[Federal Register: June 9, 2003 (Volume 68, Number 110)]
[Proposed Rules]
[Page 34344-34370]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr09jn03-24]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 14a
[REG-122917-02]
RIN 1545-BA75
Statutory Options
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking; withdrawal of previous
rulemaking; and notice of public hearing.
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SUMMARY: This document contains proposed regulations relating to
statutory options. These proposed regulations affect certain taxpayers
who participate in the transfer of stock pursuant to the exercise of
incentive stock options and the exercise of options granted pursuant to
an employee stock purchase plan (statutory options). These proposed
regulations provide guidance to assist these taxpayers in complying
with the law in addition to clarifying rules regarding statutory
options. This document also withdraws a previous notice of proposed
rulemaking.
[[Page 34345]]
DATES: Written and electronically submitted comments and requests to
speak, with outlines of topics to be discussed at the public hearing
scheduled for September 2, 2003, must be received by August 12, 2003.
ADDRESSES: Send submissions to CC:PA:RU (REG-122917-02), room 5226,
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington,
DC 20044. Submissions may be hand delivered Monday through Friday
between the hours of 8 a.m. and 5 p.m. to: CC:PA:RU (REG-122917-02),
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue,
NW., Washington, DC or sent electronically, via the IRS Internet site
www.irs.gov/regs. The public hearing will be held in the IRS
Auditorium, Internal Revenue Building, 1111 Constitution Avenue, NW.,
Washington, DC.
FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Erinn
Madden at (202) 622-6030 (not a toll-free number). To be placed on the
attendance list for the hearing, please contact Guy Traynor at (202)
622-7180.
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information contained in this notice of proposed
rulemaking has been submitted to the Office of Management and Budget
for review in accordance with the Paperwork Reduction Act of 1995 (44
U.S.C. 3507(d)). Comments on the collection of information should be
sent to the Office of Management and Budget, Attn: Desk Officer for the
Department of the Treasury, Office of Information and Regulatory
Affairs, Washington, DC 20503, with copies to the Internal Revenue
Service, Attn: IRS Reports Clearance Officer, W:CAR:MP:T:T:SP;
Washington, DC 20224. Comments on the collection of information should
be received by August 8, 2003. Comments are specifically requested
concerning:
Whether the proposed collection of information is necessary for the
proper performance of the functions of the Internal Revenue Service,
including whether the information will have practical utility;
The accuracy of the estimated burden associated with the proposed
collection of information (see below);
How the quality, utility, and clarity of the information to be
collected may be enhanced;
How the burden of complying with the proposed collection of
information may be minimized, including through the application of
automated collection techniques or other forms of information
technology; and
Estimates of capital or start-up costs and costs of operation,
maintenance, and purchase of service to provide information.
The collection of information in this proposed regulation is in
1.6039-1. Section 6039 of the Code requires all corporations that
transfer stock to any person pursuant to the exercise of a statutory
option to furnish that person with a written statement describing the
transfer. Additionally, the corporation may be required to furnish the
person a second written statement when the stock originally transferred
pursuant to the exercise of the statutory option is subsequently
disposed of by the person. The information on the statements required
to be provided by the corporation will be used by recipients to
complete their income tax returns in the year of the disposition of the
statutory option stock. The likely respondents are for-profit
corporations.
Estimated total annual reporting burden: 16,650 hours.
Estimated average annual burden hours per respondent: 20 minutes.
Estimated number of respondents: 50,000.
Estimated annual frequency of responses: annually.
An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless it displays a valid
control number assigned by the Office of Management and Budget.
Books or records relating to a collection of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns and
tax return information are confidential, as required by 26 U.S.C. 6103.
Background
This document contains proposed amendments to 26 CFR part 1 under
sections 421, 422, and, 424 of the Internal Revenue Code (Code).
Changes to the applicable tax law concerning section 421 were made by
sections 11801 and 11821 of the Omnibus Budget Reconciliation Act of
1989, Public Law 101-508 (104 Stat. 1388). Changes to the applicable
tax law concerning section 424 were made by section 1003 of the
Technical and Miscellaneous Revenue Act of 1988 (TAMRA), Public Law
100-647 (102 Stat. 3581), sections 11801 and 11821 of the Omnibus
Budget Reconciliation Act of 1989 (OBRA 89), Public Law 101-508 (104
Stat. 1388), which included re-designating section 425 as section 424
of the Code, and section 1702(h) of the Small Business Job Protection
Act of 1996, Public Law 104-188 (110 Stat. 1755). Changes concerning
section 422 were made by section 251 of the Economic Recovery Tax Act
of 1981 (95 Stat. 172), which added section 422A to the Code. Related
changes to section 422A were made by section 102(j) of the Technical
Corrections Act of 1982, Public Law 97-448, section 321(a) of Tax
Reform Act of 1986 (96 Stat. 2365), Public Law 99-514 (100 Stat. 2807),
section 1003(d) of TAMRA, and sections 11801 and 11821 of OBRA 89,
which included re-designating section 422A as section 422 of the Code.
Regulations under section 421 governing the requirements for
restricted stock options and qualified stock options, as well as
options granted under an employee stock purchase plan, were published
in the Federal Register on December 9, 1957 (TD 6276), November 26,
1960 (TD 6500), January 18, 1961 (TD 6527), January 20, 1961 (TD 6540),
December 12, 1963 (TD 6696), June 23, 1966 (TD 6887), July 24, 1978 (TD
7554), and November 3, 1980 (TD 7728). Temporary regulations under
section 422A providing guidance and transitional rules related to
incentive stock options were published in the Federal Register on
December 17, 1981 (TD 7799) and September 18, 1992 (TD 8435). Final
regulations under section 422 related to stockholder approval were
published in the Federal Register on December 1, 1988 (TD 8235) and
November 29, 1991 (TD 8374). Regulations under section 425 were
published in the Federal Register on June 23, 1966 (TD 6887).
Proposed changes to the final regulations under sections 421, 424,
and 6039 and proposed regulations under section 422A were previously
published in the Federal Register at 49 FR 4504 on February 7, 1984
(the 1984 proposed regulations). With the exception of certain
stockholder approval rules that were published in the Federal Register
on June 23, 1966 (TD 6887) and amended by TD 7728 on October 31, 1980,
the 1984 proposed regulations provided a comprehensive set of rules
under section 422 of the Code. The 1984 proposed regulations are
withdrawn.
In general, the income tax treatment of the grant of an option to
purchase stock in connection with the performance of services and of
the transfer of stock pursuant to the exercise of such option is
determined under section 83 of the Code and the regulations thereunder.
However, section 421 of the Code provides special rules for determining
the income tax treatment of the transfer of shares of
[[Page 34346]]
stock pursuant to the exercise of an option if the requirements of
section 422(a) or 423(a), as applicable, are met. Section 422 applies
to incentive stock options, and section 423 applies to options granted
under an employee stock purchase plan (collectively, statutory
options).
Under section 421, if a share of stock is transferred to an
individual pursuant to the exercise of a statutory option, there is no
income at the time of exercise of the option with respect to such
transfer, and no deduction under section 162 is allowed to the employer
corporation with respect to such transfer. However, pursuant to section
56(b)(3), section 421 does not apply with respect to the exercise of an
incentive stock option for purposes of the individual alternative
minimum tax.
Section 422(a) of the Code provides that section 421 applies to the
transfer of stock to an individual pursuant to the exercise of an
incentive stock option if (i) no disposition of the share is made
within 2 years from the date of grant of the option or within 1 year
from the date of transfer of the share, and (ii) at all times during
the period beginning on the date of grant and ending on the day 3
months before the exercise of the option, the individual is an employee
of either the corporation granting the option or a parent or subsidiary
of such corporation, or a corporation (or a parent or subsidiary of
such corporation) issuing or assuming a stock option in a transaction
to which section 424(a) applies. Section 422(b) provides several
requirements that must be met for an option to qualify as an incentive
stock option. Section 422(c) provides special rules applicable to
incentive stock options, and section 422(d) provides a $100,000
limitation with respect to incentive stock options.
Section 424 of the Code provides special rules applicable to
statutory options, including rules concerning the modification of
statutory options and the substitution or assumption of an option by
reason of a corporate merger, consolidation, acquisition of property or
stock, separation, reorganization, or liquidation. Section 424 also
contains definitions of certain terms, including disposition, parent
corporation, and subsidiary corporation. Finally, section 424 provides
special rules related to attribution of stock ownership and the effect
of stockholder approval on the date of grant of a statutory option.
Explanation of Provisions
Overview
These proposed regulations would provide a set of comprehensive
rules governing incentive stock options. These proposed regulations
incorporate many of the rules contained in the 1984 proposed
regulations, although these proposed regulations are re-numbered and
re-organized. These proposed regulations would also make changes to the
final regulations under sections 421 and 424 to provide additional
guidance, as discussed below, in certain areas, to reflect the new
organizational structure of the statutory option rules (including the
re-designation of Sec. 1.425-1 as Sec. 1.424-1), and to remove
obsolete rules and cross-references.
Section 421: General Rules
The proposed regulations under section 421 would remove obsolete
provisions and update the cross-references to reflect amendments to the
applicable statutes and re-organization of the regulations. These
proposed regulations also incorporate many provisions of the 1984
proposed regulations. There are two sections of these proposed
regulations under section 421: Sec. 1.421-1, which would provide rules
concerning the meaning and use of terms, and Sec. 1.421-2, which would
provide general rules regarding the application of section 421.
The terms defined in Sec. 1.421-1 of these proposed regulations
are the same as those previously defined in Sec. 1.421-7, but these
proposed regulations make changes to the definitions of certain terms.
For example, Sec. 1.421-1(a) of these proposed regulations expands the
definition of option to include warrants.
These proposed regulations would provide that an option must be
evidenced in paper or in an electronic form. Under either form,
however, the option must be enforceable under applicable law.
Similarly, these proposed regulations provide that the plan pursuant to
which incentive stock options are granted must be in paper or
electronic form, provided that the paper or electronic form establishes
an enforceable plan.
In addition, as with any taxpayer record, the form used for the
option or plan, whether paper or electronic, must be one that provides
adequate substantiation of the applicability of section 421. Thus, for
example, the form must be one that provides adequate substantiation of
the applicable requirements, such as the date on which the option is
granted, the number of shares subject to the option, and the option
price. In addition, the taxpayer must retain records relating to the
option that are sufficient to comply with section 6001 and the
regulations thereunder. If these records are kept electronically, the
records must meet the requirements of Rev. Proc. 97-22 (1997-1 C.B.
652), or subsequent guidance, and if the records are kept in an ADP
system, the records must meet the requirements of Rev. Proc. 98-25
(1998-11 I.R.B. 7), or subsequent guidance.
The definition of statutory option in Sec. 1.421-1(b) of these
proposed regulations is revised to provide that a statutory option may
include an option transferred to a trust if, under section 671 and
applicable state law, the individual to whom the option was granted
remains the beneficial owner. In contrast, these proposed regulations
provide that a transfer of a statutory option incident to divorce will
result in the option failing to qualify as a statutory option as of the
date of transfer.
Section 1.421-1(i) of these proposed regulations defines
corporation to have the same meaning prescribed by section 7701(a)(3)
and Sec. 301.7701-2(b). Thus, for example, a corporation includes an S
Corporation, a foreign corporation, and a limited liability corporation
that is treated as a corporation for all Federal tax purposes. In
addition, section 1.421-1(d) of these proposed regulations provides
that stock includes ownership interests other than capital stock. Thus,
under these proposed regulations, it would be permissible for any
entity that is classified as a corporation for federal tax purposes
pursuant to the provisions of Sec. 301.7701-2(b) to grant statutory
stock options with respect to ownership interests in that entity.
Section 1.421-2 of these proposed regulations incorporates both the
provisions of Sec. 1.421-8 and many of the related provisions of the
1984 proposed regulations. These proposed regulations also provide
further revisions, including specifying that the deduction in
connection with a disqualifying disposition is allowed only if
otherwise allowable under sections 83(h) and 162 and if the reporting
requirements under Sec. 1.83-6(a) are met.
Section 422: Incentive Stock Options
The proposed regulations under section 422 would provide a new set
of comprehensive rules, with the exception of the rules regarding
stockholder approval described in Sec. 1.422-5 of the final
regulations (re-numbered as Sec. 1.422-3 by these proposed
regulations). There are four sections under these proposed regulations:
Sec. 1.422-1, general rules; Sec. 1.422-2, definition of incentive
stock option; Sec. 1.422-4, the $100,000 limitation; and Sec. 1.422-
5, permissible provisions.
[[Page 34347]]
1. Special Rules Regarding Disqualifying Dispositions
The 1984 proposed regulations provided rules concerning the
consequences of disqualifying dispositions. The general disqualifying
disposition rules for incentive stock options are provided in
Sec. Sec. 1.421-2(b)(1) and 1.422-1(b)(1) of these proposed
regulations. In addition, Sec. 1.422-1(b)(2) of these proposed
regulations clarifies the operation of the special rules applicable to
a disqualifying disposition of an incentive stock option under section
422(c)(2) (section 422A(c)(2), prior to amendment by OBRA 89).
The general rules concerning disqualifying dispositions are
described in Sec. 1.421-2(b) of these proposed regulations. Under
these rules, if there is a disqualifying disposition of a share of
stock, the special tax treatment provided by section 421 and Sec.
1.421-2(a) does not apply to the transfer of the share. Instead, the
exercise of the option is treated as the exercise of a nonstatutory
option under Sec. 1.83-7. Thus, in the taxable year in which the
disqualifying disposition occurs, the individual must recognize
compensation income equal to the fair market value of the stock on the
date the stock is transferred less the exercise price (determined
without reduction for any brokerage fees or other costs paid in
connection with the disposition). A deduction attributable to the
transfer of the share of stock pursuant to the exercise of the option
is allowable for the taxable year in which such disqualifying
disposition occurs, to the employer corporation, its parent or
subsidiary corporation, or a corporation substituting or assuming an
option in a transaction to which Sec. 1.424-1(a) applies, if otherwise
allowable under sections 83(h) and 162 and if the requirements of Sec.
1.83-6(a) are met.
Section 422(c)(2), however, provides a special rule that is
applicable if an individual makes a disqualifying disposition of stock
acquired through the exercise of an incentive stock option and if the
disposition is a sale or exchange with respect to which a loss (if
sustained) would be recognized by the individual. Under this special
rule, the amount includible in gross income on the disqualifying
disposition, and the amount deductible, as compensation attributable to
the exercise of the option, shall not exceed the excess (if any) of the
amount realized on such sale or exchange over the adjusted basis of the
share. Under section 422(c)(2), this special rule is not applicable if
the disposition is a sale or exchange with respect to which a loss (if
sustained) would not be recognized by the individual. Section 1.422A-
1(b)(2) of the 1984 proposed regulations described these special rules
concerning the disqualifying disposition of an incentive stock option
and this description is incorporated into Sec. 1.422-1(b)(2) of these
proposed regulations.
For example, if the disposition is a sale described in section 1091
(relating to a loss from wash sales of stock or securities), a gift, or
a sale described in section 267(a)(1) (relating to sales between
related parties), any loss sustained would not be recognized. Because a
loss in any of these transactions would not be recognized, under Sec.
1.422-1(b)(2)(ii) of these proposed regulations, the special rule
provided in Sec. 1.422-1(b)(2)(i) of these proposed regulations does
not apply. Instead, the general rules for disqualifying dispositions
described in Sec. 1.421-2(b) of these proposed regulations apply.
For example, assume E, an employee of Corporation X, is granted an
incentive stock option to acquire X stock. The option price on the date
of grant is $100 (the fair market value of X stock on the date of
grant). E exercises the option and is transferred X stock when the fair
market value of the stock is $200. E later sells the stock for $150 to
M before the applicable holding periods expire. Because the sale is a
disqualifying disposition that meets the requirements of Sec. 1.422-
1(b)(2)(i) of these proposed regulations, in the taxable year of the
disqualifying disposition, E is only required to include $50 (the
excess of the amount realized on the sale, $150, over the adjusted
basis of the share, $100) in gross income as compensation attributable
to the exercise of the option. For its taxable year in which the
disqualifying disposition occurs, X is allowed a compensation deduction
of $50 attributable to E's exercise of the option, if otherwise
allowable under sections 83(h) and 162 and if the requirements of Sec.
1.83-6(a) are met.
In this example, however, if 10 days after the sale to M, E
purchases substantially identical stock, under section 1091, a loss
would not be recognized on the sale to M. Thus, under Sec. 1.422-
1(b)(2)(ii) of these proposed regulations, the special rule in Sec.
1.422-1(b)(2)(i) does not apply. Instead of including $50 in gross
income in the taxable year of the disqualifying disposition, E must
include $100 (the difference between the fair market value of X stock
on the date of transfer, $200, and the exercise price, $100) in gross
income as compensation attributable to the exercise of the option. In
the taxable year in which the disqualifying disposition occurs, X is
allowed a compensation deduction of $100 attributable to E's exercise
of the option if otherwise allowable under sections 83(h) and 162 and
if the requirements of Sec. 1.83-6(a) are met.
Since the 1984 proposed regulations were issued, there have been no
changes in section 422(c)(2) (other than the redesignation of section
422A(c)(2) as 422(c)(2) by OBRA 89), and these proposed regulations do
not make any substantive changes to the 1984 proposed regulations.
2. Stockholder Approval of Incentive Stock Option Plan
Among other requirements, to qualify as an incentive stock option,
the option must be granted pursuant to a plan which is approved by the
stockholders of the granting corporation within 12 months before or
after the date the plan is adopted. See section 422(b). These proposed
regulations would provide the same basic requirements for stockholder
approval as those included in the 1984 proposed regulations.
These proposed regulations, however, would provide additional
guidance concerning the circumstances in which stockholder approval is
required. As under the 1984 proposed regulations, stockholder approval
is required if there is a change in the aggregate number of shares or
in the employees (or class or classes of employees) eligible to be
granted options under the plan. In addition, while the standard for
determining when stockholder approval is required is the same as under
the 1984 proposed regulations, these proposed regulations clarify these
requirements and provide a more complete list of situations that
require new stockholder approval of the plan by specifically including
a change in the shares with respect to which options are issued or a
change in the granting corporation. Thus, for example, assume that S, a
subsidiary of P, adopts an incentive stock option plan under which
incentive stock options for S stock will be granted to S employees, and
the plan is approved by the stockholders of S (in this case, P) within
the applicable 24-month period. If S later amends the plan to provide
for the grant of incentive stock options to acquire P stock (rather
than S stock), S must obtain approval from the stockholders of S within
12 months before or after the date of the amendment to the plan because
the amendment of the plan to allow the grant of options for P stock is
considered the adoption of a new plan.
These proposed regulations also would provide additional guidance
[[Page 34348]]
regarding the application of the stockholder approval requirements in
the context of the substitution or assumption of an option by reason of
a corporate transaction. For a discussion of these rules, see the
``Substitution, assumption, and modification of options'' portion of
the preamble.
3. $100,000 Limitation
Section 422(d)(1) provides that to the extent that the aggregate
fair market value of stock with respect to which incentive stock
options (determined without regard to section 422(d)) are exercisable
for the first time by any individual during the calendar year (under
all of plans of the employer corporation and any related corporation)
exceeds $100,000, such options are not treated as incentive stock
options. Under section 422(d)(2), options are taken into account in the
order in which they are granted. Section 422(d)(3) provides that the
fair market value of stock is determined at the time the option is
granted.
The 1984 proposed regulations provided no rules concerning the
operation of the $100,000 limitation because these provisions were
enacted in 1986. However, Notice 87-49 (1987-2 C.B. 355) provides
general guidance about the operation of the $100,000 limitation,
including examples illustrating the application of this limitation.
Section 1.422-4 of these proposed regulations provides guidance on
the operation of the $100,000 limitation that incorporates and expands
on the guidance provided in Notice 87-49. Section 1.422-4(a)(1) of
these proposed regulations provides that an option that otherwise
qualifies as an incentive stock option nevertheless fails to be an
incentive stock option to the extent the $100,000 limitation is
exceeded.
To determine whether the $100,000 limitation has been exceeded, the
rules provided in Sec. 1.422-4(b) of these proposed regulations would
apply. Under these proposed regulations, an option that does not
qualify as an incentive stock option when granted (including an option
which contains terms providing that it will not be treated as an
incentive stock option) is disregarded. Additionally, the fair market
value of stock is determined on the date of grant of the option. Except
as described in the following paragraph, options are taken into account
in the order in which they are granted.
An option is considered to be first exercisable during a calendar
year if the option will first become exercisable at any time during the
year, assuming that any condition on the optionee's ability to exercise
the option related to the performance of services is satisfied. If an
optionee is able to exercise the option in a year only if an
acceleration provision is satisfied, then the option is exercisable in
that year only if the acceleration provision is triggered prior to the
end of that year. After an acceleration provision is triggered, for
purposes of applying the $100,000 limitation, the options subject to
such provision and all other options first exercisable during a
calendar year are then taken into account in the order in which
granted. However, because an acceleration provision is not taken into
account prior to its triggering, an incentive stock option that becomes
exercisable for the first time during a calendar year by operation of
such a provision does not affect the application of the $100,000
limitation with respect to an option (or portion thereof) exercised
prior to such acceleration. An acceleration provision includes, for
example, a provision that accelerates the exercisability of an option
on a change in ownership or control or a provision that conditions
exercisability on the attainment of a performance goal. See Sec.
1.422-4(d), Example 4 of these proposed regulations.
For example, assume that in 2006, E, an employee of Y Corporation,
is granted Option 1 for stock of Y with a fair market value on the date
of grant of $75,000. Option 1 is first exercisable in 2008, except that
the option provides that it will become immediately exercisable in the
event of a change in control. In 2007, E is granted Option 2 for stock
of Y with a fair market value on the date of grant of $50,000. Option 2
is immediately exercisable, and E exercises Option 2. A change in
control of Y occurs in 2007, after E has exercised Option 2, and Option
1 becomes immediately exercisable. Notwithstanding the fact that Option
1 was granted prior to Option 2, because the acceleration clause is not
taken into account until it is triggered and because E exercised Option
2 prior to the change in control, Option 2 is an incentive stock option
in its entirety. Option 1 is bifurcated into an incentive stock option
to acquire stock with a fair market value of $50,000 on the date of
grant and a nonstatutory option to acquire stock with a fair market
value of $25,000 on the date of grant.
If the change in control instead occurred prior to E's exercise of
Option 2, then Option 1, which was granted first, is treated as an
incentive stock option in its entirety, and Option 2 is bifurcated into
an incentive stock option to acquire stock with a fair market value of
$25,000 on the date of grant and a nonstatutory option to acquire stock
with a fair market value of $25,000 on the date of grant.
These proposed regulations also would provide that an option is
disregarded for purposes of the $100,000 limitation if, prior to the
calendar year during which it would have otherwise become exercisable
for the first time, the option is modified and thereafter ceases to be
an incentive stock option, is transferred in violation of the
nontransferability requirements, or is canceled. In all other
situations, a modified, transferred, or canceled option (or portion
thereof) is treated as outstanding until the end of the calendar year
during which it would otherwise have become exercisable for the first
time.
Finally, under these proposed regulations, a disqualifying
disposition has no effect on the determination of whether an option
exceeds the $100,000 limitation. Thus, for example, assume Corporation
X grants E, an employee of X, Option 1 to acquire X stock with a fair
market value on the date of grant of $75,000. Option 1 is exercisable
on January 1, 2005. On January 5, 2005, E exercises the option and
sells the stock in a disqualifying disposition. On January 15, 2005, X
grants E Option 2 to acquire X stock with a fair market value on the
date of grant of $50,000. Option 2 is immediately exercisable. Under
Sec. 1.422-4(b)(6) of the proposed regulations, the disqualifying
disposition of Option 1 has no effect on the application of the
$100,000 limitation. Thus, Option 2 is bifurcated into an incentive
stock option to acquire stock with a fair market value of $25,000 on
the date of grant and a nonstatutory option to acquire stock with a
fair market value of $25,000 on the date of grant.
4. Permissible Provisions
These proposed regulations also provide guidance on additional
provisions that may be included in an incentive stock option. Because
these provisions are not part of the requirements for an incentive
stock option, they are addressed separately in Sec. 1.422-5 of these
proposed regulations (many of these rules were previously in Sec.
1.422A-2(i) of the 1984 proposed regulations). Section 1.422-5 of these
proposed regulations addresses provisions permitting cashless exercise,
providing the right to receive additional compensation, and providing
alternative rights. In each case, these proposed regulations
essentially retain the rules described in the 1984 proposed
regulations.
[[Page 34349]]
Section 424: Definitions and Special Rules
These proposed regulations re-designate the regulations under
section 425 as regulations under section 424 and update the
regulations. For example, these proposed regulations amend the
definition of disposition to exclude a transfer of a share of stock
acquired pursuant to the exercise of a statutory option if the transfer
is described in section 1041(a) (concerning transfers between spouses
or former spouses incident to divorce).
Substitution, Assumption, and Modification of Options
Section 424(h)(1) provides that if the terms of an option are
modified, extended, or renewed, such modification, renewal, or
extension is treated as the grant of a new option. Under section
424(h)(3), the term modification (with certain exceptions) means any
change in the terms of an option which gives the optionee additional
benefits under the option. One exception to this definition is that a
change in the terms of an option attributable to a substitution or an
assumption that meets the requirements of section 424(a) is not a
modification of an option.
These proposed regulations would provide that an eligible
corporation (as defined in Sec. 1.424-1(a)(2) of these proposed
regulations) may by reason of a corporate transaction (as defined in
Sec. 1.424-1(a)(3) of these proposed regulations) substitute a new
statutory option (new option) for an outstanding statutory option (old
option) or assume an old option without the substitution or assumption
being considered a modification of the old option under section 424(h).
An eligible corporation is defined as a corporation that is the
employer of an optionee or a related corporation of such corporation.
The determination of whether a corporation is the employer of the
optionee or a related corporation of such corporation is based upon the
circumstances existing immediately after the corporate transaction.
Under the proposed regulations, a corporate transaction is (i) a
corporate merger, consolidation, acquisition of property or stock,
separation, reorganization, or liquidation; (ii) a distribution
(excluding ordinary dividends), or change in the terms or number of
outstanding shares of such corporation, such as a stock split or stock
dividend (a change in capital structure); (iii) a change in the name of
a corporation whose stock is purchasable under the old option; and (iv)
such other corporate events as may be prescribed by the Commissioner in
published guidance.
The definitions of eligible corporation and corporate transaction
would be expanded under these proposed regulations. Specifically, these
proposed regulations permit corporations with outstanding options to
substitute or assume an option under Sec. 1.424-1(a) if there is a
corporate transaction. Additionally, the definition of corporate
transaction includes events, such as a stock dividend or stock split,
that were previously addressed in Sec. 1.425-1(e) of the final
regulations, and is otherwise expanded so that events or transactions
with similar consequences are treated the same. Because of these
changes, the rules in Sec. 1.425-1(e)(5)(ii) of the current
regulations would be removed.
These proposed regulations also would eliminate the requirement
contained in Sec. 1.425-1(a)(1)(ii) of the final regulations that the
corporate transaction result in a significant number of employees being
transferred to a new employer or discharged or in the creation or
severance of a parent-subsidiary relationship. However, Sec. 1.424-
1(a)(4) of these proposed regulations would continue to impose, and
provide additional guidance concerning, the requirement that the
substitution or assumption be ``by reason of'' the corporate
transaction.
Under these proposed regulations, a change in an option or issuance
of a new option is considered to be by reason of a corporate
transaction unless the relevant facts and circumstances demonstrate
that such change or issuance is made for reasons unrelated to such
corporate transaction. For example, a change in an option or issuance
of a new option is considered to be made for reasons unrelated to such
a corporate transaction if there is an unreasonable delay between the
corporate transaction and such change in the option or issuance of a
new option or if the corporate transaction serves no substantial
corporate business purpose independent of the change in options. A
change in an option or issuance of a new option is not by reason of a
distribution or change in the terms or number of outstanding shares
unless the option as changed, or the new option, is issued on the stock
of the same corporation, or if such class of stock is eliminated by the
change in capital structure, on other stock of the same corporation.
For purposes of a change in name of the corporation, the issuance of a
new option is by reason of the change in name of the corporation only
if the option issued is on stock of the successor corporation.
These proposed regulations do not otherwise revise the requirements
that must be met for a change in an option to qualify as a substitution
or an assumption. For example, no changes are proposed with respect to
the requirements that no additional benefits be granted to the optionee
in connection with a substitution or assumption or that certain spread
and ratio tests must be met.
These proposed regulations also continue to impose the requirement
contained in the final regulations that the new or assumed option must
otherwise qualify as a statutory option. See Sec. 1.424-1(a)(5)(vi) of
these proposed regulations. Thus, except as necessary to comply with
the specific requirements regarding substitution or assumption, such as
the restrictions on ratio and spread, the option must comply with the
requirements of Sec. 1.422-2 of these proposed regulations or 1.423-2,
as applicable. Accordingly, for example, the new option must be
granted, or the old option must be assumed, under a plan approved by
the stockholders of the corporation substituting or assuming the
option.
The proposed regulations do not impose any additional stockholder
approval requirement, however, merely because there is a corporate
transaction. In Rev. Rul. 71-474 (1971-2 C.B. 215) involving qualified
stock options,\1\ the IRS held that qualified stock options assumed by
a corporation in a merger with the granting corporation retained their
status as qualified stock options without approval of the assuming
corporation's stockholders. In the ruling, the IRS indicated that
approval of the persons who owned stock of the granting corporation at
the time the plan was approved was sufficient to satisfy the
stockholder approval requirements. Similarly, the 1984 proposed
regulations provided that the stockholders of the granting corporation
must approve the plan within 12 months before or after its adoption
without additional requirements.
---------------------------------------------------------------------------
\1\ Qualified stock options are no longer permitted under
section 422, but the stockholder approval provisions applicable to a
plan under which qualified stock options were granted were the same
as those that apply to a plan uder which incentive stock options are
granted.
---------------------------------------------------------------------------
Section 1.422-2(b)(2) of these proposed regulations would provide
that the plan must be approved during the applicable 24-month period by
the stockholders of the corporation granting the incentive stock
option. There is no requirement that additional stockholder approval be
obtained because of post-approval changes in the stockholders. For
example, assume S, a subsidiary of
[[Page 34350]]
P, adopts a plan under which incentive stock options for S stock will
be granted to S employees. Under the proposed regulations, the
stockholders of S must approve the plan within 12 months before or
after the adoption of the plan. If P later completely disposes of its
interest in S, outstanding S options and new grants of S options under
the plan are treated as options granted under a plan that meets the
stockholder approval requirement of Sec. 1.422-2(b)(2) of these
proposed regulations without regard to whether S seeks approval of the
plan from the stockholders of S after the spin-off. Assuming all other
applicable requirements are met, the outstanding S options and new
options granted by S pursuant to the plan with respect to S stock will
be treated as incentive stock options.
These proposed regulations also would provide additional guidance
with respect to when a change to an option constitutes a modification.
Under these proposed regulations, as under the 1984 proposed
regulations, both a provision under an option that provides that the
optionee may receive an additional benefit at the future discretion of
the granting corporation and the exercise of that discretion are
considered modifications of the option. However, under these proposed
regulations, it is not a modification for the granting corporation to
exercise discretion related to the payment of a bonus at the time of
the exercise of the option, the availability of a loan at exercise, or
the right to tender previously-owned stock for the stock purchasable
under the option. A change to an option adding such discretion,
however, would be a modification.
In addition, these proposed regulations address more clearly
changes related to an option, including changes not only to the option
or the option plan, but also changes to any other related agreements.
In the case of a change to the stock on which the option is granted
that affects the value of the stock, there would be a modification
unless a new option is substituted for the old option by reason of the
change in the terms of the stock in accordance with the requirements of
Sec. 1.424-1(a) of these proposed regulations.
Section 6039
These proposed regulations also would provide guidance on the
statements required under section 6039 of the Code. Under these
proposed regulations, Sec. 1.6039-1 of the final regulations would be
deleted, and Sec. 1.6039-2 would be re-designated as Sec. 1.6039-1.
These proposed regulations take the same approach toward providing
notice as that taken in the 1984 proposed regulations.
Section 1.6039-1(f) of these proposed regulations states that the
matter of furnishing statements in electronic form is reserved.
Temporary and proposed regulations have been issued under sections 6041
and 6051 (relating to voluntary electronic furnishing of payee
statements on Form W-2) and section 6050S (relating to voluntary
electronic furnishing of statements to individuals for whom Forms 1098-
T, ``Tuition Payments Statement,'' and 1098-E, ``Student Loan Interest
Statement'' are filed). See 66 FR 10191 and 10247 (Feb. 14, 2001). The
preamble to those temporary and proposed regulations requested comments
regarding, among other things, the extent to which the proposed method
of electronic filing is appropriate for information statements required
under other sections of the Code. In addition, section 401 of the Job
Creation and Worker Assistance Act of 2002 authorized all statements
required by sections 6041 through 6050T of the Code to be furnished
electronically under certain conditions. The issue of electronic
statements in general is under review, and comments are requested.
Proposed Effective Date
The regulations under sections 421, 422, and 424 are proposed to
apply as of the date that is 180 days after publication of final
regulations in the Federal Register and apply to any statutory option
that is granted on or after that date. The regulations under section
6039 are proposed to apply to transfers on or after the date that is
180 days after publication of final regulations in the Federal Register
of stock acquired pursuant to a statutory option. The 1984 proposed
regulations are withdrawn. Taxpayers may rely on these proposed
regulations for the treatment of any statutory option granted after
June 9, 2003.
Special Analyses
It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in Executive Order
12866. Therefore, a regulatory assessment is not required. Section
1.6039-1 of these proposed regulations provides for the collection of
information. It is hereby certified that the collection of information
in these regulations will not have a significant economic impact on a
substantial number of small entities. This certification is based on
the fact that the provision of employee statements provided under these
proposed regulations will impose a minimal paperwork burden on most
small entities (see the discussion under the heading ``Paperwork
Reduction Act'' earlier in this preamble). Therefore, an analysis under
the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required.
Pursuant to section 7805(f) of the Code, this notice of proposed
rulemaking is being submitted to the Chief Counsel for Advocacy of the
Small Business Administration for comment on its impact on small
business.
Comments and Public Hearing
Before these proposed regulations are adopted as final regulations,
consideration will be given to any written or electronic comments (a
signed original and eight (8) copies) that are submitted timely to the
IRS. All comments will be available for public inspection and copying.
A public hearing has been scheduled for September 2, 2003,
beginning at 10 a.m. in the IRS Auditorium of the Internal Revenue
Building, 1111 Constitution Avenue, NW., Washington, DC. All visitors
must come to the Constitution Avenue entrance and present photo
identification to enter the building. Because of access restrictions,
visitors will not be admitted beyond the immediate entrance area more
than 30 minutes before the hearing starts. For information about having
your name placed on the building access list to attend the hearing, see
the FOR FURTHER INFORMATION CONTACT section of this preamble.
The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who
wish to present oral comments at the hearing must submit written
comments and an outline of the topics to be discussed and the time to
be devoted to each topic (signed original and eight (8) copies) by
August 12, 2003. A period of 10 minutes will be allotted to each person
for making comments. An agenda showing the schedule of speakers will be
prepared after the deadline for receiving outlines has passed. Copies
of the agenda will be available free of charge at the hearing.
Drafting Information
The principal author of these proposed regulations is Erinn Madden,
Office of the Division Counsel/Associate Chief Counsel (Tax Exempt and
Government Entities). However, other personnel from the IRS and
Treasury Department participated in their development.
List of Subjects in 26 CFR Parts 1 and 14a
Income taxes, Reporting and recordkeeping requirements.
[[Page 34351]]
Proposed Amendments to the Regulations
Accordingly, 26 CFR parts 1 and 14a are proposed to be amended as
follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:
Authority: 26 U.S.C. 7805 * * *
Sec. Sec. 1.421-1 through 1.421-6 [Removed]
Par. 2. Sections 1.421-1 through 1.421-6 are removed.
Par. 3. Section 1.421-7 is re-designated as Sec. 1.421-1 and is
amended as follows:
1. In paragraph (a)(1), first sentence, the language ``sections 421
through 425'' is removed and ``Sec. Sec. 1.421-1 through 1.424-1'' is
added in its place.
2. In paragraph (a)(1), first sentence, the language ``includes''
is removed, and ``means'' is added in its place.
3. In paragraph (a)(1), removing the second sentence.
4. Removing the last sentence of paragraph (a)(1) and adding two
sentences in its place.
5. Revising paragraph (a)(3).
6. Revising paragraphs (b)(1) and (b)(2).
7. In paragraph (b)(3)(i), third sentence, removing the language
``1.425-1'' and inserting ``1.424-1'' in its place.
8. In the list below, for each section indicated in the left
column, remove the language in the middle column and add the language
in the right column:
------------------------------------------------------------------------
Newly designated section Remove Add
------------------------------------------------------------------------
1.421-1(b)(3)(ii), Example 1, first, second, third and S-1 X
fourth sentences........................................
1.421-1(b)(3)(ii), Example 1, second sentence............ 1964 2004
1.421-1(b)(3)(ii), Example 1, third and fourth sentences. 1965 2005
1.421-1(b)(3)(ii), Example 2, first and second sentences. 1964 2004
1.421-1(b)(3)(ii), Example 2, first, third, and fourth S-1 X
sentences...............................................
1.421-1(b)(3)(ii), Example 2, third and fourth sentences. 1965 2005
------------------------------------------------------------------------
9. Revising the last sentence of paragraph (b)(3)(ii), Example 1.
10. Removing the last sentence of paragraph (b)(3)(ii), Example 2
and adding two sentences in its place.
11. Removing the first sentence of paragraph (c)(1) and adding two
new sentences in its place.
12. In paragraph (c)(2), second sentence, the language ``425'' is
removed and ``424'' is added in its place.
13. In paragraph (c)(3), second and last sentences, the language
``1964'' is removed and ``2004'' is added in its place.
14. In paragraph (c)(3), second sentence, the language ``1965'' is
removed and ``2005'' is added in its place.
15. Revising paragraphs (d) and (e).
16. In paragraph (f), in the first sentence, the language
``sections 421 through 425'' is removed and ``this section and
Sec. Sec. 1.421-2 through 1.424-1'' is added in its place.
17. Revising the last sentence of paragraph (f).
18. In paragraph (g), first sentence, the language ``sections 421
through 425'' is removed and ``this section and Sec. Sec. 1.421-2
through 1.424-1'' is added in its place.
19. Adding a new third sentence to paragraph (g).
20. Revising the first, second, and third sentences of paragraph
(h)(1).
21. Revising paragraph (h)(2).
22. In paragraph (h)(3), first sentence, the language ``425'' is
removed and ``424'' is added in its place.
23. In paragraph (h)(3), last sentence, the language ``or
assuming'' is removed and ``the option or substituting or assuming the
option'' is added in its place.
24. In the list below, for each section indicated in the left
column, remove the language in the middle column and add the language
in the right column:
------------------------------------------------------------------------
Newly designated section Remove Add
------------------------------------------------------------------------
1.421-1(h)(4), Example 1, 1964................ 2004.
first sentence.
1.421-1(h)(4), Example 1, 1965................ 2005.
second and last sentences.
1.421-1(h)(4), Example 2, 425................. 424.
first sentence.
1.421-1(h)(4), Example 2, issuing............. substituting.
first sentence.
1.424-1(h)(4), Example 2, 1965................ 2005.
last sentence.
1.421-1(h)(4), Example 2, for A is then to the transfer of
last sentence. employed by a the M stock
corporation which because, at all
issued an option times during the
under section period beginning
425(a). with the date of
grant of the X
option and ending
with the date of
exercise of the M
option, A was an
employee of the
corporation
granting the option
or substituting or
assuming the option
under Sec. 1.424-
1(a).
1.421-1(h)(4), Example 3, 1964................ 2004.
second sentence.
1.421-1(h)(4), Example 3, 1965................ 2005.
third, fourth, and fifth
sentences.
1.421-1(h)(4), Example 4, 425(a).............. 424(a).
first sentence.
1.421-1(h)(4), Example 5, qualified stock..... statutory.
first sentence.
1.421-1(h)(4), Example 6, an employment a right to
first sentence. contract with M reemployment with M
which provides that or a related
upon the corporation on the
termination of any termination of any
military duty E may military duty E may
be required to be required to
serve, E will be serve.
entitled to
reemployment with M
or a parent or
subsidiary of M.
1.421-1(h)(4), Example 6, of M................ of M or a related
third sentence. corporation.
[[Page 34352]]
1.421-1(h)(4), Example 6, can apply........... applies.
last sentence.
1.421-1(h)(4), Example 7, a qualified stock... an incentive.
first and last sentences.
1.421-1(h)(4), Example 7, parent or subsidiary related corporation.
first sentence.
1.421-1(h)(4), Example 7, its parent and related
last sentence. subsidiary corporations.
corporation.
1.421-1(h)(4), Example 7, terminated.......... deemed terminated.
last sentence.
------------------------------------------------------------------------
25. Revising paragraph (i).
26. Adding paragraph (j).
The additions and revisions read as follows:
Sec. 1.421-1 Meaning and use of certain terms.
(a) * * * (1) * * * While no particular form of words is necessary,
the option must express, among other things, an offer to sell at the
option price, the maximum number of shares purchasable under the
option, and the period of time during which the offer remains open. The
term option includes a warrant that meets the requirements of this
paragraph (a)(1).
* * * * *
(3) An option must be in writing (in paper or electronic form),
provided that such writing is adequate to establish an option right or
privilege that is enforceable under applicable law.
(b) Statutory options. (1) The term statutory option, for purposes
of this section and Sec. Sec. 1.421-2 through 1.424-1, means an
incentive stock option, as defined in Sec. 1.422-2(a), or an option
granted under an employee stock purchase plan, as defined in Sec.
1.423-2.
(2) An option qualifies as a statutory option only if the option is
not transferable (other than by will or by the laws of descent and
distribution) by the individual to whom the option was granted, and is
exercisable, during the lifetime of such individual, only by such
individual. See Sec. Sec. 1.422-2(a)(2)(v) and 1.423-2(j).
Accordingly, an option which is transferable or transferred by the
individual to whom the option is granted during such individual's
lifetime, or is exercisable during such individual's lifetime by
another person, is not a statutory option. However, if the option or
the plan under which the option was granted contains a provision
permitting the individual to designate the person who may exercise the
option after such individual's death, neither such provision, nor a
designation pursuant to such provision, disqualifies the option as a
statutory option. A pledge of the stock purchasable under an option as
security for a loan that is used to pay the option price does not cause
the option to violate the nontransferability requirements of this
paragraph (b). Also, the transfer of an option to a trust does not
disqualify the option as a statutory option if, under section 671 and
applicable State law, the individual is considered the sole beneficial
owner of the option while it is held in the trust. If an option is
transferred incident to divorce (within the meaning of section 1041) or
pursuant to a qualified domestic relations order (within the meaning of
section 414(p)), the option does not qualify as a statutory option as
of the day of such transfer. For the treatment of nonstatutory options,
see Sec. 1.83-7.
(3)(ii) * * * * *
Example 1. * * * Because X was a subsidiary of P on the date of
the grant of the statutory option, the option does not fail to be a
statutory option even though X ceases to be a subsidiary of P.
Example 2. * * * Because X was not a subsidiary of P on the date
of the grant of the option, the option is not a statutory option
even though S later becomes a subsidiary of P. See Sec. Sec. 1.422-
2(a)(2) and 1.423-2(b).
(c) Time and date of granting option. (1) For purposes of this
section and Sec. Sec. 1.421-2 through 1.424-1, the language ``the date
of the granting of the option'' and ``the time such option is
granted,'' and similar phrases refer to the date or time when the
granting corporation completes the corporate action constituting an
offer of stock for sale to an individual under the terms and conditions
of a statutory option. A corporate action constituting an offer of
stock for sale is not considered complete until the date on which the
maximum number of shares that can be purchased under the option and the
minimum option price are fixed or determinable. * * *
* * * * *
(d) Stock and voting stock. (1) For purposes of this section and
Sec. Sec. 1.421-2 through 1.424-1, the term stock means capital stock
of any class, including voting or nonvoting common or preferred stock.
Except as otherwise provided, the term includes both treasury stock and
stock of original issue. Special classes of stock authorized to be
issued to and held by employees are within the scope of the term stock
as used in such sections, provided such stock otherwise possesses the
rights and characteristics of capital stock.
(2) For purposes of determining what constitutes voting stock in
ascertaining whether a plan has been approved by stockholders under
Sec. 1.422-2(b) or 1.423-2(c) or whether the limitations pertaining to
voting power contained in sections Sec. Sec. 1.422-2(f) and 1.423-2(d)
have been met, stock which does not have voting rights until the
happening of an event, such as the default in the payment of dividends
on preferred stock, is not voting stock until the happening of the
specified event. Generally, stock which does not possess a general
voting power, and may vote only on particular questions, is not voting
stock. However, if such stock is entitled to vote on whether a stock
option plan may be adopted, it is voting stock.
(3) In general, for purposes of this section and Sec. Sec. 1.421-2
through 1.424-1, ownership interests other than capital stock are
considered stock.
(e) Option price. (1) For purposes of this section and Sec. Sec.
1.421-2 through 1.424-1, the term option price, price paid under the
option, or exercise price means the consideration in cash or property
which, pursuant to the terms of the option, is the price at which the
stock subject to the option is purchased. The term option price does
not include any amounts paid as interest under a deferred payment
arrangement or treated as interest.
(2) Any reasonable valuation method may be used to determine
whether, at the time the option is granted, the option price satisfies
the pricing requirements of sections 422(b)(4), 422(c)(5), 422(c)(7),
and 423(b)(6) with respect to the stock subject to the option. Such
methods include, for example, the valuation method described in Sec.
20.2031-2 of this chapter (Estate Tax Regulations).
[[Page 34353]]
(f) Exercise. * * * An agreement or undertaking by the employee to
make payments under a stock purchase plan does not constitute the
exercise of an option to the extent the payments made remain subject to
withdrawal by or refund to the employee.
(g) Transfer. * * * A transfer does not fail to occur merely
because, under the terms of the arrangement, the individual may not
dispose of the share for a specified period of time or the share is
subject to a right of first refusal at the share's fair market value at
the time of sale.
(h) Employment relationship. (1) An option is a statutory option
only if, at the time the option is granted, the optionee is an employee
of the corporation granting the option, or a related corporation of
such corporation. If the option has been assumed or a new option has
been substituted in its place under Sec. 1.424-1(a), the optionee
must, at the time of such substitution or assumption, be an employee of
the corporation so substituting or assuming the option, or a related
corporation of such corporation. The determination of whether the
optionee is an employee at the time the option is granted (or at the
time of the substitution or assumption under Sec. 1.424-1(a)) is made
in accordance with section 3401(c) and the regulations thereunder. * *
*
(2) In addition, Sec. 1.421-2(a) is applicable to the transfer of
a share pursuant to the exercise of the statutory option only if the
optionee is, at all times during the period beginning with the date of
the granting of such option and ending on the day 3 months before the
date of such exercise, an employee of either the corporation granting
such option, a related corporation of such corporation, or a
corporation (or a related corporation of such corporation) substituting
or assuming a stock option in a transaction to which Sec. 1.424-1(a)
applies. For purposes of the preceding sentence, the employment
relationship is treated as continuing intact while the individual is on
military leave, sick leave, or other bona fide leave of absence (such
as temporary employment by the Government) if the period of such leave
does not exceed 90 days, or if longer, so long as the individual's
right to reemployment with the corporation granting the option (or a
related corporation of such corporation) or a corporation (or a related
corporation of such corporation) substituting or assuming a stock
option in a transaction to which Sec. 1.424-1(a) applies, is
guaranteed either by statute or by contract. If the period of leave
exceeds 90 days and the individual's right to reemployment is not
guaranteed either by statute or by contract, the employment
relationship is deemed to terminate on the 91st day of such leave.
Thus, if the option is not exercised before such deemed termination of
employment, Sec. 1.421-2(a) applies to the transfer of a share
pursuant to an exercise of the option only if the exercise occurs
within 3 months from the date the employment relationship is deemed
terminated.
* * * * *
(i) Additional definitions. (1) Corporation. For purposes of this
section and Sec. Sec. 1.421-2 through 1.424-1, the term corporation
has the meaning prescribed by section 7701(a)(3) and Sec. 301.7701-
2(b) of this chapter. For example, a corporation for purposes of the
preceding sentence includes an S corporation (as defined in section
1361), a foreign corporation (as defined in section 7701(a)(5)), and a
limited liability company that is treated as a corporation for all
Federal tax purposes.
(2) Parent corporation and subsidiary corporation. For the
definition of the terms parent corporation (and parent) and subsidiary
corporation (and subsidiary), for purposes of this section and
Sec. Sec. 1.421-2 through 1.424-1, see Sec. 1.424-1(f)(i) and (ii),
respectively. Related corporation as used in this section and in
Sec. Sec. 1.421-2 through 1.424-1 means either a parent corporation or
subsidiary corporation.
(j) Effective date. This section applies to any statutory option
granted on or after the date that is 180 days after publication of
final regulations in the Federal Register. Taxpayers can rely on these
regulations for the treatment of any statutory option granted on or
after June 9, 2003.
Par. 4. Section 1.421-8 is re-designated as 1.421-2 and is amended
by:
1. Revising paragraphs (a)(1), (b), and (c)(1).
2. In the list below, for each section indicated in the left
column, remove the language in the middle column and add the language
in the right column:
------------------------------------------------------------------------
Newly designated section Remove Add
------------------------------------------------------------------------
1.421-2(c)(2), second sentence....... or 424(c)(1)............ .......
Add 1.421-2(c)(2), third sentence.... or 424(c)(1)............ .......
1.421-2(c)(3)(i), first, second, and 422(c)(1), 423(c), or 423(c)
third sentences. 424(c)(1).
1.421-2(c)(3)(ii), Example, first 1964.................... 2004
sentence.
1.421-2(c)(3)(ii), Example, third, 1966.................... 2006
fifth, and sixth sentences.
------------------------------------------------------------------------
3. In paragraph (c)(2), first sentence, add the phrase ``for
purposes of section 423(c)'' at the end of the first sentence.
4. Removing paragraph (c)(4)(i) and redesignating paragraphs
(c)(4)(ii) through (c)(4)(iv) as paragraphs (c)(4)(i) through
(c)(4)(iii), respectively.
5. In newly designated paragraph (c)(4)(i)(a), first sentence,
removing the phrase ``In the case of an employee dying after December
31, 1956'' and adding ``In the case of the death of an optionee'' in
its place.
6. Removing Example (1) in newly designated paragraph (c)(4)(iii)
and redesignating Examples (2) through (5) as Examples (1) through (4),
respectively.
7. In the list below, for each section indicated in the left
column, remove the language in the middle column and add the language
in the right column:
------------------------------------------------------------------------
Newly designated section Remove Add
------------------------------------------------------------------------
1.421-2(c)(4)(i)(a), last 422(c)(1), 423(c), 423(c).
sentence. or 424(c)(1).
1.421-2(c)(4)(i)(b), first, 422(c)(1), 423(c), 423(c).
second, and last sentences. or 424(c)(1).
1.421-2(c)(4)(i)(c), first 422(c)(1), 423(c), 423(c).
sentence. or 424(c)(1).
1.421-2(c)(4)(iii), Example 1964................ 2005.
1, first sentence.
1.421-2(c)(4)(iii), Example subdivision (ii)(b) paragraph
1, eighth sentence. of this (c)(4)(i)(b) of
subparagraph. this section.
1.421-2(c)(4)(iii), Example 1966................ 2006.
1, third and fifth
sentences.
1.421-2(c)(4)(iii), Example subdivision (ii)(c) paragraph
1, ninth sentence. of this (c)(4)(i)(c) of
subparagraph. this section.
[[Page 34354]]
1.421-2(c)(4)(iii), Example subdivision (ii)(a) paragraph
2, second and fifth of this (c)(4)(i)(a) of
sentences. subparagraph. this section.
1.421-2(c)(4)(iii), Example subdivision (ii)(b) paragraph
2, fifth sentence. of this (c)(4)(i)(b) of
subparagraph. this section.
1.421-2(c)(4)(iii), Example example (2)......... Example 1.
2, first sentence.
1.421-2(c)(4)(iii), Example example (2)......... Example 1.
3, first sentence.
1.421-2(c)(4)(iii), Example subdivision (ii)(a) paragraph
3, second and fourth of this (c)(4)(i)(a) of
sentences. subparagraph. this section.
1.421-2(c)(4)(iii), Example subdivision (ii)(c) paragraph
3, fourth sentence. of this (c)(4)(i)(c) of
subparagraph. this section
1.421-2(c)(4)(iii), Example example (2)......... Example 1.
4, first sentence.
1.421-2(c)(4)(iii), Example 1966................ 2006.
4, first sentence.
1.421-2(c)(4)(iii), Example 1967................ 2007.
4, first and second
sentences.
1.421-2(c)(4)(iii), Example subdivision (ii)(a) paragraph
4, third and fifth of this (c)(4)(i)(a) of
sentences. subparagraph. this section.
1.421-2(c)(4)(iii), Example subdivision (ii)(a) paragraph
4, sixth sentence. of this (c)(4)(i)(a) of
subparagraph. this section.
1.421-2(c)(4)(iii), Example subdivision (ii)(b) paragraph
4, fifth and sixth of this (c)(4)(i)(b) of
sentences. subparagraph. this section.
1.421-2(c)(4)(iii), Example subdivision (ii)(c) paragraph
4, sixth sentence. of this (c)(4)(i)(c) of
subparagraph. this section.
------------------------------------------------------------------------
8. Revising paragraph (d).
9. Adding paragraph (f).
The revisions read as follows:
Sec. 1.421-2 General rules.
(a) Effect of qualifying transfer. (1) If a share of stock is
transferred to an individual pursuant to the individual's exercise of a
statutory option, and if the requirements of Sec. 1.422-1(a) (relating
to incentive stock options) or Sec. 1.423-1(a) (relating to employee
stock purchase plans) whichever is applicable, are met, then--
(i) No income results at the time of the transfer of such share to
the individual upon the exercise of the option with respect to such
share (in addition, no income results upon grant of the option, see
Sec. 1.83-7);
(ii) No deduction under section 162 or the regulations thereunder
(relating to trade or business expenses) is allowable at any time with
respect to the share so transferred; and
(iii) No amount other than the price paid under the option is
considered as received by the employer corporation, a related
corporation of such corporation, or a corporation substituting or
assuming a stock option in a transaction to which Sec. 1.424-1(a)
(relating to corporate reorganizations, liquidations, etc.) applies,
for the share so transferred.
* * * * *
(b) Effect of disqualifying disposition. (1)(i) The disposition (as
defined in Sec. 1.424-1(c)) of a share of stock acquired by the
exercise of a statutory option before the expiration of the applicable
holding periods as determined under Sec. 1.422-1(a) or 1.423-1(a) is a
disqualifying disposition and makes paragraph (a) of this section
inapplicable to the transfer of such share. See Sec. 1.83-7 for the
treatment of nonstatutory options. The income attributable to such
transfer (determined without reduction for any brokerage fees or other
costs paid in connection with the disposition) is treated by the
individual as compensation income received in the taxable year in which
such disqualifying disposition occurs. Similarly, if otherwise
allowable under sections 83(h) and 162, a deduction attributable to
such transfer is allowable for the taxable year in which such
disqualifying disposition occurs to the employer corporation, or a
related corporation of such corporation, or a corporation substituting
or assuming an option in a transaction to which Sec. 1.424-1(a)
applies. Additionally, an amount is allowed as a deduction only if the
requirements of Sec. 1.83-6(a) are satisfied. No amount is treated as
income, and no amount is allowed as a deduction, for any taxable year
other than the taxable year in which the disqualifying disposition
occurs. If the amount realized on the disposition exceeds (or is less
than) the sum of the amount paid for the share and the amount of
compensation income recognized as a result of such disposition, the
extent to which the difference is treated as gain (or loss) is
determined under the rules of section 302 or 1001, as applicable.
(ii) The following examples illustrate the principles of this
paragraph (b):
Example 1. On June 1, 2006, X Corporation grants an incentive
stock option to A, an employee of X, entitling A to purchase 100
shares of X stock at $10 per share. On August 1, 2006, A exercises
the option when the fair market value of X stock is $20 per share,
and 100 shares of X stock are transferred to A on that date. On
December 15, 2007, A sells the stock. Because A disposed of the
stock before June 2, 2008, A did not satisfy the holding period
requirements of Sec. 1.422-1(a). Under paragraph (b)(1)(i) of this
section, A made a disqualifying disposition of the stock. Thus,
paragraph (a) of this section is inapplicable to the transfer of the
shares, and A must include the compensation income attributable to
the transfer of the shares in gross income. The amount of
compensation income A must include in income under Sec. 1.83-7 in
the year of the disqualifying disposition is $1,000 (($20, the fair
market value of X stock on transfer less $10, the exercise price per
share) times 100 shares)). If otherwise allowable under sections
83(h) and 162 and if the requirements of Sec. 1.83-6(a) are met, X
is allowed a deduction of $1,000 for its taxable year in which the
disqualifying disposition occurs.
Example 2. Y Corporation grants an incentive stock option for
100 shares of its stock to E, an employee of Y. The option has an
exercise price of $10 per share. E exercises the option and is
transferred the shares when the fair market value of a share of Y
stock is $30. Before the applicable holding periods expire, Y
redeems the shares for $70 per share. Because the holding period
requirements of Sec. 1.422-1(a) are not met, the redemption of the
shares is a disqualifying disposition of the shares. Under paragraph
(b)(1)(i) of this section, A made a disqualifying disposition of the
stock. Thus, paragraph (a) of this section is inapplicable
[[Page 34355]]
to the transfer of the shares, and E must include the compensation
income attributable to the transfer of the shares in gross income.
Under Sec. 1.83-7, the amount of compensation income attributable
to E's purchase of the share that E must include in gross income in
the year of the disqualifying disposition is $2,000 ($3,000, the
fair market value of Y stock on transfer, less $1,000, the exercise
price paid by E). The character of the additional gain that is
includible in E's income as a result of the redemption is determined
under the rules of section 302. If otherwise allowable under
sections 83(h) and 162 and if the requirements of Sec. 1.83-6(a)
are met, Y is allowed a deduction for the taxable year in which the
disqualifying disposition occurs for the compensation income of
$2,000. Y is not allowed a deduction for the additional gain
includible in E's income as a result of the redemption.
(2) If an optionee transfers stock acquired through the optionee's
exercise of a statutory option prior to the expiration of the
applicable holding periods, paragraph (a) of this section continues to
apply to the transfer of the stock pursuant to the exercise of the
option if such transfer is not a disposition of the stock as defined in
Sec. 1.424-1(c) (for example, a transfer from a decedent to the
decedent's estate or a transfer by bequest or inheritance). Similarly,
a subsequent transfer by the executor, administrator, heir, or legatee
is not a disqualifying disposition by the decedent. If a statutory
option is exercised by the estate of the optionee or by a person who
acquired the option by bequest or inheritance or by reason of the death
of such optionee, see paragraph (c) of this section. If a statutory
option is exercised by the individual to whom the option was granted
and the individual dies before the expiration of the holding periods,
see paragraph (d) of this section.
(3) For special rules relating to the disqualifying disposition of
a share of stock acquired by exercise of an incentive stock option, see
Sec. Sec. 1.422-5(b)(2) and 1.424-1(c)(3).
(c) Exercise by estate. (1) If a statutory option is exercised by
the estate of the individual to whom the option was granted (or by any
person who acquired such option by bequest or inheritance or by reason
of the death of such individual), paragraph (a) of this section applies
to the transfer of stock pursuant to such exercise in the same manner
as if the option had been exercised by the deceased optionee.
Consequently, neither the estate nor such person is required to include
any amount in gross income as a result of a transfer of stock pursuant
to the exercise of the option. Paragraph (a) of this section applies
even if the executor, administrator, or such person disposes of the
stock so acquired before the expiration of the applicable holding
periods as determined under Sec. 1.422-1(a) or 1.423-1(a). This
special rule does not affect the applicability of section 423(c),
relating to the estate's or other qualifying person's recognition of
compensation income, or section 1222, relating to what constitutes a
short-term and long-term capital gain or loss. Paragraph (a) of this
section also applies even if the executor, administrator, or such
person does not exercise the option within three months after the death
of the individual or is not employed as described in Sec. 1.421-1(h),
either when the option is exercised or at any time. However, paragraph
(a) of this section does not apply to a transfer of shares pursuant to
an exercise of the option by the estate or by such person unless the
individual met the employment requirements described in Sec. 1.421-
1(h) either at the time of the individual's death or within three
months before such time (or, if applicable, within the period described
in Sec. 1.422-1(a)(3)). Additionally, paragraph (a) of this section
does not apply if the option is exercised by a person other than the
executor or administrator, or other than a person who acquired the
option by bequest or inheritance or by reason of the death of such
deceased individual. For example, if the option is sold by the estate,
paragraph (a) of this section does not apply to the transfer of stock
pursuant to an exercise of the option by the buyer, but if the option
is distributed by the administrator to an heir as part of the estate,
paragraph (a) of this section applies to the transfer of stock pursuant
to an exercise of the option by such heir.
* * * * *
(d) Option exercised by the individual to whom the option was
granted if the individual dies before expiration of the applicable
holding periods. If a statutory option is exercised by the individual
to whom the option was granted and such individual dies before the
expiration of the applicable holding periods as determined under Sec.
1.422-1(a) or 1.423-1(a), paragraph (a) of this section does not become
inapplicable if the executor or administrator of the estate of such
individual, or any person who acquired such stock by bequest or
inheritance or by reason of the death of such individual, disposes of
such stock before the expiration of such applicable holding periods.
This rule does not affect the applicability of section 423(c), relating
to the individual's recognition of compensation income, or section
1222, relating to what constitutes a short-term and long-term capital
gain or loss.
* * * * *
(f) Effective date. This section is applies to any statutory option
granted on or after the date that is 180 days after publication of
final regulations in the Federal Register. Taxpayers can rely on these
regulations for the treatment of any statutory option granted on or
after June 9, 2003.
Par. 5. Section 1.422-1 is added to read as follows:
Sec. 1.422-1 Incentive stock options; general rules.
(a) Applicability of section 421(a). (1)(i) Section 1.421-2(a)
applies to the transfer of a share of stock to an individual pursuant
to the individual's exercise of an incentive stock option if the
following conditions are satisfied--
(A) The individual makes no disposition of such share before the
later of the expiration of the 2-year period from the date of grant of
the option pursuant to which such share was transferred, or the
expiration of the 1-year period from the date of transfer of such share
to the individual; and
(B) At all times during the period beginning on the date of grant
of the option and ending on the day 3 months before the date of
exercise, the individual was an employee of either the corporation
granting the option, a related corporation of such corporation, or a
corporation (or a related corporation of such corporation) substituting
or assuming a stock option in a transaction to which Sec. 1.424-1(a)
applies.
(ii) For rules relating to the disposition of shares of stock
acquired pursuant to the exercise of a statutory option, see Sec.
1.424-1(c). For rules relating to the requisite employment
relationship, see Sec. 1.421-1(h).
(2)(i) The holding period requirement of section 422(a)(1),
described in paragraph (a)(1)(i)(A) of this section, does not apply to
the transfers of shares by an insolvent individual described in this
paragraph (a)(2). If an insolvent individual holds a share of stock
acquired pursuant to the individual's exercise of an incentive stock
option, and if such share is transferred to a trustee, receiver, or
other similar fiduciary in any proceeding under the Bankruptcy Act or
any other similar insolvency proceeding, neither such transfer, nor any
other transfer of such share for the benefit of the individual's
creditors in such proceeding is a disposition of such share for
purposes of this paragraph (a). For purposes of this paragraph (a)(2),
an individual is insolvent only if the individual's
[[Page 34356]]
liabilities exceed the individual's assets or the individual is unable
to satisfy the individual's liabilities as they become due. See section
422(c)(3).
(ii) A transfer by the trustee or other fiduciary that is not
treated as a disposition for purposes of this paragraph (a) may be a
sale or exchange for purposes of recognizing capital gain or loss with
respect to the share transferred. For example, if the trustee transfers
the share to a creditor in an insolvency proceeding, capital gain or
loss must be recognized by the insolvent individual to the extent of
the difference between the amount realized from such transfer and the
adjusted basis of such share.
(iii) If any transfer by the trustee or other fiduciary (other than
a transfer back to the insolvent individual) is not for the exclusive
benefit of the creditors in an insolvency proceeding, then whether such
transfer is a disposition of the share by the individual for purposes
of this paragraph (a) is determined under Sec. 1.424-1(c). Similarly,
if the trustee or other fiduciary transfers the share back to the
insolvent individual, any subsequent transfer of the share by such
individual which is not made in respect of the insolvency proceeding
may be a disposition of the share for purposes of this paragraph (a).
(3) If the employee exercising an option ceased employment because
of permanent and total disability, within the meaning of section
22(e)(3), 1 year is used instead of 3 months in the employment period
requirement of paragraph (a)(1)(i)(B) of this section.
(b) Failure to satisfy holding period requirements--(1) General
rule. For general rules concerning a disqualifying disposition of a
share of stock acquired pursuant to the exercise of an incentive stock
option, see Sec. 1.421-2(b)(1).
(2)(i) Special rule. If an individual makes a disqualifying
disposition of a share of stock acquired by the exercise of an
incentive stock option, and if such disposition is a sale or exchange
with respect to which a loss (if sustained) would be recognized to the
individual, then, under this paragraph (b)(2)(i), the amount includible
in the gross income of such individual, and deductible from the income
of the employer corporation (or a related corporation of such
corporation, or of a corporation substituting or assuming the option in
a transaction to which Sec. 1.424-1(a) applies) as compensation
attributable to the exercise of such option, shall not exceed the
excess (if any) of the amount realized on such sale or exchange over
the adjusted basis of such share. Subject to the special rule provided
by this paragraph (b)(2)(i), the amount of compensation attributable to
the exercise of the option is determined under Sec. 1.83-7; see Sec.
1.421-2(b)(1)(i).
(ii) Limitation to special rule. The special rule described in
paragraph (b)(2)(i) of this section does not apply if the disposition
is a sale or exchange with respect to which a loss (if sustained) would
not be recognized to the individual. Thus, for example, if a
disqualifying disposition is a sale described in section 1091 (relating
to loss from wash sales of stock or securities), a gift (or any other
transaction which is not at arm's length), or a sale described in
section 267(a)(1) (relating to sales between related persons), the
special rule described in paragraph (b)(2)(i) of this section does not
apply because a loss sustained in any such transaction would not be
recognized.
(3) Examples. The following examples illustrate the principles of
this paragraph (b):
Example 1. On June 1, 2006, X Corporation grants an incentive
stock option to A, an employee of X Corporation, entitling A to
purchase one share of X Corporation stock. On August 1, 2006, A
exercises the option and the share of X Corporation stock is
transferred to A on that date. The option price is $100 (the fair
market value of a share of X Corporation stock on June 1, 2006) and
the fair market value of a share of X Corporation stock on August 1,
2006 (the date of transfer) is $200. The share transferred to A is
transferable and not subject to a substantial risk of forfeiture. A
makes a disqualifying disposition by selling the share on June 1,
2007, for $250. Under Sec. 1.83-7(a) (relating to options to which
section 421 does not apply), the amount of compensation attributable
to A's exercise is $100 (the difference between the fair market
value of the share at the date of transfer, $200, and the amount
paid for the share, $100). Because the amount realized ($250) is
greater than the value of the share at transfer ($200), paragraph
(b)(2)(i) of this section does not apply and thus does not affect
the amount includible as compensation in A's gross income and
deductible by X. A must include in gross income for the taxable year
in which the sale occurred $100 as compensation and $50 as capital
gain ($250, the amount realized from the sale, less A's basis of
$200 (the $100 paid for the share plus the $100 increase in basis
resulting from the inclusion of that amount in A's gross income as
compensation attributable to the exercise of the option)). For its
taxable year in which the disqualifying disposition occurs, if
otherwise allowable under sections 83(h) and 162 and if the
requirements of Sec. 1.83-6(a) are met, X Corporation is allowed a
deduction of $100 for compensation attributable to A's exercise of
the incentive stock option.
Example 2. Assume the same facts as in Example 1, except that
the share of X Corporation stock transferred to A is subject to a
substantial risk of forfeiture and not transferable for a period of
six months after such transfer. Assume further that the fair market
value of X Corporation stock is $225 on February 1, 2005, the date
on which the six-month restriction lapses. Under section 83(a) and
Sec. 1.83-7(a), the amount of compensation attributable to A's
exercise of the option and disqualifying disposition of the share is
$125 (the difference between the fair market value of the share on
the date that the restriction lapsed, $225, and the amount paid for
the share, $100). A must include $125 of compensation income and $25
of capital gain in gross income for the taxable year in which the
disposition occurs ($250, the amount realized from the sale, less
A's basis of $225 (the $100 paid for the share plus the $125
increase in basis resulting from the inclusion of that amount of
compensation in A's gross income)). For its taxable year in which
the disqualifying disposition occurs, if otherwise allowable under
sections 83(h) and 162 and if the requirements of Sec. 1.83-6(a)
are met, X Corporation is allowed a deduction of $125 for the
compensation attributable to A's exercise of the option.
Example 3. (i) Assume the same facts as in Example 1, except
that A sells the share for $150 to M.
(ii) If the sale to M is a disposition that meets the
requirements of paragraph (b)(2)(i) of this section, instead of $100
which otherwise would have been includible as compensation under
Sec. 1.83-7, under paragraph (b)(2)(i) of this section, A must
include only $50 (the excess of the amount realized on such sale,
$150, over the adjusted basis of the share, $100) in gross income as
compensation attributable to the exercise of the incentive stock
option. Because A's basis for the share is $150 (the $100 which A
paid for the share, plus the $50 increase in basis resulting from
the inclusion of that amount in A's gross income as compensation
attributable to the exercise of the option), A realizes no capital
gain or loss as a result of the sale. For its taxable year in which
the disqualifying disposition occurs, if otherwise allowable under
sections 83(h) and 162 and if the requirements of Sec. 1.83-6(a)
are met, X Corporation is allowed a deduction of $50 for the
compensation attributable to A's exercise of the option.
(iii) Assume the same facts as in paragraph (i) of this Example
3, except that 10 days after the sale to M, A purchases
substantially identical stock. Because under section 1091(a) a loss
(if it were sustained on the sale) would not be recognized on the
sale, under paragraph (b)(2)(ii) of this section, the special rule
described in paragraph (b)(2)(i) of this section does not apply.
Under Sec. 1.83-7, A must include $100 (the difference between the
fair market value of the share on the date of transfer, $200, and
the amount paid for the share, $100) in gross income as compensation
attributable to the exercise of the option for the taxable year in
which the disqualifying disposition occurred. A recognizes no
capital gain or loss on the transaction. For its taxable year in
which the disqualifying disposition occurs, if otherwise allowable
under sections 83(h) and 162 and if the requirements of Sec. 1.83-
6(a) are met, X Corporation is allowed a $100 deduction for
compensation attributable to A's exercise of the option.
[[Page 34357]]
(iv) Assume the same facts as in paragraph (ii) of this Example
3, except that A sells the share for $50. Under paragraph (b)(2)(i)
of this section, A is not required to include any amount in gross
income as compensation attributable to the exercise of the option. A
is allowed a capital loss of $50 (the difference between the amount
realized on the sale, $50, and the adjusted basis of the share,
$100). X Corporation is not allowed any deduction attributable to
A's exercise of the option and disqualifying disposition of the
share.
(c) Failure to satisfy employment requirement. Section 1.421-2(a)
does not apply to the transfer of a share of stock pursuant to the
exercise of an incentive stock option if the employment requirement, as
determined under paragraph (a)(1)(i)(B) of this section, is not met at
the time of the exercise of such option. Consequently, the effects of
such a transfer are determined under the rules of Sec. 1.83-7. For
rules relating to the employment relationship, see Sec. 1.421-1(h).
Par. 6. Section 1.422-2 is added to read as follows:
Sec. 1.422-2 Incentive stock options defined.
(a) Incentive stock option defined--(1) In general. The term
incentive stock option means an option that meets the requirements of
paragraph (a)(2) of this section on the date of grant. An incentive
stock option is also subject to the $100,000 limitation described in
Sec. 1.422-4. An incentive stock option may contain a number of
permissible provisions that do not affect the status of the option as
an incentive stock option. See Sec. 1.422-5 for rules relating to
permissible provisions of an incentive stock option.
(2) Option requirements. To qualify as an incentive stock option
under this section, an option must be granted to an individual in
connection with the individual's employment by the corporation granting
such option (or by a related corporation), and granted only for stock
of any of such corporations. In addition, the option must meet all of
the following requirements--
(i) It must be granted pursuant to a plan that meets the
requirements described in paragraph (b) of this section;
(ii) It must be granted within 10 years from the date of the
adoption of the plan or the date such plan is approved by the
stockholders, whichever is earlier (see paragraph (c) of this section);
(iii) It must not be exercisable after the expiration of 10 years
from the date of grant (see paragraph (d) of this section);
(iv) It must provide that the option price per share is not less
than the fair market value of the share on the date of grant (see
paragraph (e) of this section);
(v) By its terms, it must not be transferrable by the individual to
whom the option is granted other than by will or the laws of descent
and distribution, and must be exercisable, during such individual's
lifetime, only by such individual (see Sec. Sec. 1.421-1(b)(2) and
1.421-2(c)); and
(vi) Except as provided in paragraph (f) of this section, it must
be granted to an individual who, at the time the option is granted,
does not own stock possessing more than 10 percent of the total
combined voting power of all classes of stock of the corporation
employing such individual or of any related corporation of such
corporation.
(3) Amendment of option terms. Except as otherwise provided in
Sec. 1.424-1, the amendment of the terms of an incentive stock option
may cause it to cease to be an option described in this section. If the
terms of an option that has lost its status as an incentive stock
option are subsequently changed with the intent to re-qualify the
option as an incentive stock option, such change results in the grant
of a new option on the date of the change. See Sec. 1.424-1(e).
(4) Terms provide option not an incentive stock option. If the
terms of an option, when granted, provide that it will not be treated
as an incentive stock option, such option is not treated as an
incentive stock option.
(b) Option plan--(1) In general. An incentive stock option must be
granted pursuant to a plan that meets the requirements of this
paragraph (b). The authority to grant other stock options or other
stock-based awards pursuant to the plan, where the exercise of such
other options or awards does not affect the exercise of incentive stock
options granted pursuant to the plan, does not disqualify such
incentive stock options. The plan must be in writing or electronic
form, provided that such writing or electronic form is adequate to
establish the terms of the plan. See Sec. 1.422-5 for rules relating
to permissible provisions of an incentive stock option.
(2) Stockholder approval. (i) The plan required by this paragraph
(b) must be approved by the stockholders of the corporation granting
the incentive stock option within 12 months before or after the date
such plan is adopted. Ordinarily, a plan is adopted when it is approved
by the granting corporation's board of directors, and the date of the
board's action is the reference point for determining whether
stockholder approval occurs within the applicable 24-month period.
However, if the board's action is subject to a condition (such as
stockholder approval) or the happening of a particular event, the plan
is adopted on the date the condition is met or the event occurs, unless
the board's resolution fixes the date of approval as the date of the
board's action.
(ii) For purposes of paragraph (b)(2)(i) of this section, the
stockholder approval must comply with the rules described in Sec.
1.422-3.
(iii) The provisions relating to the maximum aggregate number of
shares to be issued under the plan (described in paragraph (b)(3) of
this section) and the employees (or class or classes of employees)
eligible to receive options under the plan (described in paragraph
(b)(4) of this section) are the only provisions of a stock option plan
that must be approved by stockholders for purposes of section
422(b)(1). Any increase in the maximum aggregate number of shares that
may be issued under the plan (other than an increase merely reflecting
a change in the number of outstanding shares, such as a stock dividend
or stock split), or change in the designation of the employees (or
class or classes of employees) eligible to receive options under the
plan is considered the adoption of a new plan requiring stockholder
approval within the prescribed 24-month period. In addition, a change
in the granting corporation or the stock available for purchase or
award under the plan is considered the adoption of a new plan requiring
new stockholder approval within the prescribed 24-month period. Any
other changes in the terms of an incentive stock option plan are not
considered the adoption of a new plan and, thus, do not require
stockholder approval.
(3) Maximum aggregate number of shares. (i) The plan required by
this paragraph (b) must designate the maximum aggregate number of
shares that may be issued under the plan through incentive stock
options, nonstatutory options, and all other stock-based awards to be
granted thereunder. If nonstatutory options or other stock-based awards
may be granted, the plan may separately designate terms for each type
of option and other stock-based award and designate the maximum number
of shares that may be issued under such option or other stock-based
award. Unless otherwise specified, all terms of the plan apply to all
options and other stock-based awards that may be granted under the
plan.
(ii) A plan that merely provides that the number of shares that may
be issued under options and other stock-based
[[Page 34358]]
awards granted under such plan may not exceed a stated percentage of
the shares outstanding at the time of each offering or grant under such
plan does not satisfy the requirement that the plan state the maximum
aggregate number of shares that may be issued under the plan. However,
the maximum aggregate number of shares that may be issued under the
plan may be stated in terms of a percentage of the authorized, issued
or outstanding shares at the date of the adoption of the plan. The plan
may specify that the maximum aggregate number of shares available for
grants under the plan may increase annually by a specified percentage
of the authorized, issued or outstanding shares at the date of the
adoption of the plan. A plan which provides that the maximum aggregate
number of shares that may be issued under the plan may change based on
any other specified circumstances satisfies the requirements of this
paragraph (b)(3) only if the stockholders approve an immediately
determinable maximum aggregate number of shares that may be issued
under the plan in any event.
(iii) It is permissible for the plan to provide that shares
purchasable under the plan may be supplied to the plan through
acquisitions of stock on the open market, that shares purchased under
the plan and forfeited back to the plan are available for re-issuance
under the plan, or that shares surrendered in payment of the exercise
price of an option are available for re-issuance under the plan.
(iv) If there is more than one plan under which incentive stock
options may be granted and stockholders of the granting corporation
merely approve a maximum aggregate number of shares that are available
for issuance under such plans, the stockholder approval requirements
described in paragraph (b)(2) of this section are not satisfied. A
separate maximum aggregate number of shares must be approved for each
plan.
(4) Designation of employees. The plan described in this paragraph
(b), as adopted and approved, must indicate the employees (or class or
classes of employees) eligible to receive the options or other stock-
based awards to be granted under the plan. This requirement is
satisfied by a general designation of the classes of employees eligible
to receive options or other stock-based awards under the plan.
Designations such as ``key employees of the grantor corporation'';
``all salaried employees of the grantor corporation and its
subsidiaries, including subsidiaries which become such after adoption
of the plan;'' or ``all employees of the corporation'' meet this
requirement. This requirement is considered satisfied even though the
board of directors, another group, or an individual is given the
authority to select the particular employees who are to receive options
or other stock-based awards from a described class and to determine the
number of shares to be optioned or granted to each such employee. If
individuals other than employees may be granted options or other stock-
based awards under the plan, the plan must separately designate the
employees or classes of employees eligible to receive incentive stock
options.
(5) Conflicting option terms. An option on stock available for
purchase or grant under the plan is treated as having been granted
pursuant to a plan even if the terms of the option conflict with the
terms of the plan, unless such option is granted to an employee who is
ineligible to receive options under the plan, options have been granted
on stock in excess of the aggregate number of shares which may be
issued under the plan, or the option provides otherwise.
(6) The following examples illustrate the principles of this
paragraph (b):
Example 1. Stockholder approval. (i) S Corporation is a
subsidiary of P Corporation, a publicly traded corporation. On
January 1, 2006, S adopts a plan under which incentive stock options
for S stock are granted to S employees.
(ii) To meet the requirements of paragraph (b)(2) of this
section, the plan must be approved by the stockholders of S (in this
case, P) within 12 months before or after January 1, 2004.
(iii) Assume the same facts as in paragraph (i) of this Example
1. Assume further that the plan was approved by the stockholders of
S (in this case, P) on March 1, 2006. On January 1, 2008, S changes
the plan to provide that incentive stock options for P stock will be
granted to S employees under the plan. Because there is a change in
the stock available for grant under the plan, the change is
considered the adoption of a new plan that must be approved by the
stockholders within 12 months before or after January 1, 2008.
Example 2. Stockholder approval. (i) Assume the same facts as in
paragraph (i) of Example 1, except that on March 15, 2007, P
completely disposes of its interest in S. Thereafter, S continues to
grant options for S stock to S employees under the plan.
(ii) The new S options are granted under a plan that meets the
stockholder approval requirements of paragraph (b)(2) of this
section without regard to whether S seeks approval of the plan from
the stockholders of S after P disposes of its interest in S.
(iii) Assume the same facts as in paragraph (i) of this Example
2, except that under the plan as adopted on January 1, 2006, only
options for P stock are granted to S employees. Assume further that
after P disposes of its interest in S, S changes the plan to provide
for the grant of options for S stock to S employees. Because there
is a change in the stock available for purchase or grant under the
plan, under paragraph (b)(2)(iii) of this section, the stockholders
of S must approve the plan within 12 months before or after the
change to the plan to meet the stockholder approval requirements of
paragraph (b) of this section.
Example 3. Maximum aggregate number of shares. X Corporation
maintains a plan under which statutory options and nonstatutory
options may be granted. The plan designates the number of shares
that may be used for incentive stock options. Because the maximum
aggregate number of shares that will be used for both statutory and
nonstatutory options is not designated in the plan, the requirements
of paragraph (b)(3) of this section are not satisfied.
Example 4. Maximum aggregate number of shares. Y Corporation
adopts an incentive stock option plan on November 1, 2006. On that
date there are two million outstanding shares of Y Corporation
stock. The plan provides that the maximum aggregate number of shares
that may be issued under the plan may not exceed 15% of the
outstanding number of shares of Y Corporation on November 1, 2006.
Because the maximum aggregate number of shares under the plan is
designated in the plan, the requirements of paragraph (b)(3) of this
section are met.
Example 5. Maximum aggregate number of shares. (i) B Corporation
adopts an incentive stock option plan on March 15, 2005. The plan
provides that the maximum aggregate number of shares available under
the plan is 50,000, increased on each anniversary date of the
adoption of the plan by 5 percent of the then-outstanding shares.
(ii) Because the maximum aggregate number of shares is not
designated under the plan, the requirements of paragraph (b)(3) of
this section are not met.
(iii) Assume the same facts as in paragraph (i) of this Example
5, except that the plan provides that the maximum aggregate number
of shares available under the plan is the lesser of (a) 50,000
shares increased each anniversary date of the adoption of the plan
by 5 percent of the then-outstanding shares or (b) 200,000 shares.
Because the maximum aggregate number of shares under the plan is
designated as the lesser of one of two numbers, one of which
provides an immediately determinable maximum aggregate number of
shares that may be issued under the plan in any event, the
requirements of paragraph (b)(3) of this section are met.
(c) Duration of option grants under the plan. An incentive stock
option must be granted within 10 years from the date that the plan
under which it is granted is adopted or the date such plan is approved
by the stockholders, whichever is earlier. To grant incentive stock
options after the expiration of the 10-year period, a new plan must be
adopted and approved.
(d) Period for exercising options. An incentive stock option, by
its terms,
[[Page 34359]]
must not be exercisable after the expiration of 10 years from the date
such option is granted, or 5 years from the date such option is granted
to an employee described in paragraph (f) of this section. An option
that does not contain such a provision when granted is not an incentive
stock option.
(e) Option price. (1) Except as provided by paragraph (e)(2) of
this section, the option price of an incentive stock option must not be
less than the fair market value of the stock subject to the option at
the time the option is granted. The option price may be determined in
any reasonable manner, including the valuation methods permitted under
Sec. 20.2031-2 of this chapter (Estate Tax Regulations), so long as
the minimum price possible under the terms of the option is not less
than the fair market value of the stock on the date of grant. For
general rules relating to the option price, see Sec. 1.421-1(e). For
rules relating to the determination of when an option is granted, see
Sec. 1.421-1(c).
(2)(i) If a share of stock is transferred to an individual pursuant
to the exercise of an option which fails to qualify as an incentive
stock option merely because there was a failure of an attempt, made in
good faith, to meet the option price requirements of paragraph (e)(1)
of this section, the requirements of such paragraph are considered to
have been met. Whether there was a good-faith attempt to set the option
price at not less than the fair market value of the stock subject to
the option at the time the option was granted depends on the relevant
facts and circumstances.
(ii) For publicly held stock that is actively traded on an
established market at the time the option is granted, determining the
fair market value of such stock by the appropriate method described in
Sec. 20.2031-2 of this chapter (Estate Tax Regulations) establishes
that a good-faith attempt to meet the option price requirements of this
paragraph (e) was made.
(iii) For non-publicly traded stock, if it is demonstrated, for
example, that the fair market value of the stock at the date of grant
was based upon an average of the fair market values as of such date set
forth in the opinions of completely independent and well-qualified
experts, such a demonstration generally establishes that there was a
good-faith attempt to meet the option price requirements of this
paragraph (e). If the stock is non-publicly traded, the optionee's
status as a majority or minority stockholder may be taken into
consideration.
(iv) Regardless of whether the stock offered under an option is
publicly traded, a good-faith attempt to meet the option price
requirements of this paragraph (e) is not demonstrated unless the fair
market value of the stock on the date of grant is determined with
regard to nonlapse restrictions (as defined in Sec. 1.83-3(h)) and
without regard to lapse restrictions (as defined in Sec. 1.83-3(i)).
(v) Amounts treated as interest and amounts paid as interest under
a deferred payment arrangement are not includible as part of the option
price. See Sec. 1.421-1(e)(1). An attempt to set the option price at
not less than fair market value is not regarded as made in good faith
where an adjustment of the option price to reflect amounts treated as
interest results in the option price being lower than the fair market
value on which the option price was based.
(3) Notwithstanding that the option price requirements of
paragraphs (e)(1) and (2) of this section are satisfied by an option
granted to an employee whose stock ownership exceeds the limitation
provided by paragraph (f) of this section, such option is not an
incentive stock option when granted unless it also complies with
paragraph (f) of this section. If the option, when granted, does not
comply with the requirements described in paragraph (f) of this
section, such option can never become an incentive stock option, even
if the employee's stock ownership does not exceed the limitation of
paragraph (f) of this section when such option is exercised.
(f) Options granted to certain stockholders. (1) If, immediately
before an option is granted, an individual owns (or is treated as
owning) stock possessing more than 10 percent of the total combined
voting power of all classes of stock of the corporation employing the
optionee or of any related corporation of such corporation, then an
option granted to such individual cannot qualify as an incentive stock
option unless the option price is at least 110 percent of the stock's
fair market value on the date of grant and such option by its terms is
not exercisable after the expiration of 5 years from the date of grant.
For purposes of determining the minimum option price for purposes of
this paragraph (f), the rules described in paragraph (e)(2) of this
section, relating to the good-faith determination of the option price,
do not apply.
(2) For purposes of determining the stock ownership of the
optionee, the stock attribution rules of Sec. 1.424-1(d) apply. Stock
that the optionee may purchase under outstanding options is not treated
as stock owned by the individual. The determination of the percentage
of the total combined voting power of all classes of stock of the
employer corporation (or of its related corporations) that is owned by
the optionee is made with respect to each such corporation in the
related group by comparing the voting power of the shares owned (or
treated as owned) by the optionee to the aggregate voting power of all
shares of each such corporation actually issued and outstanding
immediately before the grant of the option to the optionee. The
aggregate voting power of all shares actually issued and outstanding
immediately before the grant of the option does not include the voting
power of treasury shares or shares authorized for issue under
outstanding options held by the individual or any other person.
(3) Examples. The rules of this paragraph (f) are illustrated by
the following examples:
Example 1. (i) E, an employee of M Corporation, owns 15,000
shares of M Corporation common stock, which is the only class of
stock outstanding. M has 100,000 shares of its common stock
outstanding. On January 1, 2005, when the fair market value of M
stock is $100, E is granted an option with an option price of $100
and an exercise period of 10 years from the date of grant.
(ii) Because E owns stock possessing more than 10 percent of the
total combined voting power of all classes of M Corporation stock, M
cannot grant an incentive stock option to E unless the option is
granted at an option price of at least 110 percent of the fair
market value of the stock subject to the option and the option, by
its terms, expires no later than 5 years from its date of grant. The
option granted to E fails to meet the option-price and term
requirements described in paragraph (f)(1) of this section and,
thus, the option is not an incentive stock option.
(iii) Assume the same facts as in paragraph (i) of this Example
1, except that E's father and brother each owned 7,500 shares of M
Corporation stock, and E owned no M stock in E's own name. Because
under the attribution rules of Sec. 1.424-1(d), E is treated as
owning stock held by E's parents and siblings, M cannot grant an
incentive stock option to E unless the option price is at least 110
percent of the fair market value of the stock subject to the option,
and the option, by its terms, expires no later than 5 years from the
date of grant.
Example 2. Assume the same facts as in paragraph (i) of this
Example 1. Assume further that M is a subsidiary of P Corporation.
Regardless of whether E owns any P stock and the number of P shares
outstanding, if P Corporation grants an option to E which purports
to be an incentive stock option, but which fails to meet the 110-
percent-option-price and 5-year-term requirements, the option is not
an incentive stock option because E owns more than 10 percent of the
total combined voting power of all classes of stock of a related
corporation of P Corporation (i.e., M Corporation). An individual
who owns (or is treated as owning) stock in excess of the ownership
[[Page 34360]]
specified in paragraph (f)(1) of this section, in any corporation in
a group of corporations consisting of the employer corporation and
its related corporations, cannot be granted an incentive stock
option by any corporation in the group unless such option meets the
110-percent-option-price and 5-year-term requirements of paragraph
(f)(1) of this section.
Example 3. (i) F is an employee of R Corporation. R has only one
class of stock, of which 100,000 shares are issued and outstanding.
F owns no stock in R Corporation or any related corporation of R
Corporation. On January 1, 2005, R grants a 10-year incentive stock
option to F to purchase 50,000 shares of R stock at $3 per share,
the fair market value of R stock on the date of grant of the option.
On April 1, 2005, F exercises half of the January option and
receives 25,000 shares of R stock that previously were not
outstanding. On July 1, 2005, R grants a second 50,000 share option
to F which purports to be an incentive stock option. The terms of
the July option are identical to the terms of the January option,
except that the option price is $3.25 per share, which is the fair
market value of R stock on the date of grant of the July option.
(ii) Because F did not own more than 10% of the total combined
voting power of all classes of stock of R Corporation or any related
corporation on the date of the grant of the January option and the
pricing requirements of paragraph (e) of this section are satisfied
on the date of grant of such option, the unexercised portion of the
January option remains an incentive stock option regardless of the
changes in F's percentage of stock ownership in R after the date of
grant. However, the July option is not an incentive stock option
because, on the date that it was granted, F owned 20 percent (25,000
shares owned by F divided by 125,000 shares of R stock issued and
outstanding) of the total combined voting power of all classes of R
Corporation stock and, thus the pricing requirements of paragraph
(f)(1) of this section were not met.
(iii) Assume the same facts as in paragraph (i) of this Example
3 except that the partial exercise of the January incentive stock
option on April 1, 2003, is for only 10,000 shares. Under these
circumstances, the July option is an incentive stock option,
because, on the date of grant of the July option, F does not own
more than 10 percent of the total combined voting power (10,000
shares owned by F divided by 110,000 shares of R issued and
outstanding) of all classes of R Corporation stock.
Sec. 1.422-4 [Removed]
Par. 7. Section 1.422-4 is removed.
Sec. 1.422-5 [Redesignated]
Par. 8. Section 1.422-5 is re-designated as Sec. 1.422-3.
Par. 9. New Sec. 1.422-4 is added to read as follows:
Sec. 1.422-4 $100,000 limitation for incentive stock options.
(a) $100,000 per year limitation--(1) General rule. An option that
otherwise qualifies as an incentive stock option nevertheless fails to
be an incentive stock option to the extent that the $100,000 limitation
described in paragraph (a)(2) of this section is exceeded.
(2) $100,000 per year limitation. To the extent that the aggregate
fair market value of stock with respect to which an incentive stock
option (determined without regard to this section) is exercisable for
the first time by any individual during any calendar year (under all
plans of the employer corporation and related corporations) exceeds
$100,000, such option is treated as a nonstatutory option. See Sec.
1.83-7 for rules applicable to nonstatutory options.
(b) Application. To determine whether the limitation described in
paragraph (a)(2) of this section has been exceeded, the following rules
apply.
(1) An option that does not meet the requirements of Sec. 1.422-2
when granted (including an option which, when granted, contains terms
providing that it will not be treated as incentive stock option) is
disregarded. See Sec. 1.422-2(a)(4).
(2) The fair market value of stock is determined as of the date of
grant of the option for such stock.
(3) Except as otherwise provided in paragraph (b)(4) of this
section, options are taken into account in the order in which they are
granted.
(4) For purposes of this section, an option is considered to be
first exercisable during a calendar year if the option will become
exercisable at any time during the year assuming that any condition on
the optionee's ability to exercise the option related to the
performance of services is satisfied. If the optionee's ability to
exercise the option in the year is subject to an acceleration
provision, then the option is considered first exercisable in the
calendar year in which the acceleration provision is triggered. After
an acceleration provision is triggered, the options subject to such
provision are then taken into account in accordance with paragraph
(b)(3) of this section for purposes of applying the limitation
described in paragraph (a)(2) of this section to all options first
exercisable during a calendar year. However, because an acceleration
provision is not taken into account prior to its triggering, an
incentive stock option that becomes exercisable for the first time
during a calendar year by operation of such a provision does not affect
the application of the $100,000 limitation with respect to any option
(or portion thereof) exercised prior to such acceleration. For purposes
of this paragraph (b)(4), an acceleration provision includes, for
example, a provision that accelerates the exercisability of an option
on a change in ownership or control or a provision that conditions
exercisability on the attainment of a performance goal. See paragraph
(d), Example 4 of this section.
(5)(i) An option (or portion thereof) is disregarded if, prior to
the calendar year during which it would otherwise have become
exercisable for the first time, the option (or portion thereof) is
modified and thereafter ceases to be an incentive stock option
described in Sec. 1.422-2, is canceled, or is transferred in violation
of Sec. 1.421-1(b)(2).
(ii) If an option (or portion thereof) is modified, canceled, or
transferred at any other time, such option (or portion thereof) is
treated as outstanding according to its original terms until the end of
the calendar year during which it would otherwise have become
exercisable for the first time.
(6) A disqualifying disposition has no effect on the determination
of whether an option exceeds the $100,000 limitation.
(c) Bifurcation of options. The application of the rules described
in paragraph (b) of this section may result in an option being treated,
in part, as an incentive stock option and, in part, as a nonstatutory
option. In such a case, a corporation can issue a separate certificate
for incentive option stock and designate such stock as incentive stock
option stock in the corporation's transfer records. In the absence of
such a designation, a pro rata portion of each share of stock purchased
under the option is treated as incentive stock option stock and
nonstatutory option stock. See Sec. 1.83-7 for the treatment of
nonstatutory options.
(d) Examples. The following examples illustrate the principles of
this section. In each of the following examples E is an employee of X
Corporation. The examples are as follows:
Example 1. General rule. Effective January 1, 2004, X
Corporation adopts a plan under which incentive stock options may be
granted to its employees. On January 1, 2004, and each succeeding
January 1 through January 1, 2013, E is granted immediately
exercisable options for X Corporation stock with a fair market value
of $100,000 determined on the date of grant. The options qualify as
incentive stock options (determined without regard to this section).
On January 1, 2014, E exercises all of the options. Because the
$100,000 limitation has not been exceeded during any calendar year,
all of the options are treated as incentive stock options.
Example 2. Order of grant. X Corporation is a parent corporation
of Y Corporation, which is a parent corporation of Z Corporation.
Each corporation has adopted
[[Page 34361]]
its own separate plan, under which an employee of any member of the
corporate group may be granted options for stock of any member of
the group. On January 1, 2004, X Corporation grants E an incentive
stock option (determined without regard to this section) for stock
of Y Corporation with a fair market value of $100,000 on the date of
grant. On December 31, 2004, Y Corporation grants E an incentive
stock option (determined without regard to this section) for stock
of Z Corporation with a fair market value of $75,000 as of the date
of grant. Both of the options are immediately exercisable. For
purposes of this section, options are taken into account in the
order in which granted using the fair market value of stock as of
the date on the option is granted. During calendar year 2004, the
aggregate fair market value of stock with respect to which E's
options are exercisable for the first time exceeds $100,000.
Therefore, the option for Y Corporation stock is treated as an
incentive stock option, and the option for Z Corporation stock is
treated as a nonstatutory option.
Example 3. Acceleration provision. (i) In 2004, X Corporation
grants E three incentive stock options (determined without regard to
this section) to acquire stock with an aggregate fair market value
of $150,000 on the date of grant. The dates of grant, the fair
market value of the stock (as of the applicable date of grant) with
respect to which the options are exercisable, and the years in which
the options are first exercisable (without regard to acceleration
provisions) are as follows:
----------------------------------------------------------------------------------------------------------------
Fair market First
Date of grant value of stock exercisable
----------------------------------------------------------------------------------------------------------------
Option 1...................................... April 1, 2004................... $60,000 2004
Option 2...................................... May 1, 2004..................... 50,000 2006
Option 3...................................... June 1, 2004.................... 40,000 2004
----------------------------------------------------------------------------------------------------------------
(ii) In July of 2004, a change in control of X Corporation
occurs, and, under the terms of its option plan, all outstanding
options become immediately exercisable. Under the rules of this
section, Option 1 is treated as an incentive stock option in its
entirety; Option 2 exceeds the $100,000 aggregate fair market value
limitation for calendar year 2004 by $10,000 (Option 1's $60,000 +
Option 2's $50,000 = $110,000) and is, therefore, bifurcated into an
incentive stock option for stock with a fair market value of $40,000
as of the date of grant and a nonstatutory option for stock with a
fair market value of $10,000 as of the date of grant. Option 3 is
treated as a nonstatutory option in its entirety.
Example 4. Exercise of option and acceleration provision. (i) In
2004, X Corporation grants E three incentive stock options
(determined without regard to this section) to acquire stock with an
aggregate fair market value of $120,000 on the date of grant. The
dates of grant, the fair market value of the stock (as of the
applicable date of grant) with respect to which the options are
exercisable, and the years in which the options are first
exercisable (without regard to acceleration provisions) are as
follows:
----------------------------------------------------------------------------------------------------------------
Fair market First
Date of grant value of stock exercisable
----------------------------------------------------------------------------------------------------------------
Option 1...................................... April 1, 2004................... $60,000 2005
Option 2...................................... May 1, 2004..................... 40,000 2006
Option 3...................................... June 1, 2004.................... 20,000 2005
----------------------------------------------------------------------------------------------------------------
(ii) On June 1, 2005, E exercises Option 3. At the time of
exercise of Option 3, the fair market value of X stock (at the time
of grant) with respect to which options held by E are first
exercisable in 2005 does not exceed $100,000. On September 1, 2005,
a change of control of X Corporation occurs, and, under the terms of
its option plan, Option 2 becomes immediately exercisable. Under the
rules of this section, because E's exercise of Option 3 occurs
before the change of control and the effects of an acceleration
provision are not taken into account until it is triggered, Option 3
is treated as an incentive stock option in its entirety. Option 1 is
treated as an incentive stock option in its entirety. Option 2 is
bifurcated into an incentive stock option for stock with a fair
market value of $20,000 on the date of grant and a nonstatutory
option for stock with a fair market value of $20,000 on the date of
grant because it exceeds the $100,000 limitation for 2003 by $20,000
(Option 1 for $60,000 + Option 3 for $20,000 + Option 2 for $40,000
= $120,000).
(iii) Assume the same facts as in paragraph (ii) of this Example
4, except that the change of control occurs on May 1, 2005. Because
options are taken into account in the order in which they are
granted, Option 1 and Option 2 are treated as incentive stock
options in their entirety. Because the exercise of Option 3 (on June
1, 2005) takes place after the acceleration provision is triggered,
Option 3 is treated as a nonstatutory option in its entirety.
Example 5. Cancellation of option. (i) In 2004, X Corporation
grants E three incentive stock options (determined without regard to
this section) to acquire stock with an aggregate fair market value
of $140,000 as of the date of grant. The dates of grant, the fair
market value of the stock (as of the applicable date of grant) with
respect to which the options are exercisable, and the years in which
the options are first exercisable (without regard to acceleration
provisions) are as follows:
----------------------------------------------------------------------------------------------------------------
Fair market First
Date of grant value of stock exercisable
----------------------------------------------------------------------------------------------------------------
Option 1...................................... April 1, 2004................... $60,000 2005
Option 2...................................... May 1, 2004..................... 40,000 2005
Option 3...................................... June 1, 2004.................... 40,000 2005
----------------------------------------------------------------------------------------------------------------
(ii) On December 31, 2004, Option 2 is canceled. Because Option
2 is canceled before the calendar year during which it would have
become exercisable for the first time, it is disregarded. As a
result, Option 1 and Option 3 are treated as incentive stock options
in their entirety.
(iii) Assume the same facts as in paragraph (ii) of this Example
5, except that Option 2 is canceled on January 1, 2005. Because
Option 2 is not canceled prior to the calendar year during which it
would have become exercisable for the first time (2005), it is
treated as an outstanding option for purposes of determining whether
the $100,000 requirement for 2005 has been exceeded. Because options
are taken into account in the order in which granted, Option 1 is
treated as an incentive stock option in its entirety. Because Option
3 exceeds the $100,000 limitation by $40,000 (Option 1 for $60,000 +
Option 2 for $40,000 + Option 3 for
[[Page 34362]]
$40,000 = $140,000), it is treated as a nonstatutory options in its
entirety.
(iv) Assume the same facts as in paragraph (i) of this Example
5, except that on January 1, 2005, E exercises Option 2 and
immediately sells the stock in a disqualifying disposition. A
disqualifying disposition has no effect on the determination of
whether the underlying option is considered outstanding during the
calendar year during which it is first exercisable. Because options
are taken into account in the order in which granted, Option 1 is
treated as an incentive stock option in its entirety. Because Option
3 exceeds the $100,000 limitation by $40,000 (Option 1 for $60,000 +
Option 2 for $40,000 + Option 3 for $40,000 = $140,000), it is
treated as a nonstatutory option in its entirety.
Example 6. Designation of stock. On January 1, 2004, X grants E
an immediately exercisable incentive stock option (determined
without regard to this section) to acquire X stock with a fair
market value of $150,000 on that date. Under the rules of this
section, the option is bifurcated and treated as an incentive stock
option for X stock with a fair market value of $100,000 and a
nonstatutory option for X stock with a fair market value of $50,000.
In these circumstances, X may designate the stock that is treated as
stock acquired pursuant to the exercise of an incentive stock option
by issuing a separate certificate (or certificates) for $100,000 of
stock and identifying such certificates as Incentive Stock Option
Stock in its transfer records. In the absence of such a designation,
two-thirds ($100,000 / $150,000) of each share of stock is treated
as acquired pursuant to the exercise of an incentive stock option
and one-third ($50,000 / $150,000) as stock acquired pursuant to the
exercise of a nonstatutory option.
Par. 10. Section 1.422-5 is added to read as follows:
Sec. 1.422-5 Permissible provisions.
(a) General rule. An option that otherwise qualifies as an
incentive stock option does not fail to be an incentive stock option
merely because such option contains one or more of the provisions
described in paragraphs (b), (c), and (d) of this section.
(b) Cashless exercise. (1) An option does not fail to be an
incentive stock option merely because the optionee may exercise the
option with previously acquired stock of the corporation that granted
the option or stock of the corporation whose stock is being offered for
purchase under the option. For special rules relating to the use of
statutory option stock to pay the option price of an incentive stock
option, see Sec. 1.424-1(c)(3).
(2) All shares acquired through the exercise of an incentive stock
option are individually subject to the holding period requirements
described in Sec. 1.422-1(a) and the disqualifying disposition rules
of Sec. 1.422-1(b), regardless of whether the option is exercised with
previously acquired stock of the corporation that granted the option or
stock of the corporation whose stock is being offered for purchase
under the option. If an incentive stock option is exercised with such
shares, and the exercise results in the basis allocation described in
paragraph (b)(3) of this section, the optionee's disqualifying
disposition of any of the stock acquired through such exercise is
treated as a disqualifying disposition of the shares with the lowest
basis.
(3) If the exercise of an incentive stock option with previously
acquired shares is comprised in part of an exchange to which section
1036 (and so much of section 1031 as relates to section 1036) applies,
then:
(i) The optionee's basis in the incentive stock option shares
received in the section 1036 exchange is the same as the optionee's
basis in the shares surrendered in the exchange, increased, if
applicable, by any amount included in gross income as compensation
pursuant to sections 421 through 424 or section 83. Except for purposes
of Sec. 1.422-1(a), the holding period of the shares is determined
under section 1223. For purposes of Sec. 1.422-1 and sections 421(b)
and 83 and the regulations thereunder, the amount paid for the shares
purchased under the option is the fair market value of the shares
surrendered on the date of the exchange.
(ii) The optionee's basis in the incentive stock option shares not
received pursuant to the section 1036 exchange is zero. For all
purposes, the holding period of such shares begins as of the date that
such shares are transferred to the optionee. For purposes of Sec.
1.422-1(b) and sections 421(b) and 83 and the regulations thereunder,
the amount paid for the shares is considered to be zero.
(c) Additional compensation. An option does not fail to be an
incentive stock option merely because the optionee has the right to
receive additional compensation, in cash or property, when the option
is exercised, provided such additional compensation is includible in
income under section 61 or section 83. The amount of such additional
compensation may be determined in any manner, including by reference to
the fair market value of the stock at the time of exercise or to the
option price.
(d) Option subject to a condition. (1) An option does not fail to
be an incentive stock option merely because the option is subject to a
condition, or grants a right, that is not inconsistent with the
requirements of Sec. Sec. 1.422-2 and 1.422-4.
(2) An option that includes an alternative right is not an
incentive stock option if the requirements of Sec. 1.422-2 are
effectively avoided by the exercise of the alternative right. For
example, an alternative right extending the option term beyond ten
years, setting an option price below fair market value, or permitting
transferability prevents an option from qualifying as an incentive
stock option. If either of two options can be exercised, but not both,
each such option is a disqualifying alternative right with respect to
the other, even though one or both options would individually satisfy
the requirements of Sec. Sec. 1.422-2, 1.422-4, and this section.
(3) An alternative right to receive a taxable payment of cash and/
or property in exchange for the cancellation or surrender of the option
does not disqualify the option as an incentive stock option if the
right is exercisable only when the then fair market value of the stock
exceeds the exercise price of the option and the option is otherwise
exercisable, the right is transferable only when the option is
otherwise transferable, and the exercise of the right has the same
economic and tax consequences as the exercise of the option followed by
an immediate sale of the stock. For this purpose, the exercise of the
alternative right does not have the same economic and tax consequences
if the payment exceeds the difference between the then fair market
value of the stock and the exercise price of the option.
(e) Examples. The principles of this section are illustrated by the
following examples:
Example 1. On June 1, 2004, X Corporation grants an incentive
stock option to A, an employee of X Corporation, entitling A to
purchase 100 shares of X Corporation common stock at $10 per share.
The option provides that A may exercise the option with previously
acquired shares of X Corporation common stock. X Corporation has
only one class of common stock outstanding. Under the rules of
section 83, the shares transferable to A through the exercise of the
option are transferable and not subject to a substantial risk of
forfeiture. On June 1, 2005, when the fair market value of an X
Corporation share is $25, A uses 40 shares of X Corporation common
stock, which A had purchased on the open market on June 1, 2002, for
$5 per share, to pay the full option price. After exercising the
option, A owns 100 shares of incentive stock option stock. Under
section 1036 (and so much of section 1031 as relates to section
1036), 40 of the shares have a $200 aggregate carryover basis (the
$5 purchase price x 40 shares) and a three-year holding period for
purposes of determining capital gain, and 60 of the shares have a
zero basis and a holding period beginning on June 1, 2005, for
purposes of determining capital
[[Page 34363]]
gain. All 100 shares have a holding period beginning on June 1,
2005, for purposes of determining whether the holding period
requirements of Sec. 1.422-1(a) are met.
Example 2. Assume the same facts as in Example 1. Assume further
that, on September 1, 2005, A sells 75 of the shares that A acquired
through exercise of the incentive stock option for $30 per share.
Because the holding period requirements were not satisfied, A made a
disqualifying disposition of the 75 shares on September 1, 2005.
Under the rules of paragraph (b)(3) of this section, A has sold all
60 of the non-section-1036 shares and 15 of the 40 section-1036
shares. Therefore, under paragraph (b)(3) of this section and
section 83(a), the amount of compensation attributable to A's
exercise of the option and subsequent disqualifying disposition of
75 shares is $1,500 (the difference between the fair market value of
the stock on the date of transfer, $1,875 (75 shares at $25 per
share), and the amount paid for the stock, $375 (60 shares at $0 per
share plus 15 shares at $25 per share)). In addition, A must
recognize a capital gain of $675. Accordingly, A must include in
gross income for the taxable year in which the sale occurs $1,500 as
compensation and $675 as capital gain. For its taxable year in which
the disqualifying disposition occurs, if otherwise allowable under
section 162 and if the requirements of Sec. 1.83-6(a) are met, X
Corporation is allowed a deduction of $1,500 for the compensation
paid to A.
Example 3. Assume the same facts as in Example 2, except that,
instead of selling the 75 shares of incentive stock option stock on
September 1, 2005, A uses those shares to exercise a second
incentive stock option. The second option was granted to A by X
Corporation on January 1, 2005, entitling A to purchase 100 shares
of X Corporation common stock at $22.50 per share. As in Example 2,
A has made a disqualifying disposition of the 75 shares of stock
pursuant to Sec. 1.424-1(c). Under paragraph (b)(1) of this
section, A has disposed of all 60 of the non-section-1036 shares and
15 of the 40 section-1036 shares. Therefore, pursuant to paragraph
(b)(3) of this section and section 83(a), the amount of compensation
attributable to A's exercise of the first option and subsequent
disqualifying disposition of 75 shares is $1,500 (the difference
between the fair market value of the stock on the date of transfer,
$1,875 (75 shares at $25 per share), and the amount paid for the
stock, $375 (60 shares at $0 per share plus 15 shares at $25 per
share)). Unlike Example 2, A does not recognize any capital gain as
a result of exercising the second option because, for all purposes
other than the determination of whether the exercise is a
disposition pursuant to section 424(c), the exercise is considered
an exchange to which section 1036 applies. Accordingly, A must
include in gross income for the taxable year in which the
disqualifying disposition occurs $1,500 as compensation. For its
taxable year in which the disqualifying disposition occurs, if
otherwise alllowable under sections 83(h) and 162 and if the
requirements of Sec. 1.83-6(a) are met, X Corporation is allowed a
deduction of $1,500 for the compensation paid to A. After exercising
the second option, A owns a total of 125 shares of incentive stock
option stock. Under section 1036 (and so much of section 1031 as
relates to section 1036), the 100 ``new'' shares of incentive stock
option stock have the following bases and holding periods: 15 shares
have a $75 carryover basis and a three-year-and-three-month holding
period for purposes of determining capital gain, 60 shares have a
$1,500 basis resulting from the inclusion of that amount in income
as compensation and a three-month holding period for purposes of
determining capital gain, and 25 shares have a zero basis and a
holding period beginning on September 1, 2005, for purposes of
determining capital gain. All 100 shares have a holding period
beginning on September 1, 2005, for purposes of determining whether
the holding period requirements of Sec. 1.422-1(a) are met.
Example 4. Assume the same facts as in Example 2, except that,
instead of selling the 75 shares of incentive stock option stock on
September 1, 2005, A uses those shares to exercise a nonstatutory
option. The nonstatutory option was granted to A by X Corporation on
January 1, 2005, entitling A to purchase 100 shares of X Corporation
common stock at $22.50 per share. Unlike Example 3, A has not made a
disqualifying disposition of the 75 shares of stock. After
exercising the nonstatutory option, A owns a total of 100 shares of
incentive stock option stock and 25 shares of nonstatutory stock
option stock. Under section 1036 (and so much of section 1031 as
relates to section 1036), the 75 new shares of incentive stock
option stock have the same basis and holding period as the 75 old
shares used to exercise the nonstatutory option. The additional 25
shares of stock received upon exercise of the nonstatutory option
are taxed under the rules of section 83(a). Accordingly, A must
include in gross income for the taxable year in which the transfer
of such shares occurs $750 (25 shares at $30 per share) as
compensation. A's basis in such shares is the same as the amount
included in gross income. For its taxable year in which the transfer
occurs, X Corporation is allowed a deduction of $750 for the
compensation paid to A to the extent allowable under sections 83(h)
and 162 and if the requirements of Sec. 1.83-6(a) are satisfied.
Example 5. Assume the same facts in Example 1, except that the
shares transferred pursuant to the exercise of the incentive stock
option are subject to a substantial risk of forfeiture and not
transferable (substantially nonvested) for a period of six months
after such transfer. Assume further that the shares that A uses to
exercise the incentive stock option are similarly restricted. Such
shares were transferred to A on January 1, 2005, through A's
exercise of a nonstatutory stock option which was granted to A on
January 1, 2004. A paid $5 per share for the stock when its fair
market value was $22.50 per share. A did not file a section 83(b)
election to include the $700 spread (the difference between the
option price and the fair market value of the stock on date of
exercise of the nonstatutory option) in gross income as
compensation. After exercising the incentive stock option with the
40 substantially-nonvested shares, A owns 100 shares of
substantially-nonvested incentive stock option stock. Section 1036
(and so much of section 1031 as relates to section 1036) applies to
the 40 shares exchanged in exercise of the incentive stock option.
However, pursuant to section 83(g), the stock received in such
exchange, because it is incentive stock option stock, is not subject
to restrictions and conditions substantially similar to those to
which the stock given in such exchange was subject. For purposes of
section 83(a) and Sec. 1.83-1(b)(1), therefore, A has disposed of
the 40 shares of substantially-nonvested stock on June 1, 2005, and
must include in gross income as compensation $800 (the difference
between the amount realized upon such disposition, $1,000, and the
amount paid for the stock, $200). Accordingly, 40 shares of the
incentive stock option stock have a $1,000 basis (the $200 original
basis plus the $800 included in income as compensation) and 60
shares of the incentive stock option stock have a zero basis. For
its taxable year in which the disposition of the substantially-
nonvested stock occurs, X Corporation is allowed a deduction of $800
for the compensation paid to A, provided that the requirements of
Sec. 1.83-6 are satisfied.
(f) Effective date. This section applies to any statutory option
granted on or after the date that is 180 days after publication of
final regulations in the Federal Register. Taxpayers can rely on these
regulations for the treatment of any statutory option granted on or
after June 9, 2003.
Sec. 1.423-1 [Amended]
Par. 11. Section 1.423-1 is amended as follows:
1. In paragraph (a)(2), the language ``425(a)'' is removed and
``424(a)'' is added in its place.
2. In paragraph (b), first sentence, the language ``Sec. 1.421-7''
is removed and ``Sec. 1.421-1'' is added in its place.
3. In paragraph (b), second sentence, the language ``Sec. 1.421-
8'' is removed and ``Sec. 1.421-2'' is added in its place.
4. In paragraph (b), last sentence, the language ``425(c)'' is
removed and ``424(c)'' is added in its place.
5. In paragraph (b), last sentence, the language ``Sec. 1.425-1''
is removed and ``Sec. 1.424-1'' is added in its place.
Sec. 1.423-2 [Amended]
Par. 12. Section 1.423-2 is amended by:
1. In paragraph (b), last sentence, the language ``Sec. 1.421-7''
is removed and ``Sec. 1.421-1'' is added in its place.
2. In paragraph (d)(1), second sentence, the language ``425(d)'' is
removed and ``424(d)'' is added in its place.
3. In paragraph (d)(3), Example 1, fourth sentence, the language
``425(d)'' is removed and ``424(d)'' is added in its place.
[[Page 34364]]
4. In paragraph (e)(2), the language ``Sec. 1.421-7'' is removed
and ``Sec. 1.421-1'' is added in its place.
5. In paragraph (g)(1) concluding text, first sentence, the
language ``Sec. 1.421-7'' is removed and ``Sec. 1.421-1'' is added in
its place.
6. In paragraph (g)(1) concluding text, second sentence, the
language ``Sec. 1.421-7'' is removed and ``Sec. 1.421-1'' is added in
its place.
7. In paragraph (j), second sentence, the language ``Sec. 1.421-
7'' is removed and ``Sec. 1.421-1'' is added in its place.
8. In paragraph (j), last sentence, the language ``425'' is removed
and ``424'' is added in its place.
9. In paragraph (k)(2), second sentence, the language ``Sec.
1.421-8'' is removed and ``Sec. 1.421-2'' is added in its place.
Sec. 1.425-1 [Redesignated]
Par. 13. Section 1.425-1 is redesignated as Sec. 1.424-1 and is
amended by:
1. Revising paragraphs (a)(1) through (a)(6).
2. Redesignating paragraph (a)(7) as paragraph (a)(9).
3. Adding paragraph (a)(7).
4. Revising paragraph (a)(8).
5. Adding paragraph (a)(10).
6. In paragraph (b)(1), first, second, and last sentences, the
language ``425'' is removed wherever it appears and ``424'' is added in
their places.
7. In paragraph (c)(1), first sentence, the language ``425'' is
removed and ``424'' is added in its place.
8. In paragraph (c)(1), first sentence, the language
``disposition'' is removed and ``disposition of stock'' is added in its
place.
9. Adding paragraph (c)(1)(iv).
10. Redesignating paragraph (c)(3) as (c)(4).
11. Adding new paragraph (c)(3).
12. Adding newly designated paragraph (c)(4), Examples 7 through 9.
13. In the list below, for each section indicated in the left
column, remove the language in the middle column and add the language
in the right column:
------------------------------------------------------------------------
Newly designated section Remove Add
------------------------------------------------------------------------
1.424-1(c)(4), Example 1, 1964................ 2004.
first sentence.
1.424-1(c)(4), Example 1, qualified stock statutory option.
first sentence. option.
1.424-1(c)(4), Example 1, 1965................ 2005.
second and fourth sentences.
1.424-1(c)(4), Example 1, 1968................ 2006.
third sentence.
1.424-1(c)(4), Example 2, 1968................ 2006.
first sentence.
1.424-1(c)(4), Example 2, long-term ....................
last sentence.
1.424-1(c)(4), Example 3, 1968................ 2006.
first sentence.
1.424-1(c)(4), Example 4, 1968, two years and 2006.
first sentence. 11 months after the
transfer of shares
to him.
1.424-1(c)(4), Example 4, three years from the two years from the
last sentence. date. date the options
were granted and
within one year of
the date that.
1.424-1(c)(4), Example 5, 1965................ 2005.
first sentence.
1.424-1(c)(4), Example 5, qualified stock statutory option.
first sentence. option.
1.424-1(c)(4), Example 6, 1965................ 2005.
first sentence, wherever it
appears.
1.424-1(c)(4), Example 6, three years......... 2 years.
third sentence.
1.424-1(c)(4), Example 6, income.............. compensation income.
third sentence.
1.424-1(c)(4), Example 6, a qualified stock the option.
third sentence. option.
1.424-1(c)(4), Example 6, paragraph (b)(2) of Sec. 1.421-
last sentence. Sec. 1.421-8. 2(b)(2).
------------------------------------------------------------------------
14. Revising paragraph (d).
15. Revising paragraphs (e)(1) and (e)(2).
16. In paragraph (e)(3), first sentence, remove the phrase ``Except
as otherwise provided in subparagraph (4)'' and add ``If section 423(c)
applies to an option then,''.
17. In paragraph (e)(3), first sentence, remove the language ``,
and 424(b)(1).''
18. Removing paragraph (e)(4).
19. Redesignating paragraph (e)(5) as paragraph (e)(4).
20. Revising newly designated paragraph (e)(4).
21. Redesignating paragraph (e)(6) as paragraph (e)(5) and removing
the second and third sentences.
22. Adding and reserving a new paragraph (e)(6).
23. In list below, for each section indicated in the left column,
remove the language in the middle column and add the language in the
right column:
------------------------------------------------------------------------
Newly designated section Remove Add
------------------------------------------------------------------------
1.424-1(e)(7) Example 1, 1964................ 2004.
first sentence.
1.424-1(e)(7) Example 1, 1966................ 2006.
first sentence.
[[Page 34365]]
1.424-1(e)(7) Example 1, 1965................ 2005.
third, fourth, fifth, sixth
and last sentences.
1.424-1(e)(7) Example 1, 425(h).............. 424(h).
fifth sentence.
1.424-1(e)(7) Example 1, The exercise of such Because the
last sentence. requirements of
Sec. 1.424-
1(e)(3) and Sec.
1.423-2(g) have not
been met, the
exercise of such.
1.424-1(e)(7) Example 2, 1964................ 2004.
first, second, and fifth
sentences.
1.424-1(e)(7) Example 2, 1965................ 2005.
first, third, fourth, and
fifth sentences, wherever
it appears.
1.424-1(e)(7) Example 2, 1966................ 2006.
first and third sentences.
1.424-1(e)(7) Example 2, 425(h).............. 424(h).
fifth sentence.
1.424-1(e)(7) Example 2, The exercise of such Because the
last sentence. requirements of
Sec. 1.424-
1(e)(3) and Sec.
1.423-2(g) have not
been met, the
exercise of such.
1.424-1(e)(7) Example 3, 1965................ 2005.
first, second, and last
sentences.
------------------------------------------------------------------------
24. In paragraph (e)(7), remove Example 4.
25. Adding paragraphs (f) and (g).
The additions and revisions are as follows:
Sec. 1.424-1 Definitions and special rules applicable to statutory
options.
(a) Substitutions and assumptions of options--(1) In general. (i)
This paragraph (a) provides rules under which an eligible corporation
(as defined in paragraph (a)(2) of this section) may, by reason of a
corporate transaction (as defined in paragraph (a)(3) of this section),
substitute a new statutory option (new option) for an outstanding
statutory option (old option) or assume an old option without such
substitution or assumption being considered a modification of the old
option. For the definition of modification, see paragraph (e) of this
section.
(ii) For purposes of Sec. Sec. 1.421-1 through 1.424-1, the phrase
``substituting or assuming a stock option in a transaction to which
section 424 applies,'' ``substituting or assuming a stock option in a
transaction to which Sec. 1.424-1(a) applies,'' and similar phrases
means a substitution of a new option for an old option or an assumption
of an old option that meets the requirements of this paragraph (a). For
a substitution or assumption to qualify under this paragraph (a), the
substitution or assumption must meet all of the requirements described
in paragraphs (a)(4) and (a)(5) of this section.
(2) Eligible corporation. For purposes of this paragraph (a), the
term eligible corporation means a corporation that is the employer of
the optionee or a related corporation of such corporation. For purposes
of this paragraph (a), the determination of whether a corporation is
the employer of the optionee or a related corporation of such
corporation is based upon all of the relevant facts and circumstances
existing immediately after the corporate transaction.
(3) Corporate transaction. For purposes of this paragraph (a), the
term corporate transaction includes--
(i) A corporate merger, consolidation, acquisition of property or
stock, separation, reorganization, or liquidation;
(ii) A distribution (excluding ordinary dividends) or change in the
terms or number of outstanding shares of such corporation (e.g., a
stock split or stock dividend);
(iii) A change in the name of the corporation whose stock is
purchasable under the old option; and
(iv) Such other corporate events prescribed by the Commissioner in
published guidance.
(4) By reason of. (i) For a change in an option or issuance of a
new option to qualify as a substitution or assumption under this
paragraph (a), the change must be made by an eligible corporation (as
defined in paragraph (a)(2) of this section) and occur by reason of a
corporate transaction (as defined in paragraph (a)(3) of this section).
(ii) Generally, a change in an option or issuance of a new option
is considered to be by reason of a corporate transaction, unless the
relevant facts and circumstances demonstrate that such change or
issuance is made for reasons unrelated to such corporate transaction.
For example, a change in an option or issuance of a new option will be
considered to be made for reasons unrelated to a corporate transaction
if there is an unreasonable delay between the corporate transaction and
such change in the option or issuance of a new option, or if the
corporate transaction serves no substantial corporate business purpose
independent of the change in options. Similarly, a change in the number
or price of shares purchasable under an option merely to reflect market
fluctuations in the price of the stock purchasable under an option is
not by reason of a corporate transaction.
(iii) A change in an option or issuance of a new option is by
reason of a distribution or change in the terms or number of the
outstanding shares of a corporation (as described in paragraph
(a)(3)(ii) of this section) only if the option as changed or the new
option issued is an option on the same stock as under the old option
(or if such class of stock is eliminated in the change in capital
structure, on other stock of the same corporation).
(iv) A change in an option or issuance of a new option is by reason
of a change in the name of a corporation (as defined in paragraph
(a)(3)(iii) of this section) only if the option as changed or the new
option issued is an option on stock of the successor corporation.
(5) Other requirements. For a change in an option or issuance of a
new option to qualify as a substitution or assumption under this
paragraph (a), all of the requirements described in this paragraph
(a)(5) must be met.
(i) In the case of an issuance of a new option (or a portion
thereof) in exchange for an old option (or portion thereof), the
optionee's rights under the old option (or portion thereof) must be
[[Page 34366]]
canceled, and the optionee must lose all rights under the old option
(or portion thereof). There cannot be a substitution of a new option
for an old option within the meaning of this paragraph (a) if the
optionee may exercise both the old option and the new option. It is not
necessary to have a complete substitution of a new option for the old
option. However, any portion of such option which is not substituted or
assumed in a transaction to which this paragraph (a) applies is an
outstanding option to purchase stock or, to the extent paragraph (e) of
this section applies, a modified option.
(ii) The excess of the aggregate fair market value of the shares
subject to the new or assumed option immediately after the change in
the option or issuance of a new option over the aggregate option price
of such shares must not exceed the excess of the aggregate fair market
value of all shares subject to the old option (or portion thereof)
immediately before the change in the option or issuance of a new option
over the aggregate option price of such shares.
(iii) On a share by share comparison, the ratio of the option price
to the fair market value of the shares subject to the option
immediately after the change in the option or issuance of a new option
must not be more favorable to the optionee than the ratio of the option
price to the fair market value of the stock subject to the old option
(or portion thereof) immediately before the change in the option or
issuance of a new option. The number of shares subject to the new or
assumed option may be adjusted to compensate for any change in the
aggregate spread between the aggregate option price and the aggregate
fair market value of the shares subject to the option immediately after
the change in the option or issuance of the new option as compared to
the aggregate spread between the option price and the aggregate fair
market value of the shares subject to the option immediately before the
change in the option or issuance of the new option.
(iv) The new or assumed option must contain all terms of the old
option, except to the extent such terms are rendered inoperative by
reason of the corporate transaction.
(v) The new option or assumed option must not give the optionee
additional benefits that the optionee did not have under the old
option.
(vi) The new or assumed option must otherwise comply with the
requirements of Sec. 1.422-2 or Sec. 1.423-2. Thus, for example, the
old option must be assumed or the new option must be issued under a
plan approved by the stockholders of the corporation changing the
option or issuing the new option as described in Sec. 1.422-2(b)(2) or
Sec. 1.423-2(c), as applicable.
(6) Obligation to substitute or assume not necessary. For a change
in the option or issuance of a new option to meet the requirements of
this paragraph (a), it is not necessary to show that the corporation
changing an option or issuing a new option is under any obligation to
do so. In fact, this paragraph (a) may apply even when the option that
is being replaced or assumed expressly provides that it will terminate
upon the occurrence of certain corporate transactions. However, this
paragraph (a) cannot be applied to revive a statutory option which, for
reasons not related to the corporate transaction, expires before it can
properly be replaced or assumed under this paragraph (a).
(7) Issuance of stock without meeting the requirements of this
paragraph (a). A change in the terms of an option resulting in a
modification of such option occurs if an optionee's new employer (or a
related corporation of the new employer) issues its stock (or stock of
a related corporation) upon exercise of such option without satisfying
all of the requirements described in paragraphs (a)(4) and (5) of this
section.
(8) Date of grant. For purposes of applying the rules of this
paragraph (a), a substitution or assumption is considered to occur on
the date that the optionee would, but for this paragraph (a), be
considered to have been granted the option that the eligible
corporation is substituting or assuming. A substitution or an
assumption that occurs by reason of a corporate transaction may occur
before or after the corporate transaction.
* * * * *
(10) Examples. The principles of this paragraph (a) are illustrated
by the following examples:
Example 1. Eligible corporation. X Corporation acquires a new
subsidiary, Y Corporation, and transfers some of its employees to Y.
Y Corporation wishes to grant to its new employees and to the
employees of X Corporation new options for Y shares in exchange for
old options for X shares that were previously granted by X
Corporation. Because Y Corporation is an employer with respect to
its own employees and a related corporation of X Corporation, Y
Corporation is an eligible corporation under paragraph (a)(2) of
this section with respect to both the employees of X and Y
Corporations.
Example 2. Corporate transaction. (i) On January 1, 2004, Z
Corporation grants E, an employee of Z, an option to acquire 100
shares of Z stock. At the time of grant, the fair market value of Z
stock is $200 per share. E's option price is $200 per share. On July
1, 2005, when the fair market value of Z stock is $400, Z declares a
stock dividend that causes the fair market value of Z stock to
decrease to $200 per share. On the same day, Z grants to E a new
option to acquire 200 shares of Z stock in exchange for E's old
option. The new option has an exercise price of $100 per share.
(ii) A stock dividend is a corporate transaction under paragraph
(a)(3)(ii) of this section. Generally, the issuance of a new option
is considered to be by reason of a corporate transaction. None of
the facts in this Example 2 indicate that the new option is not
issued by reason of the stock dividend. In addition, the new option
is issued on the same stock as the old option. Thus, the
substitution occurs by reason of the corporate transaction. Assuming
the other requirements of this section are met, the issuance of the
new option is a substitution that meets the requirements of this
paragraph (a) and is not a modification of the option.
(iii) Assume the same facts as in paragraph (i) of this Example
2. Assume further that on December 1, 2005, Z declares an ordinary
cash dividend. On the same day, Z grants E a new option to acquire Z
stock in substitution for E's old option. Under paragraph (a)(3)(ii)
of this section, an ordinary cash dividend is not a corporate
transaction. Thus, the exchange of the new option for the old option
does not meet the requirements of this paragraph (a) and is a
modification of the option.
Example 3. Corporate transaction. On March 15, 2004, A
Corporation grants E, an employee of A, an option to acquire 100
shares of A stock at $50 per share, the fair market value of A stock
on the date of grant. On May 2, 2005, A Corporation transfers
several employees, including E, to B Corporation, a related
corporation. B Corporation arranges to purchase some assets from A
on the same day as E's transfer to B. Such purchase is without a
substantial business purpose independent of making the exchange of
E's old options for the new options appear to be by reason of a
corporate transaction. The following day, B Corporation grants to E,
one of its new employees, an option to acquire shares of B stock in
exchange for the old option held by E to acquire A stock. Under
paragraph (a)(3)(i) of this section, the purchase of assets is a
corporate transaction. Generally, the substitution of an option is
considered to occur by reason of a corporate transaction. However,
in this case, the relevant facts and circumstances demonstrate that
the issuance of the new option in exchange for the old option
occurred by reason of the change in E's employer rather than a
corporate transaction and that the sale of assets is without a
substantial corporate business purpose independent of the change in
the options. Thus, the exchange of the new option for the old option
is not by reason of a corporate transaction that meets the
requirements of this paragraph (a) and is a modification of the old
option.
Example 4. Additional benefit. On June 1, 2004, P Corporation
acquires 100 percent of the shares of S Corporation and issues a new
option to purchase P shares in exchange for
[[Page 34367]]
an old option to purchase S shares that is held by E, an employee of
S. On the date of the exchange, E's old option is exercisable for 3
more years, and, after the exchange, E's new option is exercisable
for 5 years. Because the new option is exercisable for an additional
period of time beyond the time allowed under the old option, the
effect of the exchange of the new option for the old option is to
give E an additional benefit that E did not enjoy under the old
option. Thus, the requirements of paragraph (a)(5) of this section
are not met, and this paragraph (a) does not apply to the exchange
of the new option for the old option. Therefore, the exchange is a
modification of the old options.
Example 5. Spread and ratio tests. E is an employee of S
Corporation. E holds an old option that was granted to E by S to
purchase 60 shares of S at $12 per share. On June 1, 2005, S
Corporation is merged into P Corporation, and on such date P issues
a new option to purchase P shares in exchange for E's old option to
purchase S shares. Immediately before the exchange, the fair market
value of an S share is $32; immediately after the exchange, the fair
market value of a P share is $24. The new option entitles E to buy P
shares at $9 per share. Because, on a share-by-share comparison, the
ratio of the new option price ($9 per share) to the fair market
value of a P share immediately after the exchange ($24 per share) is
not more favorable to E than the ratio of the old option price ($12
per share) to the fair market value of an S share immediately before
the exchange ($32 per share) (9/24 = 12/32), the requirements of
paragraph (a)(5)(iii) of this section are met. The number of shares
subject to E's option to purchase P stock is set at 80. Because the
excess of the aggregate fair market value over the aggregate option
price of the shares subject to E's new option to purchase P stock,
$1,200 (80 x $24 minus 80 x $9), is not greater than the excess of
the aggregate fair market value over the aggregate option price of
the shares subject to E's old option to purchase S stock, $1,200 (60
x $32 minus 60 x $12), the requirements of paragraph (a)(5)(ii) of
this section are met.
Example 6. Ratio test and partial substitution. Assume the same
facts as in Example 5, except that the fair market value of an S
share immediately before the exchange of the new option for the old
option is $8, that the option price is $10 per share, and that the
fair market value of a P share immediately after the exchange is
$12. P sets the new option price at $15 per share. Because, on a
share-by-share comparison, the ratio of the new option price ($15
per share) to the fair market value of a P share immediately after
the exchange ($12) is not more favorable to E than the ratio of the
old option price ($10 per share) to the fair market value of an S
share immediately before the substitution ($8 per share) (15/12 =
10/8), the requirements of paragraph (a)(5)(iii) of this section are
met. Assume further that the number of shares subject to E's P
option is set at 20, as compared to 60 shares under E's old option
to buy S stock. Immediately after the exchange, 2 shares of P are
worth $24, which is what 3 shares of S were worth immediately before
the exchange (2 x $12 = 3 x $8). Thus, to achieve a complete
substitution of a new option for E's old option, E would need to
receive a new option to purchase 40 shares of P (i.e., 2 shares of P
for each 3 shares of S that E could have purchased under the old
option (2/3 = 40/60)). Because E's new option is for only 20 shares
of P, P has replaced only \1/2\ of E's old option, and the other \1/
2\ is still outstanding.
Example 7. Partial substitution. X Corporation forms a new
corporation, Y Corporation, by a transfer of certain assets and, in
a spin-off, distributes the shares of Y Corporation to the
stockholders of X Corporation. E, an employee of X Corporation, is
thereafter an employee of Y. Y wishes to substitute a new option to
purchase some of its stock for E's old option to purchase 100 shares
of X. E's old option to purchase shares of X, at $50 a share, was
granted when the fair market value of an X share was $50, and an X
share was worth $100 just before the distribution of the Y shares to
X's stockholders. Immediately after the spin-off, which is also the
time of the substitution, each share of X and each share of Y is
worth $50. Based on these facts, a new option to purchase 200 shares
of Y at an option price of $25 per share could be granted to E in
complete substitution of E's old option. It would also be
permissible to grant E a new option to purchase 100 shares of Y, at
an option price of $25 per share, in substitution for E's right to
purchase 50 of the shares under the old option.
Example 8. Stockholder approval requirements. (i) X Corporation,
a publicly traded corporation, adopts an incentive stock option plan
that meets the requirements of Sec. 1.422-2. Under the plan,
options to acquire X stock are granted to X employees. X Corporation
is acquired by Y Corporation and becomes a subsidiary corporation of
Y Corporation. Y Corporation maintains an incentive stock option
plan that meets the requirements of Sec. 1.422-2. Under the plan,
options for Y stock may be granted to employees of Y or its related
corporations. After the acquisition, X employees remain employees of
X. In connection with the acquisition, Y Corporation substitutes new
options for Y stock for old options for X stock that were previously
granted to the employees of X. As a result of this substitution, on
exercise of the new options, X employees receive Y Corporation
stock.
(ii) Because Y Corporation has a plan that meets the
requirements of Sec. 1.422-2 in existence on the date it acquires
X, the new options for Y stock are granted under a plan approved by
the stockholders of Y. The stockholders of Y do not need to approve
the X plan. If the other requirements of paragraphs (a)(4) and (5)
of this section are met, the issuance of new options for Y stock in
exchange for the old options for X stock meets the requirements of
this paragraph (a) and is not a modification of the old options.
(iii) Assume the same facts as in paragraph (i) of this Example
8, except that Y Corporation does not maintain an incentive stock
option plan on the date of the acquisition of X. The Y options will
only be incentive stock options if they are granted under a plan
that meets the requirements of Sec. 1.422-2(b). Therefore, Y must
adopt a plan that provides for the grant of incentive stock options,
and the plan must be approved by the stockholders of Y in accordance
with Sec. 1.422-2(b). If the stockholders of Y approve the
incentive stock option plan within 12 months before or after the
date of the adoption of a plan by Y and the other requirements of
Sec. 1.422-2 and the requirements of this paragraph (a) are met,
the issuance of the new options for Y stock in exchange for the old
options for X stock meets the requirements of this paragraph (a) and
is not treated as a modification of the old options for X stock. The
result is the same if Y Corporation assumes the old options instead
of issuing new options.
(iv) Assume the same facts as in paragraph (i) of this Example
8, except that there is no exchange of options. Instead, as part of
the acquisition, X amends its plan to allow future grants under the
plan to be grants to acquire Y stock. Because the amendment of the
plan to allow options on a different stock is considered the
adoption of the new plan, the stockholders of X must approve the
plan within 12 months before or after the date of the amendment of
the plan. If the stockholders of X timely approve the plan, the
future grants to acquire Y stock will be incentive stock options
(assuming the other requirements of Sec. 1.422-2 have been met).
Example 9. Modification. X Corporation merges into Y
Corporation. Y Corporation retains employees of X who hold old
options to acquire X Corporation stock. When the former employees of
X exercise the old options, Y Corporation issues Y stock to the
former employees of X. Under paragraph (a)(7) of this section,
because Y issues its stock on exercise of the old options for X
stock, there is a change in the terms of the old options for X
stock. Thus, the issuance of Y stock on exercise of the old options
is a modification of the old options.
* * * * *
(c) * * * (1) * * *
(iv) A transfer between spouses or incident to divorce (described
in section 1041(a)). The special tax treatment of Sec. 1.421-2(a) with
respect to the transferred stock applies to the transferee. However,
see Sec. 1.421-1(b)(2) for the treatment of the transfer of a
statutory option incident to divorce.
* * * * *
(3) If an optionee exercises an incentive stock option with
statutory option stock and the applicable holding period requirements
(under Sec. 1.422-1(a) or 1.423-1(a)) with respect to such statutory
option stock are not met before such transfer, then sections 354, 355,
356, or 1036 (or so much of 1031 as relates to 1036) do not apply to
determine whether there is a disposition of those shares. Therefore,
there is a disposition of the statutory option stock, and the special
tax treatment of Sec. 1.421-2(a) does not apply to such stock.
(4) * * *
Example 7. On January 1, 2004, X Corporation grants to E, an
employee of X
[[Page 34368]]
Corporation, an incentive stock option to purchase 100 shares of X
Corporation stock at $100 per share (the fair market value of an X
Corporation share on that date). On January 1, 2005, when the fair
market value of a share of X Corporation stock is $200, E exercises
half of the option, pays X Corporation $5,000 in cash, and is
transferred 50 shares of X Corporation stock with an aggregate fair
market value of $10,000. E makes no disposition of the shares before
January 2, 2006. Under Sec. 1.421-2(a), no income is recognized by
E on the transfer of shares pursuant to the exercise of the
incentive stock option, and X Corporation is not entitled to any
deduction at any time with respect to its transfer of the shares to
E. E's basis in the shares is $5,000.
Example 8. Assume the same facts as in Example 7, except that on
December 1, 2005, one year and 11 months after the grant of the
option and 11 months after the transfer of the 50 shares to E, E
uses 25 of those shares, with a fair market value of $5,000, to pay
for the remaining 50 shares purchasable under the option. On that
day, X Corporation transfers 50 of its shares, with an aggregate
fair market value of $10,000, to E. Because E disposed of the 25
shares before the expiration of the applicable holding periods,
Sec. 1.421-2(a) does not apply to the January 1, 2005, transfer of
the 25 shares used by E to exercise the remainder of the option. As
a result of the disqualifying disposition of the 25 shares, E
recognizes compensation income under the rules of Sec. 1.421-2(b).
Example 9. On January 1, 2005, X Corporation grants an incentive
stock option to E, an employee of X Corporation. The exercise price
of the option is $10 per share. On June 1, 2005, when the fair
market value of an X Corporation share is $20, E exercises the
option and purchases 5 shares with an aggregate fair market value of
$100. On January 1, 2006, when the fair market value of an X
Corporation share is $50, X Corporation is acquired by Y Corporation
in a section 368(a)(1)(A) reorganization. As part of the
acquisition, all X Corporation shares are converted into Y
Corporation shares. After the conversion, if an optionee holds a
fractional share of X Corporation stock, Y Corporation will purchase
the fractional share for cash equal to its fair market value. After
applying the conversion formula to the shares held by E, E has 10 Y
Corporation shares and one-half of a share of X Corporation stock. Y
Corporation purchases E's one-half share for $25, the fair market
value of one-half of an X Corporation share on the conversion date.
Because E sells the one-half share prior to expiration of the
holding periods described in Sec. 1.422-1(a), the sale is a
disqualifying disposition of the one-half share. Thus, in 2006, E
must recognize compensation income of $5 (one-half of the fair
market value of an X Corporation share on the date of exercise of
the option, or $10, less one-half of the exercise price per share,
or $5). For purposes of computing any additional gain, E's basis in
the one-half share increases to $10 (reflecting the $5 included in
income as compensation). E recognizes an additional gain of $15
($25, the fair market value of the one-half share, less $10, the
basis in such share). The extent to which the additional $15 of gain
is treated as a redemption of X Corporation stock is determined
under section 302.
(d) Attribution of stock ownership. To determine the amount of
stock owned by an individual for purposes of applying the percentage
limitations relating to certain stockholders described in Sec. Sec.
1.422-2(f) and 1.423-2(d), shares of the employer corporation or of a
related corporation that are owned (directly or indirectly) by or for
the individual's brothers and sisters (whether by the whole or half
blood), spouse, ancestors, and lineal descendants, are considered to be
owned by the individual. Also, for such purposes, if a domestic or
foreign corporation, partnership, estate, or trust owns (directly or
indirectly) shares of the employer corporation or of a related
corporation, the shares are considered to be owned proportionately by
or for the stockholders, partners, or beneficiaries of the corporation,
partnership, estate, or trust. The extent to which stock held by the
optionee as a trustee of a voting trust is considered owned by the
optionee is determined under all of the facts and circumstances.
(e) Modification, extension, or renewal of option. (1) This
paragraph (e) provides rules for determining whether a share of stock
transferred to an individual upon the individual's exercise of an
option after the terms of the option have been changed is transferred
pursuant to the exercise of a statutory option.
(2) Any modification, extension, or renewal of the terms of an
option to purchase shares is considered the granting of a new option.
The new option may or may not be a statutory option. To determine the
date of grant of the new option for purposes of section 422 or 423, see
Sec. 1.421-1(c).
* * * * *
(4)(i) For purposes of Sec. Sec. 1.421-1 through 1.424-1 the term
modification means any change in the terms of the option (or change in
the terms of the plan pursuant to which the option was granted or in
the terms of any other agreement governing the arrangement) that gives
the optionee additional benefits under the option regardless of whether
the optionee in fact benefits from the change in terms. In contrast,
for example, a change in the terms of the option shortening the period
during which the option is exercisable is not a modification. However,
a change providing an extension of the period during which an option
may be exercised (such as after termination of employment) or a change
providing an alternative to the exercise of the option (such as a stock
appreciation right) is a modification regardless of whether the
optionee in fact benefits from such extension or alternative right.
Similarly, a change providing an additional benefit upon exercise of
the option (such as the payment of a cash bonus) or a change providing
more favorable terms for payment for the stock purchased under the
option (such as the right to tender previously acquired stock) is a
modification.
(ii) If an option is not immediately exercisable in full, a change
in the terms of the option to accelerate the time at which the option
(or any portion thereof) may be exercised is not a modification for
purposes of this section. Additionally, no modification occurs if a
provision accelerating the time when an option may first be exercised
is removed prior to the year in which it would otherwise be triggered.
For example, if an acceleration provision is timely removed to avoid
exceeding the $100,000 limitation described in Sec. 1.422-4, a
modification of the option does not occur.
(iii) A change to an option which provides, either by its terms or
in substance, that the optionee may receive an additional benefit under
the option at the future discretion of the grantor, is a modification
at the time that the option is changed to provide such discretion. In
addition, the exercise of discretion to provide an additional benefit
is a modification of the option. However, it is not a modification for
the grantor to exercise discretion reserved under an option with
respect to the payment of a cash bonus at the time of exercise, the
availability of a loan at exercise, or the right to tender previously
acquired stock for the stock purchasable under the option. An option is
not modified merely because an optionee is offered a change in the
terms of an option if the change to the option is not made.
(iv) A change in the terms of the stock purchasable under the
option that affects the value of the stock is a modification of such
option, except to the extent that a new option is substituted for such
option by reason of the change in the terms of the stock in accordance
with paragraph (a) of this section.
(v) If an option is amended solely to increase the number of shares
subject to the option, the increase is not considered a modification of
the option but is treated as the grant of a new option for the
additional shares.
(vi) Any change in the terms of an option made in an attempt to
qualify the option as a statutory option grants additional benefits to
the optionee and is, therefore, a modification.
[[Page 34369]]
(vii) An extension of an option refers to the granting by the
corporation to the optionee of an additional period of time within
which to exercise the option beyond the time originally prescribed. A
renewal of an option is the granting by the corporation of the same
rights or privileges contained in the original option on the same terms
and conditions. The rules of this paragraph apply as well to successive
modifications, extensions, and renewals.
* * * * *
(6) [Reserved.]
* * * * *
(f) Definitions. The following definitions apply for purposes of
Sec. Sec. 1.421-1 through 1.424-1:
(1) Parent corporation. The term parent corporation, or parent,
means any corporation (other than the employer corporation) in an
unbroken chain of corporations ending with the employer corporation if,
at the time of the granting of the option, each of the corporations
other than the employer corporation owns stock possessing 50 percent or
more of the total combined voting power of all classes of stock in one
of the other corporations in such chain.
(2) Subsidiary corporation. The term subsidiary corporation, or
subsidiary, means any corporation (other than the employer corporation)
in an unbroken chain of corporations beginning with the employer
corporation if, at the time of the granting of the option, each of the
corporations other than the last corporation in an unbroken chain owns
stock possessing 50 percent or more of the total combined voting power
of all classes of stock in one of the other corporations in such chain.
(g) Effective date. This section applies to any statutory option
granted on or after the date that is 180 days after publication of
final regulations in the Federal Register. Taxpayers can rely on these
regulations for the treatment of any statutory option granted on or
after June 9, 2003.
Sec. 1.6039-1 [Removed]
Par. 14. Section 1.6039-1 is removed.
Sec. 1.6039-2 [Redesignated]
Par. 15. Section 1.6039-2 is redesignated as 1.6039-1 and revised
to read as follows:
Sec. 1.6039-1 Statements to persons with respect to whom information
is furnished.
(a) Requirement of statement with respect to incentive stock
options under section 6039(a)(1). Every corporation which transfers
stock to any person pursuant to such person's exercise of an incentive
stock option described in section 422(b) must furnish to such
transferee, for each calendar year in which such a transfer occurs, a
written statement with respect to the transfer or transfers made during
such year. This statement must include the following information--
(1) The name, address, and employer identification number of the
corporation transferring the stock;
(2) The name, address, and identifying number of the person to whom
the share or shares of stock were transferred;
(3) The name and address of the corporation the stock of which is
the subject of the option (if other than the corporation transferring
the stock);
(4) The date the option was granted;
(5) The date the shares were transferred to the person exercising
the option;
(6) The fair market value of the stock at the time the option was
exercised;
(7) The number of shares of stock transferred pursuant to the
option;
(8) The type of option under which the transferred shares were
acquired; and
(9) The total cost of all the shares.
(b) Requirement of statement with respect to stock purchased under
an employee stock purchase plan under section 6039(a)(2). (1) Every
corporation which records, or has by its agent recorded, a transfer of
the title to stock acquired by the transferor pursuant to the
transferor's exercise on or after January 1, 1964, of an option granted
under an employee stock purchase plan which meets the requirements of
section 423(b), and with respect to which the special rule of section
423(c) applied, must furnish to such transferor, for each calendar year
in which such a recorded transfer of title to such stock occurs, a
written statement with respect to the transfer or transfers containing
the information required by paragraph (b)(2) of this section.
(2) The statement required by paragraph (b)(1) of this section must
contain the following information--
(i) The name and address of the corporation whose stock is being
transferred;
(ii) The name, address and identifying number of the transferor;
(iii) The date such stock was transferred to the transferor;
(iv) The number of shares to which title is being transferred; and
(v) The type of option under which the transferred shares were
acquired.
(3) If the statement required by this paragraph is made by the
authorized transfer agent of the corporation, it is deemed to have been
made by the corporation. The term transfer agent, as used in this
section means any designee authorized to keep the stock ownership
records of a corporation and to record a transfer of title of the stock
of such corporation on behalf of such corporation.
(4) A statement is required by reason of a transfer described in
section 6039(a)(2) of a share only with respect to the first transfer
of such share by the person who exercised the option. Thus, for
example, if the owner has record title to a share or shares of stock
transferred to a recognized broker or financial institution and the
stock is subsequently sold by such broker or institution (on behalf of
the owner), the corporation is only required to furnish a written
statement to the owner relating to the transfer of record title to the
broker or financial institution. Similarly, a written statement is
required when a share of stock is transferred by the optionee to
himself and another person (or persons) as joint tenants, tenants by
the entirety or tenants in common. However, when stock is originally
issued to the optionee and another person (or persons) as joint
tenants, or as tenants by the entirety, the written statement required
by this paragraph shall be furnished (at such time and in such manner
as is provided by this section) with respect to the first transfer of
the title to such stock by the optionee.
(5) Every corporation which transfers any share of stock pursuant
to the exercise of an option described in this paragraph shall identify
such stock in a manner sufficient to enable the accurate reporting of
the transfer of record title to such shares. Such identification may be
accomplished by assigning to the certificates of stock issued pursuant
to the exercise of such options a special serial number or color.
(c) Time for furnishing statements--(1) In general. Each statement
required by this section to be furnished to any person for a calendar
year must be furnished to such person on or before January 31 of the
year following the year for which the statement is required.
(2) Extension of time. For good cause shown upon written
application of the corporation required to furnish statements under
this section, the Director, Martinsburg Computing Center, may grant an
extension of time not exceeding 30 days in which to furnish such
statements. The application must contain a full recital of the reasons
for requesting an extension to aid the Director in determining the
period of the extension, if any, which will be granted and must be sent
to the Martinsburg Computing Center (Attn:
[[Page 34370]]
Extension of Time Coordinator). Such a request in the form of a letter
to the Martinsburg Computing Center signed by the applicant (or its
agent) will suffice as an application. The application must be filed on
or before the date prescribed in paragraph (c)(1) of this section for
furnishing the statements required by this section, and must contain
the employer identification number of the corporation required to
furnish statements under this section.
(3) Last day for furnishing statement. For provisions relating to
the time for performance of an act when the last day prescribed for
performance falls on Saturday, Sunday, or a legal holiday, see Sec.
301.7503-1 of this chapter (Regulations on Procedure and
Administration).
(d) Statements furnished by mail. For purposes of this section, a
statement is considered to be furnished to a person if it is mailed to
such person's last known address.
(e) Penalty. For provisions relating to the penalty provided for
failure to furnish a statement under this section, see section 6722.
(f) Electronic furnishing of statements. [Reserved]
(g) Effective date. This section applies as of the date that is 180
days after publication of final regulations in the Federal Register to
transfers of stock acquired pursuant to a statutory option on or after
that date. Taxpayers can rely on these regulations with respect to the
transfer of stock acquired pursuant to a statutory option on or after
June 9, 2003.
PART 14a--TEMPORARY INCOME TAX REGULATIONS RELATING TO INCENTIVE
STOCK OPTIONS
PART 14a--[REMOVED]
Par. 16. Part 14a is removed.
David A. Mader,
Assistant Deputy Commissioner of Internal Revenue.
[FR Doc. 03-13581 Filed 6-6-03; 8:45 am]
BILLING CODE 4830-01-P