Potential Income Deferral on the Exercise of Nonqualified Options

A grant of nonstatutory stock options is not taxable to a recipient, as long as the options do not have a readily ascertainable fair market value (FMV). The regulations define "readily ascertainable FMV" in such a fashion that, in most instances, the grant is not a taxable event. This leaves the determination of ordinary income open until the employee exercises the options, at which time the compensation-recognition event occurs. In today's volatile stock market, employees can get whipsawed if they are required to hold stock acquired through the exercise of these options for a specified period of time. Although the exercise creates ordinary (compensation) income, if the per-share price spirals downward during the period within which the employee is restricted from selling the stock, the ultimate sale will cause the employee to recognize a capital loss. Since the loss will not offset the ordinary income recognized at the time of the exercise, the question is whether alternatives might be available to reduce the impact of this adverse result.

Two common restrictions placed on the sale of stock acquired through the exercise of nonstatutory options are SEC Rule 144 and Section 16(b) of the Securities Exchange Act of 1934. Rule 144 generally requires corporate insiders to hold the stock for one year from the acquisition date before it can be sold. Section 16(b) attempts to prevent speculative "short-swing" transactions by making the profits of insiders' purchase and sale transactions subject to recovery by the company. Both of these limits on sale can make an employee who exercises nonstatutory options unable to sell the stock, even while watching its price plummet. To lessen the adverse impact, the employee may look to either delay income recognition or value the stock at a price more in line with the price at which the employee could actually sell it, when the SEC restrictions are first relieved.

To delay the taxable event, the stock received on the exercise must be subject to a substantial risk of forfeiture and nontransferable. To discount the stock's value from its listed trading price at the exercise date, the stock must be subject to a restriction which, by its terms, never lapses.

Rule 144

Rule 144 does not contain a forfeiture provision, which is typically established by a company to ensure that, for a specified period of time after exercise, an employee continues to provide services to the company. Unless the company imposes such a restriction, stock subject to Rule 144 is taxed when the options are exercised. The restrictions on sale provided in Rule 144 typically lapse at the end of a one- or two-year holding period. Since these restrictions by their terms lapse, any diminution in value of the stock that this restriction causes on sale cannot be considered in assessing the stock's FMV at exercise. As a result, Rule 144 restrictions are of little benefit to a taxpayer in this situation.

Section 16(b)

Section 16(b) is afforded somewhat different treatment. Sec. 83(c)(3) provides that, as long as the sale of property could subject a person to suit under Section 16(b), such person's rights in such property are subject to both a substantial risk of forfeiture and nontransferability. Therefore, Sec. 83(c) may delay the usual Sec. 83(a) timing for income recognition on the compensatory transfer of property (exercise of options) until such time as the Section 16(b) restrictions are no longer applicable. When the exercise of the option is considered a purchase and is subject to both Rule 144 and Section 16(b), the taxable event could be delayed six months. This deferral period may reduce the time between the compensation event and the potential sale of the stock, and therefore reduce the taxpayer's exposure to the market's vagaries. In addition, a series of exercises could continue to delay the taxable event for a period in excess of six months, since Section 16(b) liability can arise on the sale of any stock, if there has been a purchase within the previous six months.

Another Approach

Sec. 83(c)(3) was enacted in 1981, and regulations were issued in 1985. At the time of enactment, Section 16(b) provided that the exercise of options constituted a "purchase."

In 1996, the SEC revised Rule 16b-3 to allow companies to avoid the application of Section 16(b) on the exercise of options. This effectively means that, for companies that have chosen this route, the exercise is not a "purchase" within the meaning of Section 16(b). If the exercise is not a purchase but is a transfer of property under Sec. 83(a), exactly how does Sec. 83(c) come into play? The IRS could argue that Sec. 83(c) simply does not apply to the exercise of an option. However, if an employee subsequently sells the stock acquired through the exercise, any purchase of another block of stock within six months of the sale could subject the taxpayer to suit under Section 16(b). Therefore, it might be possible to argue that Sec. 83(c) delays the taxability of the option exercise for at least six months, and potentially indefinitely. While this may afford an opportunity for employees to delay reporting the income for at least six months from the exercise date, an employer may not agree with such an approach, because employers are allowed a deduction attributable to the option income in the year in which the employee "includes" this compensation as income. To avoid the difficulty of tracking when the employee actually includes such compensation in income, the regulations provide that the employee is "deemed" to have included the amount in income if the employer timely issues a Form W-2 that contains this income. Employers who do not wish to delay taking the deduction or who do not want to have to monitor when the employee actually reports the income may simply issue a W-2 to the employee reporting the compensation as income. And with the new 2001 Form W-2 including a separate box for nonqualified option income, an employee's biggest hurdle to deferral may be overcoming the red flag raised by the company's inclusion of the compensation on Form W-2.

From Robert Kane, J.D., CPA, Baltimore, MD