ISO/NQSO as Compensation

[Gary Lesser]

An employer has nonqualified stock option ("NQSO") plans, as well as an incentive stock option ("ISO") plan described in section 422

of the Code. The employer wants to exclude income from exercise of both NQSOs and ISOs from the definition of compensation for pur poses of determining HCEs for the ADP test.

Can both types of income be excluded using the 415©(3) definition of compensation? More specifically, can ISO-related income be

excluded under 415©(3)?

Under reg 1.415-2(d)(3)(ii), the 415©(3) definition of compensation excludes income from exercise of NQSO. Reg 1.415-2(d)(3)(iii) excludes "amounts realized from sale, exchange, or other disposition of stock acquired under a qualified stock option." But there aren't any qualified stock options any

more. This reg was adopted in 1980, when "qualified stock options" (under old IRC sec 422) had only one more year of life (they were phased out from 1976 to 1981). Incentive stock options ("ISOs") were not added under IRC sec. 422A until 1981. The code section for ISOs was changed from 422A to 422 in 1990.

Under IRC 422 and 421, no income is recognized under an ISO at grant of option, and income at sale of stock is capital gain. But if employee sells within 2 years of grant or 1 year of receipt of stock, then it is a "disqualifying disposition," resulting in

ordinary income reported on W-2, but from which no FIT withholding is required.

Are ISOs treated as "qualified stock options" for which all amounts realized from sale, exchange, or other disposition is excluded

from compensation? Or is income from a disqualifying disposition of ISO stock treated as being from the exercise of nonqualified stock option and therefore excluded?

The other safe harbor definitions of compensation will not work. W-2 income includes both NQSO and ISO income. 3401 includes NQSO income (but does exclude ISO income).

Could the answer be as simple as "it all depends how compensation is defined in the document" !/?

[Guest ERead]

I believe your last sentence is best summary for your question.

IMO - As far as I know, there are no regs that stipulate, other than in document language what can be excluded from the definition of compensation. You may be starting down the road to individual design.

- I think I would be inclinde to file the plan for a DL regardless of current status.

Good luck - any other opinions?