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Stock options and SEC Section 16(b).

Stock options are a popular way to attract talent. Generally, they can either be statutory (incentive stock options (ISOs)) or nonstatutory (nonqualified stock options (NQSOs)).The tax treatment of each differs. Under Sec. 83, NQSOs are taxed to the employee on the date exercised. The amount included in income is the difference between the stock's fair market value (FMV) on the vesting date and the amount the employee paid for the stock.

Income realized from the exercise of ISOs is not included in regular taxable income when exercised by the employee. Rather, assuming the requirements of Sec. 422 are met, the employee is taxed on the income realized when he or she sells the underlying stock; it is capital gain, not ordinary income. For alternative minimum tax (AMT) purposes, Sec. 56(b) (3) provides that ISOs are treated like NQSOs and taxed when exercised.

There are horror stories in which taxpayers exercised options in a high-flying stock and failed to sell the stock before the price dropped, due to Securities and Exchange Commission (SEC) and/or corporate insider trading restrictions. The taxpayer then faced a large AMT bill with no money to pay it, or had large ordinary income and a capital loss.

How are corporate insiders taxed on the exercise of stock options subject to SEC and corporate sale restrictions? Rev. Rul. 2005-48 and two TAMs provide guidance.

Rev. Rul. 2005-48

Facts: Employee E was granted NQSOs of Company M on Jan. 2, 2005. On May 1, 2005, M sold its common stock in an initial public offering. The underwriting agreement provided that E could not sell, otherwise dispose of or hedge any M common shares, options, warrants or convertible securities from May 1, 2005-Nov. 1, 2005 (lock-up period).

M also adopted an insider trading compliance program under which insiders could trade M shares only between November 5 and November 30 of that year (trading window). Failure to abide by these rules would result in termination. The exercise of the NQSOs was not prohibited.

On Aug. 15, 2005, E exercised the fully vested option. Also on that date, E possessed material nonpublic information about M that would subject him to liability under Rule 10b-5 under the Securities and Exchange Act of 1934 ('34 Act) if E sold the shares while in possession of such information.

Law: Sec. 83(a) provides that, when property is transferred to a taxpayer in connection with the performance of services, its FMV (determined without regard to any lapse restriction), less the amount paid for it, is includible in the taxpayer's income. The property's FMV is determined on the first day the transferee's rights in the property are transferable or not subject to a substantial risk of forfeiture.

Sec. 83(e)(3) provides that Sec. 83(a) does not apply to the transfer of an option without a readily ascertainable FMV. However, it does apply to an option at the time it is exercised.

Sec. 83(c)(3) and Regs. Sec. 1.833(j) provide that, if the sale of property at a profit within six months after its purchase could subject a person to suit under Section 16(b) of the '34 Act, the person's rights in the property are treated as subject to a substantial risk of forfeiture and as not transferable until after the earlier of the expiration of the six-month period or the first day on which a sale of such property at a profit will not subject the person to suit under Section 16(b). The ruling states:

Because, when enacting section 83(c)(3), Congress decided that the only provision of the securities law that would delay taxation under that section would be section 16(b), potential liability for insider trading under Rule 10b-5, for example, does not cause rights in property taxable under section 83 to be substantially nonvested.

According to the ruling, Section 16(b) is triggered by either a "purchase and sale" or a "sale and purchase" of a security within a period of less than six months by an officer, director or greater-than-10% owner of the corporation. Thus, the combination of the purchase and sale event triggers the Section 16(b) liability.

Rev. Rul. 2005-48 noted that, before May 1, 1991, the acquisition of stock as the result of the exercise of an option was viewed as a "purchase" for Section 16(b) purposes. Thus, the six-month period under Section 16(b) was measured from the date an option was exercised.

In 1991, Section 16(b) was changed to give options (and other derivatives) the same status as stock; the SEC recognized "that holding derivative securities is functionally equivalent to holding the underlying equity securities for purposes of Section 16(b), since the value of the derivative securities is a function of or related to the value of the underlying equity security." Thus, after 1991, the six-month holding period under Section 16(b) begins when the options are granted, rather than when they are exercised.

Ruling: The ruling concluded that Section 16(b) interacts with Sec. 83 as follows: if, for example, shares are acquired through the exercise of an NQSO in a transfer taxable under Sec. 83, such shares will not be subject to Section 16(b) liability unless they are acquired during the six-month period beginning with the grant date. Even if an optionee exercises an option and sells the underlying shares within six months of the grant date, an exemption from liability under Sec-tion 16(b) may be available under other SEC rules.

E's Section 16(b) liability expired on July 2, 2005 (six months after the options were granted). Thus, the liability expired before E exercised his options and the shares were not subject to a substantial risk of forfeiture under Sec. 83(c)(3) and Regs. Sec. 1.83-3(j).

The ruling also decided two other issues. First, the lock-up agreements and insider trading compliance programs did not provide that E's rights were subject to a substantial risk of forfeiture. None of the shares were conditioned on "anyone's future performance ... of substantial services." Second, as to the valuation of the shares, the transfer restrictions im-posed on E's sales of the shares were "lapse restrictions." Thus, they had to be ignored when valuing the shares obtained via the exercises.

The ruling noted that the issues in the case were the same as those considered in Tanner, 117 TC 237 (2001), aff'd, 65 FedAppx 508 (Fifth Cir. 2003), and that the conclusions reached are consistent with the decision in that case.


Letter Rulings (TAMs) 200338010 and 200338011 are two nearly identical rulings that provide guidance on ISOs. The TAMs followed a very similar logic to Rev. Rul. 2005-48, and concluded that income is recognized for AMT purposes on the exercise date (assuming it is at least six months after the grant date).


Corporate insiders who receive stock options may be restricted as to when they can sell the underlying stock. This restriction can create a tax burden, should the stock decline significantly in value by the time the insider is allowed to dispose of the shares. The conclusions in the ruling and the two TAMs should be considered. Treasury intends to amend the Sec. 83 regulations to explicitly set forth the holdings in Rev. Rul. 200548, but no amendments have been finalized yet.

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Author:Coscia, Matthew R.
Publication:The Tax Adviser
Date:Dec 1, 2006
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