Income from ISO Exercise Includible in AMTI on Transfer of Purchased Shares

A  was granted incentive stock options (ISOs) under Company Ss plan on August 27 and November 18 of year 1. Liability under Section 16(b) of the Securities Exchange Act of 1934 (34 Act) expired on February 27 and May 18 of year 2, respectively. S sold common stock in an initial public offering on May 5 of year 2. A agreed not to sell, otherwise dispose of or hedge any S common shares, options, warrants or convertible securities from May 5November 2 of year 2 (lock-up period), as required under the underwriting agreement (and other agreements).

Under Ss insider trading compliance program, insiders (such as A) could trade S stock only between November 5 and November 30 of year 2 (the trading window). After that, S denied A the right to trade in S shares from December 1 of year 2 until May of year 3. If A traded S shares without Ss consent, S had the right to terminate his employment. However, the referenced agreements did not prohibit the exercise of ISOs. A exercised ISOs in July, August and November of year 2, and in April, June and August of year 3. A sold the shares he acquired via the ISOs in August and December of year 3.

On their year 2 joint return, A and B reported a tax preference item of $499,521 attributable to the ISOs, and an overall alternative minimum tax (AMT) liability of $151,053. However, A and B filed an amended year 2 return, seeking a $148,758 abatement, claiming that (1) the original AMT calculation was based on the market price of S stock when acquired by A; (2) the fair market value (FMV) was mistakenly assigned the market price; (3) the FMV should have reflected the three-week window restriction in year 2; and (4) the AMT preference had to be adjusted to reflect the stocks true FMV.

A further contends that rights in the S shares he purchased through his ISOs were substantially nonvested, because he would have been subject to penalties under Securities and Exchange Commission (SEC) Rule 10b-5 (Rule 10b-5) if he had sold S shares anytime during the period beginning in January of year 2 and ending in May of year 3.

Analysis

Sec. 55 imposes the AMT on certain tax preference items, such as ISOs. For AMT purposes, Sec. 83 applies to determine the compensation income (if any) attributable to ISOs. Property is not taxable under Sec. 83 until it is transferred to and substantially vested in the service provider (or beneficiary thereof).

Transfer

A transfer of property occurs when a person acquires a beneficial ownership interest in it (disregarding any lapse restriction); see Regs. Sec. 1.83-3(a)(1). A lapse restriction is a restriction other than a nonlapse restriction and includes (but is not limited to) one that carries a substantial risk of forfeiture; see Regs. Sec. 1.83-3(i). Under Regs. Sec. 1.83-3(h), a restriction which, by its terms, will never lapse (nonlapse restriction) is a permanent limit on the transferability of property that will (1) require the transferee to sell (or offer to sell) the property at a price determined under a formula and (2) continue to apply and be enforced against the transferee or any subsequent holder (other than the transferor). An obligation to resell (or to offer to sell) the transferred property to a specific person(s) at its FMV at the time of the sale is not a nonlapse restriction.

Substantially Vested

For Sec. 83 purposes, property is substantially nonvested when it is both subject to a substantial risk of forfeiture and nontransferable under Regs. Sec. 1.83-3(c) and (d). Property is substantially vested when it is either transferable or not subject to a substantial risk of forfeiture.

Whether a risk of forfeiture is substantial depends on the facts and circumstances. A substantial risk of forfeiture exists when transferred property rights are conditioned (directly or indirectly) on the future performance (or refraining from performance) of substantial services by any person or the occurrence of a condition related to the purpose of the transfer; the possibility of forfeiture is substantial if such condition is not satisfied.

For Sec. 83 purposes, a persons property rights are transferable if the person can transfer any interest in the property to any person other than the transferor, but only if the transferees rights are not subject to a substantial risk of forfeiture. Thus, property is transferable if (1) the person performing the services or receiving the property can sell, assign or pledge (as collateral for a loan, as security for the performance of an obligation or for any other purpose) his interest to any person other than the transferor; and (2) if the transferee is not required to give up the property or its value in the event that the substantial risk of forfeiture materializes; see Regs. Sec. 1.83-3(d).

Under Sec. 83(c)(1) and Regs. Sec. 1.83-3(j), if the sale of property at a profit within six months after its purchase could subject a person to suit under Section 16(b) of the 34 Act, that persons rights are subject to a substantial risk of forfeiture (and not transferable) until the earlier of (1) the expiration of such six-month period or (2) the first day on which the sale of such property at a profit will not subject the person to suit under Section 16(b). Section 16(b) is triggered by either a purchase and sale or a sale and purchase of a security within a period of less than six months by an officer, director or greater-than-10% owner of the corporation.

Conclusion

The Section 16(b) periods expired on February 27 and May 18 of year 2, respectively, before A first exercised his ISOs and the shares were transferred to him. Thus, neither Section 16(b) of the 34 Act, nor Sec. 83(c)(3), imposed a substantial risk of forfeiture on any of those shares.  Congress decided that Section 16(b) is the only securities law provision that would delay taxation under Sec. 83(c)(3); thus, Rule 10b-5 did not cause shares purchased through As ISOs to be substantially nonvested when they were transferred to him.

Moreover, there is no information suggesting that As or any subsequent transferees retention of rights in the shares were conditioned on anyones future performance (or refraining from performance) of substantial services. Thus, the lock-up agreements did not make those rights subject to a substantial risk of forfeiture and could not have prevented Sec. 83s taxation of those rights when the shares were transferred to him.

Any transfer restrictions imposed on As sales (or other trading) by the referenced agreements were lapse restrictionsdemonstrated by both their tolling (the underwriters agreement and the lock-up agreements) and the window periods (the insider trading compliance program). Thus, those restrictions must be ignored when valuing the shares obtained via the ISOs under Sec. 83.

IRS Letter Ruling (TAM) 200338010 (9/19/03)

Reflections: A similar decision was issued in IRS Letter Ruling (TAM) 200338011 (9/19/03). According to the IRS, the issues in both rulings are (in relevant portion) the same as those considered in Paul A. Tanner, 117 TC 237 (2001), affd, 5th Cir., 3/26/03; the conclusions reached in the TAMs are consistent with the decision reached in that case.