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Keeping Your Options Open: Highlights From the IRS Final Regulations on Incentive Stock Options and Practical Guidance

Update
09.17.2004

In August 2004, the Internal Revenue Service issued final regulations relating to incentive stock options (ISOs). Although the final regulations are similar to the proposed ISO regulations published last year, the final regulations contain important guidance and changes relating to a number of issues affecting ISOs.

This Update summarizes some of the highlights of the final regulations and offers practical guidance.

Guidance on Tax Treatment of Early Exercise ISOs

Disqualifying Dispositions and Section 83. The final regulations clarify the application of the disqualifying disposition rules to the receipt of unvested shares upon exercise (commonly known as an "early exercise") of an ISO.

    • Background Regarding ISO Holding Periods. For an option to qualify as an ISO, the optionee must not dispose of the stock received upon exercise within the two-year period from the date the option was granted or the one-year period from the date of exercise. Any disposition within these periods is considered a disqualifying disposition, and generally results in the recognition of ordinary income.

    • Section 83(b) Election Not Available (Other Than for AMT). The final regulations provide that, in connection with an early exercise, the optionee may not make an 83(b) election with respect to the unvested shares for purposes of determining the amount and timing of the optionee's income upon a disqualifying disposition. In the event of a disqualifying disposition, the optionee's compensation income is determined by reference to the value of the stock on the vesting date, rather than on the exercise date, and the optionee's holding period for capital gains purposes begins upon the vesting date, rather than on the exercise date.
ISO Holding Periods and AMT. The final regulations contain two other important clarifications relating to the early exercise of an ISO.
    • One-year ISO Holding Period Begins at Exercise. The one-year ISO holding period (the one-year period described above for determining whether or not a disqualifying disposition has occurred) begins at the time of exercise, notwithstanding the fact that the shares are unvested.

    • Section 83(b) Election Available for AMT. Optionees may make an 83(b) election for purposes of determining the alternative minimum tax consequences of the exercise of the option.

Practical Tip

Review Tax Information Provided to Employees. Companies that permit early exercises of ISOs should review any information regarding the tax consequences of the early exercise provided to optionees to verify that the information is consistent with the final regulations. These companies should also advise employees to discuss the consequences of early exercises of ISOs with their tax advisors prior to any early exercise.

Shareholder Approval in Corporate Transactions

Approval of Acquiring Company's Shareholders in Corporate Transaction Not Necessarily Required to Preserve ISO Status. ISOs must be issued under a plan that has been approved by the shareholders of the granting corporation. The proposed regulations contained a much-criticized requirement that outstanding ISOs assumed or substituted in connection with certain corporate transactions (including mergers, consolidations, stock or asset acquisitions, separations, reorganizations or liquidations) be issued under a plan approved by the shareholders of the acquiring company in order to retain ISO status. The final regulations do not impose this additional approval requirement. If the granting corporation satisfied the shareholder approval requirements, the outstanding options assumed or substituted by the acquiring company in a corporate transaction remain ISOs without separate approval by the acquiring company's shareholders.

Acquiring Company's Shareholders Must Approve Acquired Company's Plan for Future ISO Grants. Under the final regulations, approval by the acquiring company's shareholders generally continues to be required in corporate transactions if the acquiring company desires to make future grants of ISOs with respect to acquiring company shares under the ISO plan of the acquired company. For this purpose, shareholder approval is deemed to be satisfied if the transaction is approved by the acquiring company's shareholders and the definitive acquisition agreement describes the terms of the acquired company's plan.

Practical Tip

Bootstrap Target Plan Approval, When Possible. As a practical matter, the opportunity to continue an acquired company's ISO plan with respect to future ISO grants will be limited to mergers of equals (because many acquisitions are intentionally structured to avoid approval by the acquiring company's shareholders). Nevertheless, in the limited circumstances where shareholder approval of both companies is obtained, consider whether to provide for future ISO grants under the acquired company's ISO plan following the acquisition by describing of the terms of the acquired company's ISO plan in the acquisition agreement that is approved by the acquiring company's shareholders.

ISO Plan Must State Maximum Aggregate Number of Shares That May Be Issued as ISOs

Final Regulations Do Not Require Separate Limits for Each Type of Award. An ISO plan must include a provision stating the aggregate number of shares that may be issued as options under the plan. The proposed regulations provided that the maximum number of all shares that could possibly be issued under a plan had to be designated in the plan, including shares that may be issued through ISOs, nonqualified stock options and all other stock-based awards. Under the final regulations, companies need only designate the maximum aggregate number of shares that may be issued as ISOs under the plan.

Practical Tip

Separate ISO Limit Not Required Where Plan Has Overall Limit. The application of the final regulations is not entirely clear with respect to plans that contain an overall share limit, but do not contain a limit specific to ISOs. However, we understand that the Internal Revenue Service only intended to require a separate ISO limit for plans that do not contain an overall share limit, and that a technical correction to the regulations will clarify this issue.

Net Share Counting Provisions Permitted. The final regulations also clarify that only the net number of shares actually issued to the optionee upon exercise need to be counted against the maximum aggregate number of shares that may be issued under the plan as ISOs. Under this interpretation, a plan may provide that if an optionee uses shares (whether the shares are "mature" or obtained upon exercise of the option through a cashless exercise procedure) to pay the exercise price and withholding taxes, those shares are not counted against the maximum aggregate number of shares that may be issued as ISOs under the plan.

Guidance on Which Changes Are "Modifications" That Affect ISO Status

Exercising Existing Discretion Is Not a Modification, but Adding the Ability to Exercise Discretion in the Future Is a Modification. ISOs may lose their ISO status, and be treated as nonqualified stock options for tax purposes, if they are modified, which generally includes any change in the terms of an ISO that provides additional benefits to the optionee. The final regulations clarify when a modification has occurred.

    • Adding the Ability to Exercise Discretion in the Future Is a Modification. A change to an option that may provide the optionee with additional benefits at the future discretion of the granting corporation is considered a modification.

    • Exercising Existing Discretion Is Not a Modification. No modification occurs where a granting corporation exercises discretion that it has specifically reserved with respect to certain benefits, including the payment of a bonus at the time of the exercise, the availability of a loan at exercise, the right to tender previously owned stock in payment of the exercise price, or the payment of employment taxes or withholding taxes resulting from exercise.

    • Offer to Change Terms of ISO Only a Modification if Accepted or Outstanding for 30 Days or More. A modification does not occur simply because a company offers to change the terms of an option if the optionee does not accept the change, unless the offer remains outstanding for 30 days or more.

    • Inadvertent Modifications May Be Corrected. The final regulations also provide that inadvertent modifications will not be treated as modifications to the extent the change is reversed before exercise or the last day of the calendar year, whichever is earlier.

Practical Tip

Review Plans to Maximize Flexibility. Companies should consider reviewing their plans to ensure that the company has the ability to exercise the maximum amount of discretion permitted by the final regulations with respect to modifications of ISOs. However, any changes in the terms of the plan should apply only to ISOs granted after the changes are effective.

Consider Use of Limited Cash-Out Offers. The final regulations clarify that a cash-out offer to optionees, which may be beneficial in connection with certain corporate transactions, that is outstanding for less than 30 days can be made without jeopardizing the ISO treatment for those who do not elect to cash out, even if a cash-out provision was not part of the original option grant or plan.

Effective Date and Transition Rules

Companies May Rely on Proposed or Final Regulations for Transition Period. The final regulations became effective August 3, 2004. However, taxpayers generally may continue to rely on the 2003 proposed regulations (and, in some circumstances, prior proposed regulations) until the earlier of:

    • January 1, 2006; or

    • the granting corporation's first regularly scheduled shareholders meeting occurring at least six months after August 3, 2004.

Final Effective Date. After December 31, 2005, all taxpayers must follow the final regulations.

Proposed or Final Regulations to Be Applied Consistently. During the interim period before the final regulations become effective with respect to a particular company, all ISOs the company grants must be treated consistently, and taxpayers must rely on a particular set of regulations in their entirety.

Additional Information

This Update is only intended to provide a brief summary of certain aspects of the final ISO regulations. You can find the full text of the final regulations at http://www.treasury.gov/press-center/press-releases/Documents/isofinalregstd9144.pdf.

You can find additional information regarding recent developments and recent laws, regulations and rule proposals of interest to public companies on our website.