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Incentive Stock Options Revisited

I. Introduction

There is increasing interest among corporate employers in the use of incentive stock options (or "ISO's") qualifying under Section 422 of the Internal Revenue Code of 1986, as amended (the "Code") as a part of employee compensation. Like other types of options, ISO's provide a reward to employees which is tied directly to the value of the stock of the corporate employer, thereby providing employees with an incentive to improve the corporation's overall performance.

From an employee's perspective, ISO's offer generally more favorable tax treatment than non-qualified stock options and other equity-based compensation such as restricted stock. If specific requirements (described below) are satisfied, the gain realized by an employee upon exercise of an ISO is not subject to tax at that time, and no gain is recognized for as long as the shares are not sold or otherwise disposed of. Moreover, if an individual exercising an ISO holds the shares so acquired until death, the excess of the fair market value of the stock over its basis will escape income tax entirely by reason of the step-up of basis at death. If and when shares acquired by an employee through the exercise of an ISO are sold by that individual for an amount exceeding cost, the amount realized, as reduced by the holder's basis for the shares, is taken into account as capital gain if the shares are capital assets in the hands of the holder (as is generally the case).

The employer corporation does not receive a deduction in connection with the grant or, in general, the exercise of an ISO. As compared to employee stock purchase plans qualifying under Code section 423 and other tax- qualified plan arrangements, however, ISO's offer greater flexibility because they are not subject to minimum participation and nondiscrimination rules. Thus, a corporation can direct the grant of ISO's to those employees who are most valuable or most in need of an incentive linked to company performance, and to those employees most likely to benefit from the special tax characteristics of ISO's.

Incentive stock options have become more attractive recently for several reasons. The strong stock market performance over the past decade has fueled interest in stock options and other forms of equity-based compensation. Also, senior management appears to be increasingly of the view that, to improve overall business performance, the rewards associated with improved results should be shared broadly among employees rather than limited to the most senior executives.⁽¹⁾ Incentive stock options are attractive and readily understood to managers and others as an opportunity to participate in corporate growth. Also, as compared to performance-based compensation payable in cash, stock options do not adversely affect cash flow and, generally, do not detract significantly from corporate earnings as computed for accounting purposes.

Finally, the increasing rates of tax on ordinary income over the past decade (now approaching 50% for some individuals in the top brackets who are also subject to state and local income taxes), when coupled with recent reductions in tax rates on capital gains and increasing sophistication regarding the means and potential benefits of deferring the recognition of gain indefinitely, have substantially enhanced the appeal of ISO's as compared to nonqualified stock options -- with respect to which gain must be taken into account as ordinary income at the time of exercise.

The case for ISO's is even more compelling for start-up or other corporations with no current taxable income or substantial net operating loss carryovers, for which the unavailability of tax deductions upon the grant or exercise of ISO's is less significant.

Part II of the discussion below describes the basic rules relating to the grant of ISO's, and Part III discusses certain requirements relating to the exercise of such options. Part IV addresses the tax consequences of the exercise of ISO's in more detail, including the adverse consequences of an early sale or other disposition of stock acquired through the exercise of an ISO. Finally, Part V discusses the potential additional benefit of providing in the option plan for the use of previously acquired shares of employer stock to pay the exercise price under an ISO, and addresses other means of facilitating the exercise of ISO's by employees.

II. ISO Qualification Requirements

Limited to Employees

An option to purchase stock can qualify as an ISO only if the option is granted to an individual in connection with the individual's employment by a corporation, and only if granted by the employer corporation or its parent or subsidiary corporation (that is, a corporation in an ownership chain beginning or ending with the employer corporation, with each corporation linked to the others by not less than 50% stock ownership as determined by voting power). The option must grant the holder the right to purchase stock in the employer corporation or its parent or subsidiary.

Taking into account the increasing use by corporations of partnerships and limited liability companies for joint ventures, it is noteworthy that, under this rule, ISO's cannot be granted to employees of partnerships (or other entities, such as limited liability companies, that are treated as partnerships for tax purposes), even if the partnership is controlled by a corporation that has adopted or could adopt an ISO plan. It is hoped that future legislation will correct this apparent oversight.

Adoption of Plan

Incentive stock options must be granted pursuant to a plan that must be approved by the shareholders of the corporation granting the options within 12 months before or after the date on which the plan is adopted.⁽²⁾ The plan must specify the aggregate number of shares of stock that may be issued under options and the employees or class of employees eligible to receive options. The plan need not, and typically does not specify the individuals to receive options, with that responsibility usually being delegated to a person or committee appointed pursuant to the plan.

Maximum Term of Plan and Options

Each ISO granted under a plan must be issued within 10 years after the adoption of the plan; and an ISO must, by its terms, not be exercisable after the 10th anniversary of the date of grant.⁽³⁾

Exercise Price

For an option to qualify as an ISO, the exercise price cannot be less than the fair market value of the stock at the time the option is granted.⁽⁴⁾ For publicly traded shares, fair market value may be determined by reference to market prices.

Compliance with this pricing requirement is obviously more difficult where the underlying stock is not publicly traded. So long as a good faith attempt is made to comply with this requirement, the requirement will be considered to be met even if the fair market value of the shares subject to an ISO is ultimately determined to be higher than the exercise price.⁽⁵⁾ Thus, where options are being issued with respect to non-publicly traded stock, it is important to make a good faith effort to value the stock at the time of grant of the option (by reference, perhaps, to a valuation formula based on a reasonable multiple of earnings or sales), and to maintain records documenting the derivation of fair market value.

Nontransferability

The ISO must by its terms be nontransferable by the employee except by will or the laws of descent and distribution.⁽⁶⁾ Upon an employee's death, the ISO may pass under the will or by the laws of intestacy, and the executor of the estate or other distributee may exercise the ISO.

Stock Ownership

In general, an ISO cannot be granted to an individual who, at the time of grant, owns stock having more than 10% of the combined voting power of all classes of stock of the employer corporation or of its parent or subsidiary corporation. Stock ownership attribution rules apply in determining whether an individual is a 10% stockholder.⁽⁷⁾ This limitation obviously discourages the adoption of an ISO plan principally for the benefit of employees who are also substantial shareholders. The limitation does not apply, however, to the grant of an option if the exercise price is at least 110% of fair market value of the shares (as determined at the time of grant) and if the option ceases to be exercisable on or before the fifth anniversary of the date of grant.⁽⁸⁾

Restriction on Quantity of Shares Subject to ISO

Perhaps the most confusing ISO restriction is the limitation, applied on an annual basis, on the number of shares that may be purchased by an employee under options that first become exercisable in a particular year. Specifically, the fair market value of shares with respect to which ISO's may first become exercisable in any one year (under all plans of the employer corporation and its parent and subsidiary corporations) cannot exceed $100,000.⁽⁹⁾ To the extent that options otherwise qualifying as ISO's exceed this limitation, the excess options are treated as options which are not ISO's. For purposes of computing the limitation, the fair market value of the stock is determined as of the date the ISO is granted.

If the exercise price of each ISO granted under an employer's plan is equal to the fair market value of the underlying shares of stock at the time of grant (a common situation, although ISO's with exercise prices in excess of current fair market value are obviously permissible), then compliance with the limit can be tested by comparing $100,000 to the sum, for all of the ISO's of an employee that are first exercisable in a particular year, of the product of (i) the number of shares with respect to which each such ISO becomes exercisable in that year, multiplied by (ii) the exercise price per share. The qualification of an ISO under this restriction can be determined when the ISO is granted, since the fair market value of the shares subject to an ISO at the time of exercise is not relevant to this determination.

An example may make this limitation clearer. Assume that, upon the adoption of an ISO plan, the stock of an employer corporation has a fair market value of $20 per share. The corporation may then grant to an employee an ISO, exercisable immediately or after a specified interval, to purchase up to 5,000 shares of stock (5,000 x $20 = $100,000). If the corporation wants to grant to the employee an ISO with respect to a greater quantity of shares, an ISO could be granted which is exercisable over a multi-year interval; e.g., for a total of 10,000 shares, exercisable to the extent of 5,000 shares per year.

If a corporation grants to an employee ISO's first becoming exercisable in a single year that relate to shares with a combined fair market value that exceeds $100,000, the rule precluding options on shares in excess of $100,000 per year from qualifying as ISO's is applied by taking options into account in the order in which they were granted.⁽¹⁰⁾

Designation

An option will not be treated as an ISO if, at the time it is granted, the terms of the option provide that it will not be treated as an ISO.⁽¹¹⁾ Very often plans are adopted that authorize the grant of both ISO's and nonqualified options. Particularly (but not exclusively) in the context of granting options under such "dual" plans, the agreement or letter evidencing the grant of the option should state whether or not it is intended that the option be treated as an ISO.⁽¹²⁾

III. Other Requirements

The favorable tax treatment associated with ISO's will not be obtained, in general, unless the individual exercising the ISO is an employee of the corporation granting the option or of its parent or subsidiary corporation at all times during the period between the time the option is granted and the day which is three months before the option is exercised.⁽¹³⁾ Thus, an employee terminating employment has three months from the date of termination to exercise an ISO option as such, unless the terms of the option specify that it lapses within a shorter period.

If an employee becomes permanently and totally disabled, that individual may exercise an ISO as such at any time within one year after ceasing to be an employee. Also, the continued employment requirement described in the immediately preceding paragraph does not apply with respect to the exercise of an ISO by an employee's estate or other distributee following the death of the employee.⁽¹⁴⁾

The agreement or letter evidencing the grant of an ISO may set forth other restrictions on the exercise of the option, or on the disposition of shares acquired through the exercise of the option. Thus, options may be made exercisable only after a specified time interval, or after certain performance goals have been attained; and the stock sold under an ISO may be subjected to restrictions on transfer, including a provision permitting or requiring the employer to buy the stock back under specified circumstances.

IV. Consequences of Exercise of ISO's

In General

Generally, the holder of an ISO does not include any amount in income upon the receipt of shares pursuant to the exercise of the option, and the employer corporation is not allowed any deduction upon the transfer of the shares. The amount paid for the shares becomes the ISO holder's basis in the shares so acquired.⁽¹⁵⁾

Assuming that there has not been a "disqualifying disposition" of the shares (see below), and that the shares are held by the purchaser as a capital asset (which is generally the case), the sale or other disposition of the shares in a taxable transaction will result in a capital gain or loss to the holder. Under the Code as amended in 1997, if the shares are held for more than 18 months, the current maximum stated rate of federal income tax on gain from the disposition of the shares will be 20%. For certain taxpayers having taxable income that would (without regard to the special rates applicable to capital gains) be taxed at a rate below 28%, the maximum rate of tax on capital gains is currently 10%.

The employer or other corporation transferring stock pursuant to the exercise of an ISO must file an information return and must provide to the transferee, by January 31 of the calendar year following the transfer, a written statement with specified information relating to each transfer.⁽¹⁶⁾

Disqualifying Dispositions

A "disqualifying disposition" occurs if shares acquired by an individual through the exercise of an ISO are sold or otherwise disposed of by the individual within two years after the grant of the option or within one year after the transfer of shares to the individual pursuant to the ISO.⁽¹⁷⁾ In that event, under the rules governing the tax treatment of nonqualified options, the fair market value of the shares of stock on the date of exercise, as reduced by the amount paid for the shares, is included in the income of the employee as compensation; and the employer takes the same amount into account as compensation expense.⁽¹⁸⁾ The compensation income and expense is taken into account in the taxable years of the individual and the corporation in which the nonqualifying disposition occurred.⁽¹⁹⁾

Alternative Minimum Tax

The alternative minimum tax (or "AMT") provisions of the Code impose an additional income tax equal to the excess, if any, of (i) the product of the taxpayer's "alternative minimum taxable income," or "AMTI," as multiplied (after subtraction of an exemption amount) by specified rates (26%-28% for noncorporate taxpayers), over (ii) the taxpayer's "regular tax" for the year.⁽²⁰⁾ Alternative minimum taxable income is determined by reference to taxable income with specified adjustments. One of the adjustments applicable in computing an individual's AMTI is that the gain realized upon the transfer of shares of stock pursuant to the exercise of an ISO is taken into account under the regular rules applicable to nonqualified options, rather than under the ISO rules. Thus, the excess of the fair market value of the shares acquired on exercise over the amount paid for the shares is includible at the time of exercise in the individual's AMTI.

If an individual is required to pay additional tax in the year of exercise by reason of the AMT, an offsetting tax credit may be available in a later year or years in which the individual's regular tax liability exceeds the individual's tentative tax under the minimum tax provisions.⁽²¹⁾ This credit can be carried over indefinitely. The computations required under the credit provisions are complex, however, and the credit appears to expire if not used during the taxpayer's lifetime. For these reasons as well as time-value-of-money considerations, many people attempt to spread the exercise of ISO's in such a manner as to avoid triggering an AMT liability.

V. Facilitating the Exercise of ISO's

In preparing an ISO plan, consideration should be given to possible means of facilitating the exercise of ISO's by employees. Two techniques for encouraging employees to exercise ISO's -- permitting employer stock to be transferred by the employee to the issuer of the option in payment of the exercise price, and lending funds to employees to finance the purchase of shares -- are discussed below.

Note that some of the most popular measures for facilitating the exercise of options by employees with limited funds -- e.g., so-called "cashless exercise" programs, often involving the financing of the exercise price through a broker and an immediate sale of the shares so purchased to the extent necessary to pay the loan -- do not work well in the ISO context because of the ISO holding period requirements. The person exercising the ISO must hold the shares so acquired for a full year after purchase (and 2 full years after the option was granted) in order to avoid inclusion in income of the built-in gain (as of the time of exercise) as compensation; and, to obtain the benefit of the most favorable capital gains rates now available, the shares must not be sold until more than 18 months after purchase. (Even lower capital gains rates are to apply to certain dispositions after the year 2000 of property held for more than five years.) Thus, from a tax perspective, the exercise of ISO's is most advantageous for employees willing and able to hold the shares so acquired for substantial periods of time.

Also, the alternatives for payment of the option exercise price that are to be offered under an option plan should be considered before the option plan is adopted and, generally, should be set forth in the plan itself. If, for example, a plan provides that the option exercise price must be paid in cash in all instances, and it is later desired to permit the exercise price to be paid through the transfer of employer stock by the employee to the employer, an amendment to the plan may be necessary. Such an amendment may be treated as the grant of a new option to each holder of an ISO affected by the amendment.⁽²²⁾ Those options will then continue to qualify as ISO's only if they meet the pricing and other requirements of the ISO provisions at the time of the amendment.

Thus, but for certain specific plan or option modifications which, by statute, are not considered to result in the grant of a new option, the amendment or other modification of existing options should generally be avoided. Therefore, every effort should be made to include in the option plan as originally adopted any special features that may ultimately be desired with respect to the exercise of options granted under the plan.

Use of Stock of the Granting Corporation

An ISO to purchase shares of stock of the employer corporation may permit an employee to pay the exercise price with other shares of stock of the same corporation. When an employee uses stock previously acquired to exercise an ISO, the shares transferred by the employee to the issuer of the option are deemed to have been exchanged for an equal number of shares from the ISO issuer, in an exchange with respect to which no income or gain is recognized if the holding periods applicable in the ISO context are met.⁽²³⁾ Thus, an ISO holder with previously acquired shares can use those shares to exercise the ISO without triggering the recognition of gain or incurring borrowing costs.

If the exercise price is paid in the form of shares of employer stock, the employee's basis in the shares of stock treated as having been acquired in exchange for the shares previously held is equal to the basis of the employee in the previously acquired shares. The employee's holding period for the shares acquired in the exchange includes that which the employee had in the shares transferred to the employer. The employee's basis in the additional shares of stock acquired by reason of the exercise of the ISO is zero, and the holding period for the additional shares begins at the time of the purchase pursuant to the option.

The Service has ruled in at least one private letter ruling that an employee's constructive, but not actual, surrender of stock of the employer corporation to exercise an ISO will be treated as an actual exchange for tax purposes -- avoiding the need for an actual tender of those shares.⁽²⁴⁾

The following example illustrates the consequences of the use of previously acquired stock of an employer to exercise an ISO. Assume that an individual employed by a corporation owns 1,000 shares of the stock of the employer, purchased on the open market, with a basis of $10 per share; that the current fair market value of the stock is $40 per share; and that the employee also has an ISO to purchase 400 shares of the employer's stock for $20 per share. If the option permits the use of stock to pay the exercise price for the option, the employee may exercise the ISO and acquire 400 shares of employer stock, for aggregate consideration of $8,000, by tendering 200 shares. The employee will have a substituted basis of $10 per share in 200 shares of the newly acquired stock, and a basis of zero in the other 200 shares acquired.

If stock acquired through the exercise of an ISO ("option stock") is used to exercise an ISO, and the stock holding period requirements for ISO treatment (that is, no disposition within two years after the grant of the option or within one year after the transfer of shares to the optionee pursuant to the option) are not met, the use of the option stock to exercise the ISO will constitute a nonqualified disposition of those shares. Therefore, the employee will recognize ordinary income upon the disposition of the option stock used in the exercise, generally to the extent of the excess of the fair market value of the shares over the amount paid for the option stock.⁽²⁵⁾ Under proposed regulations, however, by reason of Code section 1036 no additional gain will be recognized if the value of the option stock at the time of disposition exceeds the amount taken into account as ordinary income because of the early disposition.⁽²⁶⁾

If an ISO is exercised with previously acquired shares, resulting in a basis allocation between shares deemed acquired in exchange under section 1036 and other shares as described above, and there is then a disqualifying disposition of some of the shares acquired pursuant to the ISO, the stock with the lowest basis is deemed to be disposed of.⁽²⁷⁾

Where employees are permitted to exercise ISO's with previously acquired stock, some employers have granted "reload" options to providing the employees with the right to purchase a quantity of shares equal to that surrendered to the corporation in connection with the ISO exercise. The reload option preserves an employee's opportunity to benefit, to the same extent as before the exercise, from further appreciation in the stock of the employer.

Loans From the Granting Corporation

Another means of facilitating the exercise of options is to offer loans to employees of all or a portion of the funds needed to exercise the options. Such loans should, however, be approached with caution. Any such loan by an employer or affiliate should be properly documented with a promissory note, and be made on arm's length terms and with adequate security (perhaps including a pledge of the shares purchased), so as to minimize the risk that the loan transaction may be recharacterized by the Internal Revenue Service as the payment of additional compensation or (in certain circumstances) as a dividend. Also, if the exercise price is lent on a nonrecourse basis secured only by the shares acquired, there may, depending on the circumstances, be some uncertainty as to whether the employee has in substance purchased the shares pursuant to the ISO, or merely entered into an option to acquire the shares upon payment of the purported debt.⁽²⁸⁾

VI. Conclusion

As compared to nonqualified stock options, ISO's offer significant advantages for employees and merit serious consideration as an addition or alternative to nonqualified options and other types of equity compensation arrangements. If the requirements imposed by the Code relating to the grant and exercise of ISO's pursuant to the plan are met, an employee:

• will not be required to include any amount in the employee's income upon the exercise of an ISO;
• will defer the recognition of any gain with respect to the shares so acquired, for so long as the employee does not dispose of the shares; and,
• upon any ultimate sale of the shares, will generally take any gain into account as capital gain.

Employees can achieve an extra element of gain deferral by exercising an ISO with stock of the employer corporation.

From the employer's perspective, ISO's provide the same non-tax benefits as nonqualified options, by linking the employee's personal financial interest to the value of the stock of the corporation and thereby providing employees with a direct incentive to contribute to corporate performance. Incentive stock options also, by reason of their particular tax characteristics, provide to employees a strong incentive to retain the shares acquired through the exercise of such options, thereby strengthening employees' long-term interest in the continued prosperity of their employer.

Taking into account the expanding differential between the tax rates applicable to compensation taxable as ordinary income and the rates applicable to capital gains, the advantages of ISO's will in many cases exceed any detriment to the corporation from the loss of deductions upon the exercise of stock options. Thus, ISO's are becoming more attractive as an element of employee compensation.

FOOTNOTES____________________

1. See, P&G Plans to Offer Its Stock Options To Nearly All Workers, Wall Street Journal, Nov. 7, 1997, at B9, col. 3.

2. IRC Search7RH422(b)(1).

3. IRC Search7RH422(b).

4. IRC Search7RH422(b)(4).

5. IRC Search7RH422(c)(1).

6. IRC Search7RH422(b)(5).

7. IRC Search7RH424(d).

8. IRC Search7RH422(c)(5); Temporary Reg. Search7RH14a.422A-1, A-2(c)(6).

9. IRC Search7RH422(d).

10. If a stock option plan authorizes both ISO's and nonqualified options, and the aggregate fair market value of the options to be issued to an employee for exercise beginning in the same year will exceed $100,000, some of the options may be designated as ISO's and others as nonqualified options.

11. IRC Search7RH422(b) (last sentence).

12. Temporary Reg. Search7RH14a.422A-1, A-20.

13. IRC Search7RH422(a)(2).

14. IRC Search7RH421(c)(1).

15. IRC Search7RHSearch7RH421(a)(1), 1012.

16. IRC Search7RH6039; Reg. Search7RHSearch7RH1.6039-1, 1.6039-2.

17. IRC Search7RHSearch7RH421(b), 422(a).

18. See Reg. Search7RHSearch7RH1.83-6(a)(1), 1.83-7(a).

19. IRC Search7RH421(b).

20. IRC Search7RH55.

21. IRC Search7RH53.

22. See IRC Search7RH424(h).

23. See IRC Search7RH1036; Proposed Reg. Search7RH1.422A-2(i)(1); Rev. Rul. 80-244, 1980-2 C.B. 234. For a more extensive discussion of the consequences of the use of stock to exercise an ISO, see Norman J. Misher, Tax Consequences of Exercising An Incentive Stock Option with Stock of the Granting Corporation, 36 The Tax Executive 357 (July, 1984).

24. PLR 9736040 (June 10, 1997).

25. IRC Search7RH424(c)(3). If there is a disqualifying disposition (whether or not relating to the exercise of another ISO), and the disposition is a sale or exchange with respect to which a loss would, if sustained, be recognized to the individual, the amount of compensation includible in the employee's income -- and the employer's related deduction for compensation expense -- is limited to the excess of the amount realized over the adjusted basis for the shares. For example, if stock with a value of $25 per share is acquired pursuant to the exercise of an ISO for $10 per share, and the shares are sold to a third party six months later in a disqualifying disposition for an amount realized of $20 per share, the amount includible in the employee's income as compensation, and potentially deductible by the employer, is limited to $10 per share.

26. See Proposed Reg. Search7RH1.422A-2(i)(4), Ex. 3.

27. Proposed Reg. Search7RH1.422A-2(i)(1)(ii).

28. See Reg. Search7RH1.83-3(a)(2).