IRS Updates Incentive Stock Options Do's and Don'ts

June 9, 2003 (PLANSPONSOR.com) - The Internal Revenue Service is updating the list of do's and don'ts when it comes to issuing and tracking incentive stock options.

>Once finalized, the new proposed regulations (REG-122917-02) will replace the nearly 20-year-old proposed rules for the incentive options, according to Washington-based legal publisher BNA. In addition to covering options issues under tax code Sections 421, Section 422 and Section 424, the proposed regulatory scheme is also renumbered and reorganized, according to the BNA.

>The new Section 421 regulations strip away obsolete provisions and update cross-references to reflect amendments to the applicable statutes and reorganization of the regulations. They would provide that there must be evidence of the option grant on paper or electronically. There also must be either a written or electronic plan document for the plan under which the options are granted, provided that the paper or electronic form establishes an enforceable plan.

IRS also said that the form used for the option or plan, whether paper or electronic, must be one that provides adequate substantiation of the applicability of Section 421, including the date on which the option is granted, the number of shares subject to the option, and the option price.

The taxpayer must also retain records relating to the option that are sufficient to comply with Section 6001. IRS said if these records are kept electronically, they must meet the requirements of Revenue Procedure 97-22 (1997-1 C.B. 652), or subsequent guidance, and if the records are kept in an actual deferral percentage (ADP) system, the records must meet the requirements of Revenue Procedure 98-25 (1998-11 I.R.B. 7), or subsequent guidance.

Treating Disqualifying Dispositions

On the issue of disqualifying dispositions, the new proposed rules mandate that the special tax treatment provided by tax code Section 421 does not apply to the transfer of the shares if there is a disqualifying disposition of a share of stock. Instead, the exercise of the option is treated as the exercise of a nonstatutory option.

So, in the taxable year in which the disqualifying disposition occurs, the individual must recognize compensation income equal to the fair market value of the stock on the date the stock is transferred less the exercise price, IRS said. A deduction attributable to the transfer of the share of stock pursuant to the exercise of the option is allowable for the taxable year in which such disqualifying disposition occurs, to the employer corporation, its parent or subsidiary corporation, or a corporation substituting or assuming an option in a transaction to which Treasury Code Section 1.424-1(a) applies, if otherwise allowable under tax code Sections 83(h) and 162 and if the requirements of Treasury Code Section 1.83-6(a) are met.

Regarding stockholder approval of incentive stock option plans, IRS said the proposed regulations would provide the same basic requirements for stockholder approval as those included in the proposed 1984 regulations. The new proposed rules would provide, however, additional guidance regarding when stockholder approval is required and a more complete list of situations that require new stockholder approval of the plan by specifically including a change in the shares with respect to which options are issued or a change in the granting corporation.

The new proposed regulations also expand on previous guidance by providing that an option that otherwise qualifies as an incentive stock option nevertheless fails to be an incentive stock option to the extent the $100,000 limitation is exceeded.

Rules the Same in Some Cases

Also included in the new proposed regulations is guidance on additional provisions that might be included in an incentive stock option, including permitting cashless exercise, providing the right to receive additional compensation, and providing alternative rights. IRS said the proposed regulations essentially retain the rules described in the proposed 1984 regulations in each of these cases.

Also, the new proposed regulations would provide additional guidance regarding a change to an option and whether it constitutes a modification. Under the regulations, both a provision under an option that provides that the option holder may receive an additional benefit at the future discretion of the granting corporation and the exercise of that discretion are considered modification of the option, just as they are under the proposed 1984 rules. However, under the new proposed rules, it is not a modification for the granting corporation to exercise discretion related to the payment of a bonus at the time of the exercise of the option, the availability of a loan at exercise, or the right to tender previously owned stock for the stock purchasable under the option. A change to an option adding such discretion, however, would be a modification, IRS said.

The proposed, temporary, and final rules are in the  June 9 Federal Register .

Comments on the proposed incentive stock option rules should be sent to CC:PA:RU (REG-122917-02), Room 5226, IRS, P.O. Box 7604, Ben Franklin Station, Washington, D.C. 20044; or delivered to CC:PA:RU (REG-122917-02), Courier’s Desk, IRS, 1111 Constitution Ave. N.W., Washington, D.C.

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