period to qualify for long-term capital gain for regular tax reporting starts on the exercise date. The employee will avoid ordinary income reporting, despite the fact the stock is non-vested, provided the stock is held more than one year after the exercise date and more than two years after the grant date of the ISO. (Final Regulations Section 1.422-1(b)(2), Example 2.)

There is also a regular tax disadvantage of disallowing the Section 83(b) election for an early exercise of an ISO. If there is a disqualifying disposition of ISO stock, the ordinary income for unvested stock will be measured based on the excess of the fair market value over the option price on the vesting date, not the date of exercise. If the employee is planning to make a disqualifying disposition of the stock, there is generally no advantage of making an early exercise of an ISO. The employee might receive more tax benefits from an early exercise of an NQO with a Section 83(b) election than from an early exercise of an ISO with a disqualified disposition.

Since the tax benefits of ISOs don't apply for the alternative minimum tax (AMT), a Section 83(b) election can be made (and should be seriously considered) for alternative minimum tax purposes.

The general rule (under Section 83) when an employee receives restricted property (unvested stock) relating to his or her employment is the property received is valued when the restrictions lapse. When an employee makes a Section 83(b) election, he or she is electing to have the restrictions disregarded and the property valued on the date received.

The election must be made within 30 days of exercising the option (certified mail recommended). It is sent to the Internal Revenue Service, a copy is given to the employer and a copy is attached to the income tax return for the year of election.

For example, Peach Company permits employees to exercise their ISOs early. Peach is planning an initial public offering of its stock in six months, so the employees exercise their options early. The option price is $1. The estimated fair market value at exercise is $2. When the stock is vested after the IPO, the stock is trading at $100. If an employee makes a Section 83(b) election, his or her AMT income will be $1 per share. If an employee does not make the election, his or her AMT income will be $99 per share.

(T.D. 9144)

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ISO explanation updated

We have updated our report, Incentive Stock Options -- Executive Tax and Financial Planning Strategies. If you would like a free copy of the update, please fill out our form at www.stockoptionadvisors.com/noindex/isorequest.shtml.

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Related party sales don't stop ordinary income for NQOs

The IRS has finalized temporary and proposed regulations issued during 2003 that state that a sale or other disposition of a non- qualified stock option to a related person is not treated as a transaction that closed the application of Section 83 with respect to the option.

Under Section 83, ordinary income equal to the excess of the fair market value of the stock on the date of transfer over the option price is generally recognized when an NQO is transferred. After the transfer, any additional gain from the sale of the option or property received from exercising the option would be taxed as a capital gain.

This means that when the transferee related person later exercises the NQO, the employee will be taxed on any additional fair market value on the date of exercise over the fair market value on the date of the previous transfer.

Related persons include certain family members, controlled businesses owned more than 20% by the employee, and certain persons engaged in trades or businesses under common control.

These regulations knock out a strategy once widely promoted of selling NQOs at fair market value to family limited partnerships.

The regulations are effective for transfers of NQOs on or after July 2, 2003.

(T.D. 9148.)

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IRS Circular 230 Disclosure:

As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this communication 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.

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Consult with a tax advisor

For our readers who aren’t tax advisors, this newsletter is intended to alert you about tax issues that could affect you. It is not a substitute for advice from a professional tax advisor. You will find that getting advice from a qualified advisor is a worthwhile investment.

Tax advisors should view the newsletter as an alert to become aware of issues relating to employee stock options for further research and study.

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(Michael Gray is the co-author of Employee Stock Options – A Strategic Planning Guide for the 21st Century Optionaire. You can order the book at http://www.amazon.com or http://www.barnesandnoble.com/ or buy it at Stacey’s Books.)

P.S.

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