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Stock options.

Many companies allow their employees to exercise stock options by tendering previously owned shares and cash in exchange for new shares. In private letter ruling 9629028, a corporation with an incentive stock option (ISO) plan and a nonqualified stock option (NQSO) plan was allowed to let its employees make a "constructive exchange" (not physical exchange) of the shares already owned instead of mailing them to the corporation. The Internal Revenue Service taxed the employees based on the type of plan. According to Internal Revenue Code section 422(a), the employee must hold the stock until it is mature, that is for more than two years after the ISO is granted and more than one year after the stock is transferred in order to receive tax benefits.

Assume that employee E owns 1,000 shares, bought five years ago at the option price of $5 per share, when the stock was selling for $7 a share. E has an option to buy an additional 5,000 shares at $10 a share, with the stock selling for $20 a share. In a constructive exchange, E will simply keep the original 1,000 shares and send in a check for $30,000 (cost of new shares [$50,000]-current fair market value [fmv] of old shares [$20,000]), and receive 5,000 additional shams.

ISO Plan. If the 1,000 shares offered as payment are mature ISO shares and the 5,000 shares are offered under an ISO plan:

* E will recognize no gain on the constructive exchange of the 1,000 shares.

* E will recognize no income on the exercise of the option.

* The 4,000 new shares will have a basis of $30,000 (the cash paid to exercise the option) and a new holding period beginning on the day the option was exercised.

* The 1,000 original shares will have a carryover cost basis of $5,000 and a long-term holding period for purposes of capital assets.

If the 1,000 shares offered as payment are not mature ISO shares, E will be taxed on $2,000 of the compensation (the original option savings of $2 per share X 1,000 shares). E will not be taxed on the pure appreciation of $13,000 associated with the original 1,000 shares (current FMV $20.00 per share-FMV on date of original purchase of $7 x 1,000 shares).

NQSO plan. Finally, if E possesses an NQSO to buy the 5,000 shares, E must recognize $50,000 of ordinary income ($80,000 FMV of 4,000 new shares-S30,000 cash paid on the constructive exchange). No income is recognized on the exchange of the 1,000 previously owned shares for the 1,000 new shares.

Observation: CPAs should be aware that the IRS will not treat constructive exchanges as a modification, extension or renewal of the ISO. Companies need not amend their plans or seek shareholder approval, before instituting these new procedures. --Michael Lynch, CPA, Esq., Associate professor of accounting at Bryant College, Smithfield, Rhode Island.
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Title Annotation:constructive exchange of employee stock options
Author:Lynch, Michael
Publication:Journal of Accountancy
Date:Oct 1, 1996
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