Guest Article
(From the August 9, 2004 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)
IRS Issues Final Incentive Stock Option Regulations
The final regulations providing guidance on incentive stock options ("ISOs") were released on
Monday, August 2, 2004. 69 FR 46401 (August 3, 2004). Except for a few clarifications and
modifications, the final regulations are essentially the same as the proposed regulations issued
June 9, 2003, which reorganized and updated the previous confusing mix of proposed, temporary
and final regulations, as well as other guidance.
The major changes of interest are as follows:
- Maximum number of shares: One of the conditions for an ISO is that it be issued under a
plan "which includes the aggregate number of shares which may be issued under
options." It is very common for plans to provide for the issuance of ISOs, non-ISO
options and other forms of equity-based compensation. The 2003 proposed regulations
stated that a plan satisfied this condition only if it set forth the total number of shares that
could be issued for any reason. It was not necessary to specify the number that could be
issued through the exercise of ISOs. The final regulations reverse this stance, requiring a
separate ISO limit.
This change in particular will require companies maintaining equity compensation plans
to take action. A plan that states merely an overall plan limit on shares that is not specific
to ISOs will have to be amended to provide for a limit specific to ISOs. Further, such an
amendment will need to be submitted for shareholder approval, since shareholder
approval is required for amendments changing the number of shares that can be issued.
However, since the final regulations are not immediately effective, action is not required
immediately. See the discussion below on the effective date.
- "Net" shares and the overall plan limit: The final regulations change the rule for how
shares are counted against the aggregate limit for ISOs. The final regulations provide
that only the net number of shares issued as a result of the exercise of the option is
counted against the maximum limit under the plan. For example, if an employee uses 20
shares he or she owns to pay the exercise price of an option in 100 shares, the employee
will have received only 80 additional shares. The final regulations clarify that only the
net shares issued (80 in this case) count against the overall limit in the plan on ISOs.
- Shareholder approval for changes to the granting corporation or shares to be issued:
The 2003 proposed regulations added a rule requiring that changes to a plan regarding
either the granting corporation or the shares to be issued (i.e., shares of a different
corporation) required shareholder approval (in addition to changes increasing the number
of shares to be issued or the classes of employees). For example, as a result of a
consolidation, a new corporation may assume an ISO plan maintained by its target and
issue its own shares. The final regulations allow this shareholder approval requirement to
be satisfied if the consolidation agreement describes the plan and the consolidation
agreement is approved by shareholders.
- Corporate transactions and shareholder vote and modification rules: The 2003 proposed
regulations required that ISOs (and ESPPs) must be substituted or assumed under a plan
approved by the shareholders of the acquiring company in order to retain their status after
a corporate transaction. However, the final regulations provide that in a corporate
transaction, ISOs (and ESPPs) existing at the time of the transaction that are substituted
or assumed by the acquiring company are not required to be submitted to additional
approval by the shareholders of the acquiring company. However, future option grants
under the plan qualify only if the acquiring company's shareholders approve the plan.
The final regulations also exclude stock dividends or stock splits from the definition of
distributions that are considered corporate transactions. Thus, in the event of stock
dividends or stock splits that only change the number of shares outstanding, the ISOs are
not considered as substituted or assumed and the exercise price may be proportionally
adjusted to reflect the change in the number of shares without being considered a
modification.
- Nonvested stock and disqualifying dispositions: The final regulations elaborate on a
number of points with respect to disqualifying dispositions in general, and the receipt of
nonvested stock upon the exercise of an option.
- The final regulations clarify that a "transfer" is considered to have occurred even
if the individual receives nonvested shares upon the exercise of an ISO. Under
Section 422(a)(1), an individual must hold the stock for one year following the
date of transfer (as well as two years after the grant of the option) in order to
receive favorable ISO treatment. As a result, the holding period starts when the
stock is transferred, regardless of whether the stock received is subject to
restrictions.
- The final regulations clarify the effect of elections under Section 83(b) when the
individual receives restricted stock. The final regulations clarify that a Section
83(b) election will have no effect for "regular" income tax purposes, but will be
recognized for purposes of the Alternative Minimum Tax. As a result, if there is a
subsequent disqualifying disposition, the amount of compensation income the
individual is required to recognize is based on the value of the stock at the date it
vests, rather than the date it was originally transferred.
- The final regulations clarify that the corporation's deduction allowable upon a
disqualifying disposition is allowed provided that the requirements of Section
83(h) and Reg. 1.83-6(a) are satisfied.
- Inadvertent modifications: The final regulations provide that if an ISO or an ISO plan is
inadvertently modified in such a way as to disqualify the ISOs or the plan, then if the
modification is cancelled before the earlier of the exercise of the ISO or the end of the
calendar year of the modification, the ISO is not disqualified.
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Although the new final regulations also provide some minor guidance on employee stock
purchase plans (ESPPs) governed by Section 423, the Service has also issued Notice 2004-55,
requesting comments on certain aspects of ESPPs.
Effective Date and Transition Rules
The final regulations are effective on August 3, 2004, but there are transition rules permitting
reliance on the 2003 proposed regulations and the old guidance. For ISOs and ESPPs granted on
or before June 9, 2003, taxpayers may rely on the old 1984 proposed regulations, the 2003
proposed regulations, or the final regulations, until January 1, 2006 or if earlier, the first
regularly scheduled shareholders meeting occurring six months after August 3, 2004. For
options granted after June 6 and before the earlier of January 1, 2006, or the first regularly
scheduled shareholders' meeting occurring six months after August 3, 2004, taxpayers may rely
on the 2003 proposed regulations or the final regulations. If a taxpayer relies on the 2003
proposed regulations, then the taxpayer cannot pick and choose which provisions of the 2003
proposed regulations to follow, but must follow all provisions of those regulations, and all
options granted during the reliance period must be treated consistently.
| The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have questions or need additional information about articles appearing in this
or previous versions of Washington Bulletin, please contact: Robert Davis
202.879.3094, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Mike
Haberman 202.879.4963, Stephen LaGarde 202.879.5608, J. D. Lutz 202.879.5366,
Bart Massey 202.220.2104, Diane McGowan 202.220.2077, Martha Priddy
Patterson 202.879.5634, Tom Pevarnik 202.879.5324, Tom Veal 312.946.2595, or
Deborah Walker 202.879.4955.
Copyright 2004, Deloitte. |
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