Clarification

The item, “ISOs in a Down Market,” in the December 2000 Tax Clinic presented the view that an employee with incentive stock option (ISO) shares could repurchase the stock without concern for the wash sale rules, because the stock was sold for more than the exercise price ($10 sales price versus $5 exercise price in the example in the item). This is not the case. ISO holders should be aware of a trigger that exists on repurchase within 30 days of a disqualifying disposition. Under Sec. 422(c)(2)(B), if “such disposition is a sale or exchange with respect to which a loss (if sustained) would be recognized to such individual, then the amount which is includible in the gross income of such individual, and the amount which is deductible from the income of his employer corporation, as compensation attributable to the exercise of such option shall not exceed the excess (if any) of the amount realized on such sale or exchange over the adjusted basis of such share.”

First reading would indicate that no loss exists, as the stock was sold for more than the exercise. But the language extends beyond the pure economic gain or loss of the transaction. Sec. 422(c)(2)(B) asks the question, from a hypothetical standpoint, of whether a loss (if sustained) would be recognized. Prop. Regs. Sec. 1.422A-1(b)(2) and (b)(3), Example (6), outlines Sec. 422(c)(2)(B)’s intent. The income limit of Sec. 422(c)(2) does not apply when a disqualifying disposition is a sale described in Sec. 1091 (pertaining to wash sales). When the income limit does not apply, the hypothetical loss becomes a real one and the wash sale rules apply. The taxpayer then reports compensation income from the bargain element as of the date the option was exercised (in the original item, $55 fair market value less $5 exercise price, or $50/share). The taxpayer’s basis in the stock is increased by the amount of the compensation income reported. In the example, the taxpayer is treated as selling stock with a $55 basis for $10, producing a loss. As a result of the loss, the wash sale rules apply to the ISO sale and repurchase.

Other Concerns

Purchase of company stock through an employee stock purchase plan (ESPP) within 30 days of a disqualifying disposition of ISO stock could also trigger income under Sec. 422(c)(2)(B). An additional exercise of ISO stock could also be treated as a repurchase of ISO stock and would have the same effect as an ESPP purchase within 30 days of the ISO-disqualifying disposition.

Summary

As with the original exercise of option stock, the option holder must be aware of the potential downside to the sale and repurchase of optioned stock. If a taxpayer wants to repurchase stock, he should wait 30 days before and after the disqualifying disposition, to avoid application of the wash sale rules.

From Kent Busek, CPA, MBT, Eide Bailly LLP, Fargo, ND (Not associated with AFAi)