§ 1.422-5 Permissible provisions.
(a) General rule. An option that otherwise qualifies as an incentive stock option does not fail to be an incentive stock option merely because such option contains one or more of the provisions described in paragraphs (b), (c), and (d) of this section.
(b) Cashless exercise.
(1) An option does not fail to be an incentive stock option merely because the optionee may exercise the option with previously acquired stock of the corporation that granted the option or stock of the corporation whose stock is being offered for purchase under the option. For special rules relating to the use of statutory option stock to pay the option price of an incentive stock option, see § 1.424-1(c)(3).
(2) All shares acquired through the exercise of an incentive stock option are individually subject to the holding period requirements described in § 1.422-1(a) and the disqualifying disposition rules of § 1.422-1(b), regardless of whether the option is exercised with previously acquired stock of the corporation that granted the option or stock of the corporation whose stock is being offered for purchase under the option. If an incentive stock option is exercised with such shares, and the exercise results in the basis allocation described in paragraph (b)(3) of this section, the optionee's disqualifying disposition of any of the stock acquired through such exercise is treated as a disqualifying disposition of the shares with the lowest basis.
(3) If the exercise of an incentive stock option with previously acquired shares is comprised in part of an exchange to which section 1036 (and so much of section 1031 as relates to section 1036) applies, then:
(i) The optionee's basis in the incentive stock option shares received in the section 1036 exchange is the same as the optionee's basis in the shares surrendered in the exchange, increased, if applicable, by any amount included in gross income as compensation pursuant to sections 421 through 424 or section 83. Except for purposes of § 1.422-1(a), the holding period of the shares is determined under section 1223. For purposes of § 1.422-1 and sections 421(b) and 83 and the regulations thereunder, the amount paid for the shares purchased under the option is the fair market value of the shares surrendered on the date of the exchange.
(ii) The optionee's basis in the incentive stock option shares not received pursuant to the section 1036 exchange is zero. For all purposes, the holding period of such shares begins as of the date that such shares are transferred to the optionee. For purposes of § 1.422-1(b) and sections 421(b) and 83 and the regulations thereunder, the amount paid for the shares is considered to be zero.
(c) Additional compensation. An option does not fail to be an incentive stock option merely because the optionee has the right to receive additional compensation, in cash or property, when the option is exercised, provided such additional compensation is includible in income under section 61 or section 83. The amount of such additional compensation may be determined in any manner, including by reference to the fair market value of the stock at the time of exercise or to the option price.
(d) Option subject to a condition.
(1) An option does not fail to be an incentive stock option merely because the option is subject to a condition, or grants a right, that is not inconsistent with the requirements of §§ 1.422-2 and 1.422-4.
(2) An option that includes an alternative right is not an incentive stock option if the requirements of § 1.422-2 are effectively avoided by the exercise of the alternative right. For example, an alternative right extending the option term beyond ten years, setting an option price below fair market value, or permitting transferability prevents an option from qualifying as an incentive stock option. If either of two options can be exercised, but not both, each such option is a disqualifying alternative right with respect to the other, even though one or both options would individually satisfy the requirements of §§ 1.422-2, 1.422-4, and this section.
(3) An alternative right to receive a taxable payment of cash and/or property in exchange for the cancellation or surrender of the option does not disqualify the option as an incentive stock option if the right is exercisable only when the then fair market value of the stock exceeds the exercise price of the option and the option is otherwise exercisable, the right is transferable only when the option is otherwise transferable, and the exercise of the right has economic and tax consequences no more favorable than the exercise of the option followed by an immediate sale of the stock. For this purpose, the exercise of the alternative right does not have the same economic and tax consequences if the payment exceeds the difference between the then fair market value of the stock and the exercise price of the option.
(e) Examples. The principles of this section are illustrated by the following examples:
Example 1.
On June 1, 2004, X
Corporation grants an
incentive stock option to A,
an employee of X
Corporation, entitling A to
purchase 100 shares of X
Corporation common stock at $10 per share.
The option provides that A may
exercise the option with previously acquired shares of X
Corporation common stock. X
Corporation has only one class of common stock outstanding. Under
the rules of section 83,
the shares transferable to A through
the exercise of
the option are transferable and not subject to a
substantial risk of forfeiture. On June 1, 2005, when
the fair market value of an X
Corporation share is $25, A uses 40 shares of X
Corporation common stock, which A had purchased on
the open market on June 1, 2002, for $5 per share, to pay
the full
option price. After exercising
the option, A owns 100 shares of
incentive stock option
stock. Under section 1036 (and so much of section 1031 as relates to section 1036), 40 of
the shares have a $200 aggregate carryover
basis (
the $5
purchase price × 40 shares) and a three-year holding period for purposes of determining
capital gain, and 60 of
the shares have a zero
basis and a holding period beginning on June 1, 2005, for purposes of determining
capital gain. All 100 shares have a holding period beginning on June 1, 2005, for purposes of determining whether
the holding period
requirements of
§ 1.422-1(a) are met.
Example 2.
Assume
the same
facts as in
Example 1. Assume further that, on September 1, 2005, A sells 75 of
the shares that A acquired through
exercise of
the incentive stock option for $30 per share. Because
the holding period
requirements were not satisfied, A made a disqualifying
disposition of
the 75 shares on September 1, 2005. Under
the rules of paragraphs (b)(2) and (b)(3) of this section, A has sold all 60 of
the non-section-1036 shares and 15 of
the 40 section-1036 shares. Therefore, under
paragraph (b)(3) of this section and section 83(a),
the amount of
compensation attributable to A's
exercise of
the option and subsequent disqualifying
disposition of 75 shares is $1,500 (
the difference between
the fair market value of
the stock on
the date of
transfer, $1,875 (75 shares at $25 per share), and
the amount paid for
the stock, $375 (60 shares at $0 per share plus 15 shares at $25 per share)). In
addition, A must recognize a
capital gain of $675, which consists of $375 ($450,
the amount realized from
the sale of 15 shares, less A's
basis of $75) plus $300 ($1,800,
the amount realized from
the sale of 60 shares, less A's
basis of $1,500 resulting from
the inclusion of that
amount in income as
compensation). Accordingly, A must include in
gross income for
the taxable year in which
the sale occurs $1,500 as
compensation and $675 as
capital gain. For its
taxable year in which
the disqualifying
disposition occurs, if otherwise
allowable under section 162 and if
the requirements of § 1.83-6(a) are met, X
Corporation is
allowed a
deduction of $1,500 for
the compensation paid to A.
Example 3.
Assume
the same
facts as in
Example 2, except that, instead of selling
the 75 shares of
incentive stock option
stock on September 1, 2005, A uses those shares to
exercise a second
incentive stock option.
The second
option was granted to A by X
Corporation on January 1, 2005, entitling A to
purchase 100 shares of X
Corporation common stock at $22.50 per share. As in
Example 2, A has made a disqualifying
disposition of
the 75
shares of stock pursuant to
§ 1.424-1(c). Under
paragraph (b) of this section, A has disposed of all 60 of
the non-section-1036 shares and 15 of
the 40 section-1036 shares. Therefore, pursuant to
paragraph (b)(3) of this section and section 83(a),
the amount of
compensation attributable to A's
exercise of
the first
option and subsequent disqualifying
disposition of 75 shares is $1,500 (
the difference between
the fair market value of
the stock on
the date of
transfer, $1,875 (75 shares at $25 per share), and
the amount paid for
the stock, $375 (60 shares at $0 per share plus 15 shares at $25 per share)). Unlike
Example 2, A does not recognize any
capital gain as a
result of exercising
the second
option because, for all purposes
other than
the determination of whether
the exercise is a
disposition pursuant to section 424(c),
the exercise is considered an exchange to which section 1036 applies. Accordingly, A must include in
gross income for
the taxable year in which
the disqualifying
disposition occurs $1,500 as
compensation. If
the requirements of § 83(h) and
§ 1.83-6(a) are satisfied and
the deduction is otherwise
allowable under section 162, for its
taxable year in which
the disqualifying
disposition occurs, X
Corporation is
allowed a
deduction of $1,500 for
the compensation paid to A. After exercising
the second
option, A owns a total of 125 shares of
incentive stock option
stock. Under section 1036 (and so much of section 1031 as relates to section 1036),
the 100 “new” shares of
incentive stock option
stock have
the following bases and holding periods: 15 shares have a $75 carryover
basis and a three-year-and-three-month holding period for purposes of determining
capital gain, 60 shares have a $1,500
basis resulting from
the inclusion of that
amount in income as
compensation and a three-month holding period for purposes of determining
capital gain, and 25 shares have a zero
basis and a holding period beginning on September 1, 2005, for purposes of determining
capital gain. All 100 shares have a holding period beginning on September 1, 2005, for purposes of determining whether
the holding period
requirements of
§ 1.422-1(a) are met.
Example 4.
Assume
the same
facts as in
Example 2, except that, instead of selling
the 75 shares of
incentive stock option
stock on September 1, 2005, A uses those shares to
exercise a nonstatutory
option.
The nonstatutory
option was granted to A by X
Corporation on January 1, 2005, entitling A to
purchase 100 shares of X
Corporation common stock at $22.50 per share. Unlike
Example 3, A has not made a disqualifying
disposition of
the 75
shares of stock. After exercising
the nonstatutory
option, A owns a total of 100 shares of
incentive stock option
stock and 25 shares of nonstatutory stock option
stock. Under section 1036 (and so much of section 1031 as relates to section 1036),
the 75 new shares of
incentive stock option
stock have
the same
basis and holding period as
the 75 old shares used to
exercise the nonstatutory
option.
The additional 25
shares of stock received upon
exercise of
the nonstatutory
option are taxed under
the rules of section 83(a). Accordingly, A must include in
gross income for
the taxable year in which
the transfer of such shares occurs $750 (25 shares at $30 per share) as
compensation. A's
basis in such shares is
the same as
the amount included in
gross income. For its
taxable year in which
the transfer occurs, X
Corporation is
allowed a
deduction of $750 for
the compensation paid to A to
the extent
the requirements of section 83(h) and
§ 1.83-6(a) are satisfied and
the deduction is otherwise
allowable under section 162.
Example 5.
Assume
the same
facts in
Example 1, except that
the shares transferred pursuant to
the exercise of
the incentive stock option are subject to a
substantial risk of forfeiture and not transferable (substantially nonvested) for a period of six months after such
transfer. Assume further that
the shares that A uses to
exercise the incentive stock option are similarly restricted. Such shares were transferred to A on January 1, 2005, through A's
exercise of a nonstatutory stock option which was granted to A on January 1, 2004. A
paid $5 per share for
the stock when its
fair market value was $22.50 per share. A did not file a section 83(b) election to include
the $700 spread (
the difference between
the option price and
the fair market value of
the stock on date of
exercise of
the nonstatutory
option) in
gross income as
compensation. After exercising
the incentive stock option with
the 40 substantially-nonvested shares, A owns 100 shares of substantially-nonvested
incentive stock option
stock. Section 1036 (and so much of section 1031 as relates to section 1036) applies to
the 40 shares exchanged in
exercise of
the incentive stock option. However, pursuant to section 83(g),
the stock received in such
exchange, because it is
incentive stock option
stock, is not subject to
restrictions and
conditions substantially similar to those to which
the stock given in such
exchange was subject. For purposes of section 83(a) and
§ 1.83-1(b)(1), therefore, A has disposed of
the 40 shares of substantially-nonvested
stock on June 1, 2005, and must include in
gross income as
compensation $800 (
the difference between
the amount realized upon such
disposition, $1,000, and
the amount paid for
the stock, $200). Accordingly, 40 shares of
the incentive stock option
stock have a $1,000
basis (
the $200 original
basis plus
the $800 included in income as
compensation) and 60 shares of
the incentive stock option
stock have a zero
basis. For its
taxable year in which
the disposition of
the substantially-nonvested
stock occurs, X
Corporation is
allowed a
deduction of $800 for
the compensation paid to A, provided
the requirements of section 83(h) and
§ 1.83-6(a) are satisfied and
the deduction is otherwise
allowable under section 162.
(f) Effective/applicability date—(1) In general. Except for § 1.422-2(b)(6) Example 1 (iii), the regulations under this section are effective on August 3, 2004. Section 1.422-2(b)(6) Example 1 (iii) is effective on November 17, 2009. Section 1.422-2(b)(6) Example 1 (iii) applies to statutory options granted on or after January 1, 2010.
(2) Reliance and transition period. For statutory options granted on or before June 9, 2003, taxpayers may rely on the 1984 proposed regulations LR-279-81 (49 FR 4504), the 2003 proposed regulations REG-122917-02 (68 FR 34344), or this section until the earlier of January 1, 2006, or the first regularly scheduled stockholders meeting of the granting corporation occurring 6 months after August 3, 2004. For statutory options granted after June 9, 2003, and before the earlier of January 1, 2006, or the first regularly scheduled stockholders meeting of the granting corporation occurring at least 6 months after August 3, 2004, taxpayers may rely on either REG-122917-02 or this section. Taxpayers may not rely on LR-279-81 or REG-122917-02 after December 31, 2005. Reliance on LR-279-81, REG-122917-02, or this section must be in its entirety, and all statutory options granted during the reliance period must be treated consistently.
[T.D. 9144,
69 FR 46417, Aug. 3, 2004;
69 FR 61310, Oct. 18, 2004;
69 FR 70551, Dec. 7, 2004; T.D. 9471,
74 FR 59078, Nov. 17, 2009]
