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Certain ISO exercises trigger corporate tax deductions.

Corporations that issue incentive stock options (ISOs) to service providers may get an unanticipated tax deduction if the ISO holders fail to follow the statutory holding period requirements for ISOs. In such a case, the ISOs will be treated as nonqualified.

The differences in tax treatment between ISOs and nonqualified options are summarized in the chart on page 82.

Under Sec. 422, an employee cannot dispose of the stock acquired by the exercise of an ISO within two years from the option grant date or one year after the exercise date. A disposition not meeting these requirements is called a disqualifying disposition. A disqualifying disposition causes the "spread" between the stock's fair market value (FMV) at the exercise date and the exercise price to be treated as ordinary income to the ISO holder and a deduction to the corporation.

If the disqualifying disposition takes place when the stock's FMV is lower than its value on the exercise date, Sec. 422(c)(2) provides that the excess of the amount realized on the sale over the exercise price will be the basis of determining the ordinary income to the ISO holder and the deduction to the corporation. If, on the other hand, the stock's selling price is higher than its value on the exercise date, such excess results in capital gain to the shareholder with no deduction to the corporation.

Example: In 1990, employee E received 10 ISOs, which allowed him to purchase 10 shares of stock for $2 each. In 1994, E decides to exercise the 10 options, when the stock is selling for $10. Two weeks later, when the selling price is $11, E decides to sell two of the shares to pay for the exercise price. Since he failed to hold two shares of the stock for one year, the two options constitute nonqualified options, creating ordinary income of $16 ($10 - $2 = $8 X 2 shares) to E and a $16 deduction to the corporation in 1994. In addition, E has a short-term capital gain of $2 ($11 - $10 = $1 X 2 shares).

Corporations may not always know when their employees violate the ISO holding period rules. This information is particularly difficult to discover when the employee is no longer employed by the corporation. To help track these exercises, the corporation should require all option holders to notify it of any disqualifying dispositions.

Two additional points to keep in mind: First, under current accounting rules, a deduction created by a disqualifying stock disposition does not create an expense for financial statement purposes. This is because the exercise price of an ISO cannot be less than the value of the stock at the date of grant.

Second, under Regs. Sec. 1.83-6(a)(2), the corporation must withhold appropriate income taxes from employees on exercise of nonqualified options; failure to properly withhold results in the loss of a deduction. (If the service provider was an independent contractor, no withholding is necessary, although a Form 1099 may be required.) This requirement will often be difficult to administer, especially for fiscal-year corporations, when the premature sale may not be discovered until after the end of the calendar year. Accordingly, the IRS ruled in Notice 87-49 that Regs. Sec. 1.83-6(a)(2) did not apply to disqualifying dispositions of ISOs. However, the Service may be reconsidering this decision.

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Article Details
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Title Annotation:incentive stock options
Author:Goldberg, Michael J.
Publication:The Tax Adviser
Date:Feb 1, 1994
Previous Article:Shifting S income with salary adjustments.
Next Article:U.S. tax relief for foreign partners.

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