Compensation deduction from NQSO exercise.

• Position: Nonqualified stock options

The IRS, in Rev. Rul. 2003-98, provided guidance on which taxpayer, among several parties in a purchase or merger, can deduct employees' exercise of target nonqualified stock options (NQSOs). The ruling generally holds that the target can take the deduction in the situations described below.

Example 1: In year 1, X began employment with T Corp. and was granted NQSOs to purchase T's common stock. The NQSOs have no readily ascertainable fair market value (FMV) at grant and are not exercisable until January 1 of year 4. On November 15 of year 4, A Corp. acquired all of T's outstanding shares for cash, but did not make a Sec. 338(g) election. T thereafter conducts its business as A's wholly owned subsidiary. Both corporation are accrual-basis taxpayers with a tax year ending September 30.

On the acquisition date, X surrendered his TNQSOs to A for A NQSOs with no readily ascertainable FMV. On January 15 of year 5, while employed by T, X exercises his A NQSOs and receives substantially vested A stock.

Example 2: The Facts are the same as in Example 1, except that, on January 15 of year 5, under an agreement, A cancels the NQSOs for a payment (in cash or shares) to X.

Example 3: The facts are the same as in Example 1, except that, instead of exchanging T NQSOs for A shares on the acquisition date, the T NQSOs remain in effect. On January 15 of year 5, under an agreement, A cancels the T NQSOs and pays X (in cash or value-equivalent substantially vested A shares) the excess of the FMV of the stock subject to the NQSOs over their exercise price.

Example 4: The facts are the same as in Example 1, except that on November 4 of year 4, A and T merge under state law, with A as the survivor, in a merger that qualifies as a complete liquidation under Sec. 332.

Law

Income: Under Sec. 83(a), when property is transferred to any person in connection with the performance of services, he or she must include in income (as compensation) the excess of the property's FMV over the amount (if any) paid for the property. FMV is determined when the transferee's rights to the property are either transferable or not subject to a substantial risk of forfeiture.

Sec. 83(e)(3) contains an exception for options; it provides that the transfer of an option is not includible in income if it has no readily ascertainable FMV at grant. Instead, income is generally recognized when the option is exercised or otherwise disposed of. Under Temp. Regs. Sec. 1.83-7T, however, this does...