March 6, 2012

Options and Taxes: Tax Treatment of Incentive Stock Options

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As part of AdvisorOne’s Special Report, 22 Days of Tax Planning Advice for 2012, throughout the month of March 2012, we are partnering with our Summit Business Media sister service, Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format. In this first article, we look at the tax treatment of an incentive stock option.

Q. How is the grant of an incentive stock option taxed? How is the exercise of the option taxed?

No income is realized by the employee upon granting of an incentive stock option. If the transfer of stock pursuant to his exercise of an incentive stock option is a qualifying transfer, no income will be realized by the employee at the time the option is exercised. The transfer will be a qualifying transfer if both of the following requirements are met: 

(1) Holding period requirement: no disposition (defined below) of the stock may be made by the employee within two years of the date the option was granted to him, nor within one year of the date the stock was transferred to him pursuant to the option; and 

(2) Employment requirement: the transferee must be employed by the corporation granting the option (or its parent or subsidiary) at all times from the date the option was granted until three months before the date of exercise 

If an employee becomes permanently and totally disabled, the 3-month employment period is extended to 12 months In the case of the death of an employee, the employment and holding requirements are waived. 

If an incentive stock option is exercised by an individual who does not meet the employment requirement described above (except in the event of the employee’s death), there will not be a qualifying transfer and the individual will recognize compensation income in the year the option is exercised. The amount of compensation income realized will be the excess, if any, of the fair market value of the stock over the exercise price of the option. 

In other words, if the employment requirement is met, the question of whether a transfer is a qualifying transfer can be answered with certainty only after the holding periods have been satisfied. If the holding periods (and employment requirement) are met, the taxpayer’s subsequent disposition of the stock will be taxed. If the 1-year and 2-year holding periods are not eventually satisfied, ordinary income is realized as of the date the option is exercised, which is recognized (i.e., taxed), in the year of the disposition.

For purposes of the holding period requirement, “disposition” includes sales, exchanges, gifts, and transfers of legal title. But the following will not constitute a disposition: (i) a transfer from a decedent to an estate or a transfer by bequest or inheritance; (ii) certain exchanges pursuant to a corporate reorganization or exchanges of stock for stock of the same corporation or a controlled corporation; or (iii) the making of a mere pledge or hypothecation. Additionally, the acquisition of stock as a joint tenant with right of survivorship or transfer of stock to joint ownership will not constitute a disposition until the joint tenancy is terminated.

A transfer between spouses or former spouses incident to divorce also will not be considered a disposition, and the transferee spouse will receive the same tax treatment that would have applied to the transferor. The IRS determined that a transfer to a grantor trust, resulting in ownership of stock by a husband and wife with right of survivorship, did not constitute a disposition.

For purposes of the 1-year and 2-year holding period requirements, a transfer resulting from bankruptcy proceedings will not be considered a disposition. But such a transfer will be considered a disposition for purposes of the recognition of capital gain or loss.

Generally, an individual’s basis in stock acquired in a qualifying transfer upon exercise of an incentive stock option is the amount he paid to exercise the option. (If there is a disqualifying disposition, the individual’s basis is increased by amounts includable as compensation income.) 

In informational guidance released in 2002, the IRS analyzed whether the “deemed sale” election under Section 311(e) of TRA ’97 is a “disposition” within the meaning of IRC Section 424(c) under two circumstances: (1) where employees are holding incentive stock options that were granted to them prior to 2001, but that were not exercised as of January 1, 2001; (2) where employees were granted incentive stock options and exercised those options during November 2000. In the first situation, the IRS stated that there is no provision in Section 311(e) or the incentive stock option rules providing for a “deemed exercise” of the option in order to have the holding period start in 2001. In the second situation, the Service stated it appeared that any deemed sale of the stock acquired upon exercise of an incentive stock option would be treated as a disqualifying disposition for purposes of the incentive stock option rules, thus triggering the application of IRC Section 83. The Service concluded by stating that the informational guidance did not constitute a ruling on any issue. The Service also recognized that the interaction of the incentive stock option rules with the Section 311(e) election is a novel issue that the Service has not yet addressed. 

The Service has released Final Regulations relating to the required return and information statements under IRC Section 6039. 

FICA and FUTA taxes
The term “wages” excludes remuneration received on account of the following: (1) a transfer of a share of stock to any individual pursuant to an exercise of an incentive stock option; or (2) any disposition by the individual of such stock. The exclusion applies to stock acquired pursuant to options exercised after October 22, 2004. [Proposed regulations provided that an individual exercising an incentive stock option would receive wages for FICA and FUTA purposes. But in 2002, the IRS announced that until further guidance was issued, the Service would not assess the FICA or FUTA tax, or apply federal income tax withholding obligations, upon the exercise of the option or the disposition of the stock acquired by an employee pursuant to the exercise of an option. In AJCA 2004, Congress codified the exclusionary rule, above.]

Alternative Minimum Tax 
For purposes of the alternative minimum tax, the excess of the fair market value of the stock on the date of exercise of the option over the exercise price will be added to alternative minimum taxable income in the year the option is exercised, provided the taxpayer’s rights are not subject to a substantial risk of forfeiture. But if the taxpayer is subject to the alternative minimum tax, his basis in the stock for alternative minimum tax purposes will be increased by the amount included in income. A taxpayer with unvested stock may wish to make a special election under IRC Section 83(b) to include in his gross income for the taxable year an amount equal to the excess of the fair market value of the property at the time it was transferred over the amount (if any) paid for such property. By making the special election, the adjustment for AMT purposes will be reported in the year the election is made instead of the year the stock actually vests. This may be beneficial if the stock price is expected to significantly appreciate before the stock vests.

The Service has stated that for tax years in which a taxpayer is liable for both incentive stock option AMT and non-incentive stock option AMT, it would apply the taxpayer’s payments first to the non-incentive stock option liabilities and related interest and penalties (if any). 

2008 legislative relief for incentive stock options. As noted above, under the AMT a taxpayer must pay tax on the stock value when the option is exercised. The economic downturn in 2000 resulted in many individuals having to pay tax on “phantom income” because the stock prices dropped dramatically since the date of exercise. Congress provided relief for these situations in 2006, but recognized that additional relief was still needed to correct this problem. The Tax Extenders and Alternative Minimum Tax Relief Act of 2008 addressed problems concerning the treatment of certain underpayments, interest, and penalties attributable to the treatment of incentive stock options. The Act provided relief by (1) abating any underpayment of tax outstanding on the date of enactment related to incentive stock options and the AMT, including interest; (2) eliminating the income phase-out; and (3) extending and modifying the AMT credit allowance against incentive stock options.

For further details and citations on this topic, we invite you to sign up for a 15-day free trial of Tax Facts Online by clicking here.

Concerned about estate planning in light of the possible termination of the Bush-era tax cuts? Join AdvisorOne sister publication Tax Facts Online on March 7 at 2:00 PM EST for a free case-study webinar on “Estate Planning with Exemption Uncertainty.”

To purchase the 2012 Tax Facts on Insurance & Employee Benefits books, please click here. And to sign up for a free Tax Facts Online product demonstration webinar on  March 28 at 2 PM EST, please click here.

See all six articles from Tax Facts Online, part of AdvisorOne's 22 Days of Tax Planning for 2012 Special Report.

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