An employee stock option is a contract that gives employees the right to buy a certain amount of the company’s stock at a predetermined exercise price after a specified vesting period. The exercise price is normally the fair market price of the stock at the time the option is granted, and the option is typically exercisable for a certain period of time.
Incentive stock options are a form of qualified stock options that are granted to an employee by their employer to purchase the employer’s stock. Reg. § 1.421-1(d)(3). Significantly, no regular income tax consequences occur when an incentive stock option is granted or exercised. Reg. § 1.83-3(a)(2). However, the employee will recognize a capital gain if the qualifying stock is sold at a gain. IRC Sec. 421(a).
To meet the special tax rules for favorable treatment, options acquired through the exercise of an incentive stock option generally cannot be disposed either within one year after the stock is transferred, or within two years after the option is granted. IRC Sec. 422(a)(1). Additionally, at all times from the date an incentive stock option is granted until three months before its exercise, the option holder must be an employee of the option grantor. IRC Sec. 422(a)(2). Employees who satisfy both holding periods won’t recognize income as a result of exercising the incentive stock option. IRC Sec. 421(a)(1). If, after holding the stock for longer than one year, the individual sells the stock acquired by exercising the incentive stock option at a gain, all of the gain will qualify be taxed as capital gains.
However, if there is a disqualifying disposition of a share of stock, a sale of the stock not meeting the holding periods, IRC Sec. 421 does not apply to the stock transfer. The exercise of the option flows to IRC Sec. 83, which governs the transfer of property other than money in return for services. The individual would recognize ordinary compensation income equal to the fair market value of the stock on the date the stock is transferred less the exercise price and receive an increase in basis. Reg. § 1.421-2(b). If the disqualifying disposition triggered an allowable loss, the amount includible in the individual’s income as a result of that sale cannot be more than the amount realized on the sale minus the employee’s adjusted basis in the stock. IRC Sec. 422(c)(2); Reg. § 1.422-1(b)(2)(i).