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the alternative minimum tax (AMT). Instead, the excess of the (1) fair market value of the Minimum Tax. The favorable tax treatment of ISOS does not apply for purposes of stock received upon the exercise of the option, over (2) the amount paid for the stock, plus any amount paid for the ISO, must generally be recognized as an AMT adjustment (1435). As a result, individuals who have exercised ISOs to purchase stock with a high fair market value which declined before they could sell it maybe left with large AMT liabilities and no cash to pay them.

Incentive Stock Options Plan Requirements. A stock option granted by an employer to an employee must satisfy several requirements to qualify for favorable tax treatment as an incentive stock option (ISO) (1925) (Code Sec. 422 (b); Reg. $1.422-2).27 ISOs must be granted under a plan adopted by the granting corporation and approved by its shareholders that sets out the total number of shares that may be issued under options and the employees who may receive the options. The plan must be approved by the stockholders within 12 months before or after the date such plan is
adopted.
The options must be granted within 10 years from the date the plan is adopted or approved, whichever is earlier. Further, the options must be exercisable within 10 years from the date of the grant. The option price may not be less than the fair market value of the stock at the time the option is granted, and the option may not be transferable other than at the grantee’s death. The option may be exercised only by the employee. Finally, the employee, at the time the option is granted, may not own stock with more than 10 percent of the total combined voting power of all classes of stock of the employer corporation or its parent or any subsidiary.

Employee Stock Purchase Plans. An employee stock purchase plan (ESPP) may grant employees the option to purchase stock in their employer or the employer’s parent or subsidiary. Unlike a nonstatutory stock option (1923), if certain require- ments are met, no gain or loss is generally realized by the employee when an option is granted or exercised under an ESPP (Code Sec. 421 (a)).28 Instead, the employee is not subject to income tax until shares acquired by the exercise of the option are sold. See ¶ 1931 for a discussion of ESPP plan requirements.
Gain or loss from the sale of the stock received in an ESPP is a capital gain or loss if: (1) the taxpayer does not dispose of the stock for at a least two years from the date on which the option is granted; and (2) the stock is held for at least one year after the option is exercised (Code Sec. 423 (a)).29 The amount of gain or loss is the difference between the amount the taxpayer paid for the stock (the option price) and the amount the taxpayer received when he or she sold the stock. The taxpayer must remain an employee of the corporation from the time the option is granted until three months before the option is exercised (one year if the taxpayer ceased employment because of permanent and total disability). In the event the employee dies, his or her executor, administrator, or representative may exercise the option but he or she does not have to exercise the option within three months after the death of the employee (Reg. $1.421-2(c)).30
If the option price is less than 100 percent (but not less than 85 percent) of the fair market value of the stock, then the favorable tax treatment does not apply when the taxpayer disposes of the stock (Code Sec. 423 (c)).31 Instead, the employee recognizes ordinary income in the amount of the lesser of:
⚫ the excess of the fair market value of the shares when sold or on the employee’ death, over the option price, or
⚫ the excess of the fair market value of the shares when the option was granted, over the option price.
References are to Standard Federal Tax Reports; Tax Research Consultant; and Practical Tax Explanations.

27 ¶ 19,800, ¶ 19,801C; COM-
PEN: 24,100; § 21,515.05
28
¶ 19,602; COMPEN: 21,050;
§ 21,601
29 ¶ 19,900; COMPEN: 21,054; $21,625.10
30
¶ 19,609; COMPEN:
21,054.15; § 21,625.10
31 q 19,900; COMPEN:
21,054.10; §21,625.10
1/1929
19
SECURITIES

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expired in December without being exercised. The holder (buyer) of the options Example 1: Ten call options were issued on April 8 for $4,000. The options recognizes a short-term capital loss of $4,000. The writer of the options recognizes
a short-term capital gain of $4,000.
the options were sold for $6,000. The holder (buyer) of the options who sold them Example 2: Assume the same facts as in Example 1, except that, on May 10, them back, he or she would recognize a short-term capital loss of $2,000. recognizes a short-term capital gain of $2,000. If the writer of the options bought
Example 3: Assume the facts as in Example 1, except that the options were exercised on May 27. The holder (buyer) adds the cost of the options to the basis of the stock bought through the exercise of the options. The writer adds the stock. The gain or loss is short term or long term, depending on the holding period amount received from writing the options to the amount realized from selling the
of the stock.

Nonstatutory Stock Options. An employee or independent contractor granted a stock option as compensation for the performance of services is generally subject to the rules regarding restricted property transfers (713) when the option is granted or exercised, unless it is an incentive stock option (ISO) (1925) or an option granted under an employee stock purchase plan (ESPP) (1929) (Code Sec. 83 (e) (1);
Reg. $1.83-7).19
A nonstatutory stock option with a readily ascertainable fair market value when granted is subject to the restricted property rules on the grant date. The taxpayer has ordinary income equal to the stock’s fair market value on the grant date, less any amount paid. A nonstatutory stock option without a readily ascertainable fair market value when granted is subject to the restricted property rules when it is exercised or disposed of by the taxpayer, even if the fair market value becomes ascertainable before the option is exercised or disposed. If the option is exercised, the taxpayer has ordinary income equal to the stock’s fair market value at the exercise date or when substantially vested, less the exercise price.
If a nonstatutory stock option is sold or disposed in an arm’s-length transaction, the taxpayer is considered to have exercised the option and has income equal to the amount of money or property received, less the exercise price. If the sale or disposition is not an arm’s-length transaction, the taxpayer is not considered to have exercised the option. The taxpayer must, nonetheless, include in income as compensation the amount of money or property received. In addition, when the transferee exercises the option, the laxpayer (transferor) has additional income equal to the fair market value of stock acquired by the transferee, less the exercise price and any amount the taxpayer received from the sale of the option. A sale or disposition of a nonstatutory stock option to a person is not treated as an arm’s-length transaction for this purpose. If the holder
related
of an option incurs a loss on failure to exercise the option, then it is deemed to have been sold or exchanged on the date it expired (¶ 1919).
Readily Ascertainable Market Value. A stock option generally has a readily ascertain- able fair market value if it is actively traded on an established securities market (Reg. $1.83-7(b)) 20 Even if the option is not actively traded on an established securities market, it will be considered to have a readily ascertainable value if the taxpayer can demonstrate that the option is transferable, immediately exercisable, there is no condi- or restriction on the underlying property that would have a significant effect on its fair market value, and the fair market value of the option privilege is readily
ascertainable.
Sale of Stock. Stock acquired through the exercise of a nonstatutory stock option is treated as any other investment property when sold or exchanged (IRS Pub. 525). The taxpayer’s basis in the stock is the amount paid for the stock, plus any amount included in income upon grant or exercise of the option. The taxpayer’s holding period begins References are to Standard Federal Tax Reports; Tax Research Consultant; and Practical Tax Explanations.
19
FOR SECURITIES

670
the capital gain or loss is short term or long term unless the sale or
exchange is
taxpayer (1741). The length of time the taxpayer held the option determines whether any gain or loss from the sale or exchange of the option may be section 1231 gain or loss hedging transaction (1949). If the underlying property is section 1231 property, then If the holder of an option incurs a loss from the failure to exercise the option, then of the grantor of an option for stock, securities, commodities, or commodity
(including an option granted as part of a straddle (1948)), gain or loss from
futures
any closing
loss. See ¶ 1921 for a discussion of holders and writers of options on securities (puts and exchange of an option by a dealer who holds options primarily for sale to customers The characterization rules above do not apply to gain or loss realized on the sale or (1903). They also do not apply to gain realized from the sale or exchange of a or sell inventory, an option equivalent to a dividend, an option involving section 306 employee stock option (1925 and ¶ 1927), an option to lease property, an option to buy
stock (¶ 739), and an option included as part of a short sale (¶ 1944).

Puts and Calls. Puts are options to sell, and calls are options to buy, stock, securities, or commodities at a set price on or before a specified date. Puts and calls are issued by writers (grantors) to holders for premiums. They end when the option is exercised by the holder, the option lapses, or due to a closing transaction (Rev. Rul. 78-182; IRS Pub. 550).16
Holders of Puts and Calls. The purchase of a put option or call option is not a taxable event. The cost of purchasing the put or call, however, is a nondeductible capital expenditure (Rev. Rul. 71-521).17 If the holder sells a put or call without exercising it, the difference between its cost and the amount received is either a long-term or short-term capital gain or loss, depending on how long it was held (¶ 1919). If the option expires, its cost is either a long-term or short-term capital loss, depending on the taxpayer’s holding period, which ends on the expiration date. If the holder exercises a call, its cost is added to the basis of the security purchased. If the holder exercises a put, the amount realized on the sale of the underlying security is reduced by the cost of the put when computing gain or loss on the sale of the stock. That gain or loss is long term or short term depending on the taxpayer’s holding period for the underlying security (Rev. Rul. 78-182, IRS Pub. 550).18 The acquisition of a put is considered a short sale, and the exercise, sale, or lapse of the put is a closing of the short sale (¶ 1944).
Writers of Puts and Calls. If a taxpayer writes or grants a call or put option, the premium received is not included in income at the time of receipt. Instead it is deferred until the option expires, the taxpayer buys or sells the underlying security when the
option is exercised, or the taxpayer engages in a closed transaction.
When the option expires, the premium can then be treated as a short-term capital short-term depending on the taxpayer’s holding period of the security. If a put is gain. If a call is exercised and the taxpayer sells the underlying security, then the premium is added to the amount realized on the sale and any gain or loss is long-term or exercised and the taxpayer buys the underlying security, then the premium reduces its basis in the security. The taxpayer’s holding period on the security begins on the date of The taxpayer can also terminate a put or call through a closing transaction-such as repurchasing the option or substituting the original option by purchasing another option with identical terms. If the taxpayer closes the transaction, the difference between the premium originally received and the amount paid in the closing transaction is short-term
the purchase, not on the date the put was written.
capital gain or loss.
References are to Standard Federal Tax Reports; Tax Research Consultant; and Practical Tax Explanations.
16 30,614.14; SALES: 45,200;
§19,105
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672
option was exercised if it did not.
gross
when the option was acquired if it had a readily ascertainable value, or the date the option as a business expense for the tax year in which the option is included in the Employer’s Deduction. An employer may deduct the value of a nonqualified stock income of the employee (Code Sec. 83 (h); Reg. §1.83-6(a)).21 When the employer and the employee have different tax years, the employer generally claims the deduction in value, however, is not readily ascertainable at the time of grant, and the employee’s the tax year in which, or with which, the employee’s tax year ends. If the option’s market rights in the stock are substantially vested upon exercise, the employer may take the fied stock option, the employer is required to report the excess of the fair market value Reporting Requirements. In most situations, when an employee exercises a nonquali- of the stock received over the amount that the employee paid for that stock (i.e., “the
deduction in accordance with its usual method of accounting.
spread”) on the employee’s Form W-2.

Incentive Stock Options. An incentive stock option (ISO) is an option right to purchase stock of the employer, often at a discount. Unlike a nonstatutory stock granted by a corporation (or related corporation) to an employee giving him or her the option (1923), if certain requirements are met, no gain or loss is generally realized by the employee when an ISO is granted or exercised (Code Sec. 421 (a)).22 Instead, the employee is not subject to income tax until shares acquired by the exercise of the option
are sold. See ¶ 1927 for a discussion of ISO plan requirements.
23
Minimum Tu the alternative minimum tax stock received upon the ex plus any amount paid for th (1435). As a result, indivi fair market value which d liabilities and no cash to pa
Gain or loss from the sale of the stock received in an ISO is a capital gain or loss if: (1) the taxpayer does not dispose of the stock for at least two years from the date on which the option is granted; and (2) the stock is held for at least one year after the option is exercised (Code Sec. 422 (a); Reg. § 1.422-1(a)). The amount of gain or loss is the difference between the amount the taxpayer paid for the stock (the option price) and the amount the taxpayer received when he or she sold the stock. The taxpayer must remain an employee of the corporation from the time the option is granted until three months before the option is exercised (one year if the taxpayer ceased employment because of permanent and total disability). In the event the holder of an ISO dies, the deceased’s executor, administrator, or representative may exercise the option but he or she does not have to exercise the option within three months after the death of the employee (Reg. §1.421-2 (c)).24

Incentive Stoc employer to an employee treatment as an incenti 81.422-2).27 ISOs must be approved by its sharehold under options and the approved by the stockho adopted.
If the employee sells the stock before the required holding period ends (a disquali- fying disposition), gain on the sale is ordinary income equal to the fair market value of the stock when the option was exercised, less the exercise price (Code Sec. 421 (b); Reg. §1.421-2(b)),25 Any excess gain is capital gain, and any loss is a capital loss. The gain is recognized for the tax year in which the sale occurs. In addition, any gain from a disqualifying disposition is excluded from wages for FICA and FUTA tax purposes and is not subject to income tax withholding (Code Secs. 3121 (a) (22) and 3306(b) (19)).
Basis of ISO. An employee’s basis in an ISO is the amount that the employee paid for the option. If the employee did not pay for the option and the option lapses, the employee does not have a deductible loss because he or she does not have a basis. An employee’s basis in stock purchased through an ISO is the amount he or she paid for the stock when the option was exercised (plus any amount he or she paid for the option).
The options must b approved, whichever is from the date of the gra the stock at the time the than at the grantee’s de the employee, at the ti percent of the total co corporation or its parer 1929. Employee may grant employees parent or subsidiary. ments are met, no gai granted or exercised subject to income tax ¶ 1931 for a discussion
Annual Dollar Limit. The maximum value of stock with respect to which ISOs may first become exercisable in any one year is $100,000. Stock is valued when the option is granted. Options are taken into account in the order in which they are granted, and options issued under ISO plans of any parent, subsidiary, or predecessor corporation are
taken into account (Code Sec. 422(d)).26
References are to Standard Federal Tax Reports; Tax Research Consultant; and Practical Tax Explanations.
18,508; §21,720
21 ¶ 6380, ¶ 6386; COMPEN:
2219,602; COMPEN: 24,050;
$21,510
11925
23
19,800, ¶ 19,801A; COM-
PEN: 24,150; §21,525.05
24
19,609; COMPEN: 24,152;
$21,520.15
25
PT 19,602, ¶ 19,609; COM- PEN: 24,056, COMPEN: 24,154; $21,530.10
2619,800; COMPEN: 24,116;
821
Gain or loss from if: (1) the taxpayer do which the option is option is exercised ( between the amount the taxpayer receive employee of the cor before the option is permanent and tota administrator, or rep exercise the option §1.421-2(c)). 30
If the option pr market value of the taxpayer disposes ordinary income in
the ex
employee’ de:
the ex granted, over References are to Star
27
19,800,¶19,80
PEN: 24,100; $21,515
28
19,

5 APPLICA
672
option was exercised if it did not.
ax Guid
when the option was acquired if it had a readily ascertainable value, or the date the Employer’s Deduction. An employer may deduct the value of a nonqualified s income of the employee (Code Sec. 83 (h); Reg. § 1.83-6(a)).21 When the employer a option as a business expense for the tax year in which the option is included in the grow the employee have different tax years, the employer generally claims the deduction in value, however, is not readily ascertainable at the time of grant, and the employee the tax year in which, or with which, the employee’s tax year ends. If the option’s marke rights in the stock are substantially vested upon exercise, the employer may take the Reporting Requirements. In most situations, when an employee exercises a nonqual fied stock option, the employer is required to report the excess of the fair market value of the stock received over the amount that the employee paid for that stock (ie., “the
deduction in accordance with its usual method of accounting.
spread”) on the employee’s Form W-2.

Incentive Stock Options. An incentive stock option (ISO) is an option right to purchase stock of the employer, often at a discount. Unlike a nonstatutory stock granted by a corporation (or related corporation) to an employee giving him or her the the employee when an ISO is granted or exercised (Code Sec. 421(a)).22 Instead, the option (1923), if certain requirements are met, no gain or loss is generally realized by employee is not subject to income tax until shares acquired by the exercise of the option
are sold. See ¶ 1927 for a discussion of ISO plan requirements.
Gain or loss from the sale of the stock received in an ISO is a capital gain or loss if (1) the taxpayer does not dispose of the stock for at least two years from the date on which the option is granted; and (2) the stock is held for at least one year after the option is exercised (Code Sec. 422 (a); Reg. § 1.422-1(a)). The amount of gain or loss is the difference between the amount the taxpayer paid for the stock (the option price) and the amount the taxpayer received when he or she sold the stock. The taxpayer must remain an employee of the corporation from the time the option is granted until three months before the option is exercised (one year if the taxpayer ceased employment because of permanent and total disability). In the event the holder of an ISO dies, the deceased’s executor, administrator, or representative may exercise the option but he or she does not have to exercise the option within three months after the death of the employee (Reg. § 1.421-2(c)).24
If the employee sells the stock before the required holding period ends (a disquali- fying disposition), gain on the sale is ordinary income equal to the fair market value of the stock when the option was exercised, less the exercise price (Code Sec. 421(b); Reg. § 1.421-2(b)).25 Any excess gain is capital gain, and any loss is a capital loss. The gain recognized for the tax year in which the sale occurs. In addition, any gain from
disqualifying disposition is excluded from wages for FICA and FUTA tax purposes and is
not subject to income tax withholding (Code Secs. 3121 (a) (22) and 3306 (b) (19)).
SECURITIES T Minimum 1
the alternative n stock received plus any amour (1435). As a r fair market val liabilities and n 1927. In employer to a treatment as §1.422-2).27 19 approved by i under option approved by adopted. The opt
Basis of ISO. An employee’s basis in an ISO is the amount that the employee paid employee does not have a deductible loss because he or she does not have a basis. An for the option. If the employee did not pay for the option and the option lapses, the employee’s basis in stock purchased through an ISO is the amount he or she paid for the stock when the option was exercised (plus any amount he or she paid for the option). first become exercisable in any one year is $100,000. Stock is valued when the option is Annual Dollar Limit. The maximum value of stock with respect to which ISOs may granted. Options are taken into account in the order in which they are granted, and options issued under ISO plans of any parent, subsidiary, or predecessor corporation a
taken into account (Code Sec. 422 (d)).26
References are to Standard Federal Tax Reports; Tax Research Consultant; and Practical Tax Explanations.
21 ¶
6380, ¶ 6386; COMPEN
23
25
602, T 19,609; COM
24,154;
approved, w from the da the stock at than at the the employ percent of corporation
1929
may grant parent or ments are
granted c subject to 1931 fc Gai if: (1) th which th option i between the tax employ before
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27
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