Bonus payments to key employees required to sell ISO stock not capitalized.

• Author: Kautter, David J.
• Position: Incentive stock options

The issue of what compensatory-based expenses must be capitalized under INDOPCO, Inc., 503 US 79 (1992), continues to receive attention from the IRS National Office.

Under the facts of Letter Ruling (TAM) 9527005, key management employees who held incentive stock options (ISOs) on the date of a merger exercised their ISOs and then immediately sold the stock. Under Secs. 421 (a) and 422 (a), if the merger had not occurred and an employee had exercised ISOs, no ordinary income would have been recognized at the time of exercise and the disposal of the stock would have resulted in long-term gain (had the employee held the stock for the requisite holding period). To leave these employees in the same after-tax position as if the merger had not occurred, the taxpayer corporation paid out special bonuses to cover the additional tax as a result of the "forced" exercise of the options.

The taxpayer claimed a deduction for the special bonuses under Sec. 162. The examining agent disallowed the deduction on the grounds that the special bonuses were incurred as a result of a capital transaction and were not compensatory in nature.

The IRS National Office disagreed agreed and found that the bonuses arose from the preexisting stock options that were issued pursuant to an employment relationship. The stated purpose of the payments was to assist personnel in financing acquisition of the new corporation's stock and in paying income taxes incurred in connection with the effects of...