Internal Revenue Service (IRS)
Revenue Ruling (Rev. Rul.)
26 USC § 1036
(Also § 83, 421, 422, 425, 1031; 1.83-7, 1.421-8, 1.422-1, 1.425-1, 1.1031(d)-1.)
Published: September 8, 1980
Employee Stock Options; Payment with Stock
Employee stock options; payment with stock. An explanation is provided of the federal income tax consequences of the acquisition of stock pursuant to the exercise of a nonqualified stock option and payment for the stock with identical shares of the corporation’s stock that were previously acquired pursuant to the exercise of a qualified stock option.
What are the federal income tax consequences of the acquisition of stock pursuant to the exercise of a nonqualified stock option, if payment for the stock is made with shares of the same corporation’s stock that were previously acquired pursuant to the exercise of a qualified stock option?
A corporation, whose outstanding stock consists of a single class of common stock, has a qualified stock option plan described in section 422 of the Internal Revenue Code and a nonqualified stock option plan. An optionee who exercises an option granted under the nonqualified plan may pay for the shares (1) in cash, (2) with previously acquired shares having a fair market value equal to the option price, or (3) with cash and previously acquired shares having a fair market value less than the option price.
On May 1, 1977, an employee of the corporation exercised a qualified stock option and acquired 1,000 shares of stock for 2x dollars. The fair market value of the stock steadily increased, and on July 1, 1979, when the employee exercised a nonqualified option (which was granted after April 21, 1969, and did not have a readily ascertainable fair market value when granted) for 2,000 shares of stock, the 1,000 shares of stock acquired pursuant to the qualified option had a fair market value of 6x dollars. The employee paid for the 2,000 shares of stock received pursuant to the nonqualified option with the 1,000 shares of identical stock acquired in 1977 when the employee exercised the qualified option. The nonqualified option price for the 2,000 shares of stock was 6x dollars; however, the fair market value was 12x dollars. Thus, the employee exchanged 1,000 shares of stock with a basis of 2x dollars and a fair market value of 6x dollars for 2,000 shares of stock with a fair market value of 12x dollars.
Law and Analysis
Section 421(a)(1) of the Code provides that if a share of stock is transferred to an individual in a transfer in respect of which the requirements of section 422(a) are met, no income results when the share is transferred to the individual upon the exercise of the option with respect to that share.
Section 422(a) of the Code provides that section 421(a) applies with respect to the transfer of a share of stock to an individual pursuant to the exercise of a qualified stock option if no disposition of the share is made by the employee within the three-year period beginning on the day after the day of the transfer of the share.
Section 1.421-8(b) of the Income Tax Regulations provides that a disposition of a share of stock, acquired by the exercise of a statutory option, before the expiration of the applicable holding period, makes section 421 of the Code inapplicable to the transfer of the share. The income attributable to the transfer is treated by the individual as income received in the taxable year in which the disposition occurs.
Section 1.421-8(b)(2) of the regulations provides that section 421 of the Code is not made inapplicable by a transfer before the expiration of the applicable holding period if the transfer is not a disposition of stock as defined in section 425(c).
Section 425(c) of the Code provides that the term ‘disposition’ includes a sale, exchange, gift, or a transfer of legal title, but does not include an exchange to which section 1036 applies.
Section 1036(a) of the Code provides that no gain or loss shall be recognized if common stock in a corporation is exchanged solely for common stock in the same corporation, or if preferred stock in a corporation is exchanged solely for preferred stock in the same corporation.
Section 1031(d) of the Code provides that if property is acquired in an exchange described in section 1036(a), the basis shall be the same as that of the property exchanged.
Section 83(a) of the Code provides that, if, in connection with the performance of services, property is transferred to any person other than the person for whom such services are performed, the excess of (1) the fair market value of the property at the first time the rights of the person having the beneficial interest in the property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier, over (2) the amount (if any) paid for the property, is included in the gross income of the person who performed the services.
Section 83(e) of the Code provides that section 83 does not apply to the transfer of an option without a readily ascertainable fair market value. However, under section 1.83-7(a) of the regulations, if such option is exercised, section 83(a) applies to the transfer of property pursuant to the exercise, and the employee realizes compensation upon the transfer at the time and in the amount determined under section 83(a).
The exercise of the nonqualified stock option caused the realization of 6x dollars of income under section 83(a) of the Code.
(1) The exchange of 6x dollars in value of common stock (1,000 shares) for 6x dollars in value of common stock (1,000 shares) qualifies for nonrecognition of gain under section 1036 of the Code. Pursuant to section 1031(d), the employee-shareholder’s basis in this 1,000 shares of stock received pursuant to the exercise of the nonqualified option is the same as the employee-shareholder’s basis in the 1,000 shares of stock exchanged therefor (2x dollars). Therefore, a disposition within the meaning of section 425(c) did not occur because section 1036 applies to the exchange of the 1,000 shares of stock that were acquired in 1977 pursuant to the exercise of the qualified option, and the employee-shareholder did not receive income pursuant to section 1.421-8(b) of the regulations.
(2) The additional 1,000 shares of common stock received by the employee-shareholder are compensation for services under section 83(a) of the Code. Accordingly, the employee-shareholder must include in gross income the fair market value (6x dollars) of the additional 1,000 shares of stock received pursuant to the exercise of the nonqualified stock option. The employee-shareholder’s basis in the additional 1,000 shares of stock is the same as the amount included in gross income (6x dollars).