Dealing with ISOs and disqualifying dispositions in reorganizations.
If stock acquired by exercise of the ISO (ISO stock) is held until the later of one year from the date the option is exercised or two years from the date the option is granted, any gain on the disposition of the ISO stock is entitled to be treated as long-term capital gain (Sec. 422(a)(1)). A disposition generally includes a sale, exchange, gift, or transfer of legal title, but it does not include a transfer from a decedent to an estate or a transfer by bequest or inheritance; an exchange to which Sec. 354,355,356, or 1036 (or so much of Sec. 1031 as relates to Sec. 1036) applies; or a mere pledge or hypothecation (Sec. 424(c)(1)). If the ISO stock is disposed of before the holding period is met, it is a "disqualifying disposition" (Sec. 421(b)), which results in W-2 wages to the employee and an income tax deduction for the company. However, the wages are not subject to Federal Insurance Contributions Act taxes, Federal Unemployment Tax Act taxes, or wage withholding.
CCA 201519031 explored the application of the disqualifying disposition rules in two scenarios: Scenario 1 involves a transaction that qualified as a Sec. 368 reorganization with boot, and Scenario 2 deals with a reorganization that failed to qualify under Sec. 368. The following is from the CCA:
Scenario 1: Corporation A and Corporation Y are unrelated corporations that are incorporated under the laws of State B. On July 1,2011, Corporation X grants a stock option to A, an employee of Corporation X since Jan. 4,2011, entitling A to purchase 100 shares of Corporation A voting common stock for $15 per share. The stock option qualifies as an ISO, as defined in Sec. 422. On Dec. 30,2011, A exercises the option when the fair market value (FMV) of Corporation X stock is $25 per share, and 100 shares of Corporation X voting common stock are transferred to A on that date. On Jan. 3,2012, Corporation X and Corporation Y enter into an agreement (the merger agreement) pursuant to which Corporation Y will acquire Corporation X by forming a new subsidiary (Corporation Z) that will merge with and into Corporation A, with Corporation X surviving. Pursuant to the merger, each outstanding share of Corporation X voting common stock will be converted into one share of Corporation Y voting common stock with a value of $25 and $1.50 in cash. The exchange does not have the effect of the distribution of a dividend under Sec. 356(a)(2). The stock of Corporation Z will be converted into voting common stock of Corporation X. Corporation Z merges into Corporation A in a transaction that qualifies as a reorganization described in Sec. 368(a)(1)(A) by reason of Sec. 368(a)(1)(E). Following the merger, Corporation A continues in existence as a wholly owned subsidiary of Corporation Y. Since Jan. 4,2011, A and Corporation A have maintained a continuous employment relationship, and on Aug. 1,2013, A sells the 100 shares of Corporation Y stock for $40 per share.
Scenario 2: Assume the same facts as in Scenario 1, except that each share of Corporation X common stock is converted into one share of Corporation Y common stock with a value of $16.50 and $10 in cash. The transaction does not meet the requirements of Sec. 368(a)(2)(E)(ii) because shareholders of Corporation X did not exchange for Corporation Y stock voting stock of Corporation X that constitutes control (80%) of Corporation X, but rather exchanged more than 20% of Corporation As stock for cash. As a result, the transaction does not qualify as a reorganization under Sec. 368(a)(1)(A) by reason of Sec. 368(a)(2)(E) or any other provision of Sec. 368(a).
Scenario 1: The CCA concluded that a disqualifying disposition had not occurred, as there had not been a disposition of the stock even though $150 of gain was recognized as a result of the $1.50 of boot received with respect to the 100 Corporation X shares exchanged. (A discussion of whether the boot constitutes capital gain or a dividend under Sec. 356(a)(2) is beyond the scope of this item.) The receipt of acquirer stock and boot in a Sec. 368 reorganization is governed by Sec. 356 and therefore does not constitute a disposition of the ISO stock under Sec. 424(c)(1)(B), even though the holder of the ISO stock recognizes gain.
The stock received in the reorganization steps into the shoes of the original ISO stock for purposes of the disqualifying disposition rules (Sec. 424(b)). When the holder of the ISO stock subsequently sells the stock for $40 per share on Aug. 1, 2013, 19 months after acquiring it by exercise of the ISO, the result is a qualifying disposition. The employee recognizes long-term capital gain of $2,500 on the sale of his or her 100 shares ($40 per share proceeds less basis of $15 per share).
Scenario 2: The transaction fails to qualify as a reorganization under Sec. 368, and, as a result, neither Sec. 354 nor Sec. 356 applies to the exchange. Rather, the exchange of ISO stock for stock and cash is a taxable exchange under Sec. 1001, and there is a disqualifying disposition. The total gain the employee recognizes on the 100 shares is $1,150 ($26.50 per share proceeds less $15 per share basis). Because of the disqualifying disposition, the employee's $1,150 gain has two components on the date of the failed reorganization: $1,000 of ordinary income W-2 wages and $150 of short-term capital gain. The W-2 income from the disqualifying disposition is based on the excess of the FMV of the stock over the exercise price on the date exercised. The 100 options were exercised for $15 per share at a time when the stocks FMV was $25 per share. The disqualifying disposition results in $1,000 of W-2 wages to the employee ($10 per share gain at exercise date multiplied by 100 shares). After the disqualifying disposition, the employee's basis in the 100 shares of ISO stock is $2,500, and an additional $150 of gain is recognized when the shares are sold for $2,650 in the failed reorganization. When the employee subsequently sells the stock for $40 per share, or $4,000, on Aug. 1, 2013, the result is $2,350 of short-term capital gain.
If there is a Sec. 368 reorganization, the acquiring company will need to continue to monitor employees' holdings of ISO stock. In Scenario 1, an employee's disposition of stock on Aug. 1,2013, constitutes a qualifying disposition of ISO stock because the stock received in the Sec. 368 reorganization continues to be treated as ISO stock. However, had the employee sold all of his or her stock on Nov. 15,2012, the result still would be a disqualifying disposition.
From Carl P. Karpiak, J.D., LL.M., New York City
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|Title Annotation:||incentive stock options|
|Author:||Karpiak, Carl P.|
|Publication:||The Tax Adviser|
|Date:||Sep 1, 2015|
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