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|
|Publication:||Journal of Accountancy|
|Date:||Oct 1, 1996|
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