Dealing with ISOs and disqualifying dispositions in reorganizations.

• Author: Karpiak, Carl P.
• Position: Incentive stock options

A recent Chief Counsel advice (CCA 201519031) provides guidance on disqualifying dispositions of incentive stock options (ISOs) in reorganizations. The holder of an ISO that meets the requirements of Sec. 422 generally does not recognize income upon exercise (although the holder does incur an alternative minimum tax adjustment). Correspondingly, an employer does not receive a deduction when the ISO is exercised.

If stock acquired by exercise of the ISO (ISO stock) is held until the later of one year from the date the option is exercised or two years from the date the option is granted, any gain on the disposition of the ISO stock is entitled to be treated as long-term capital gain (Sec. 422(a)(1)). A disposition generally includes a sale, exchange, gift, or transfer of legal title, but it does not include a transfer from a decedent to an estate or a transfer by bequest or inheritance; an exchange to which Sec. 354,355,356, or 1036 (or so much of Sec. 1031 as relates to Sec. 1036) applies; or a mere pledge or hypothecation (Sec. 424(c)(1)). If the ISO stock is disposed of before the holding period is met, it is a "disqualifying disposition" (Sec. 421(b)), which results in W-2 wages to the employee and an income tax deduction for the company. However, the wages are not subject to Federal Insurance Contributions Act taxes, Federal Unemployment Tax Act taxes, or wage withholding.

CCA 201519031 explored the application of the disqualifying disposition rules in two scenarios: Scenario 1 involves a transaction that qualified as a Sec. 368 reorganization with boot, and Scenario 2 deals with a reorganization that failed to qualify under Sec. 368. The following is from the CCA:

Scenario 1: Corporation A and Corporation Y are unrelated corporations that are incorporated under the laws of State B. On July 1,2011, Corporation X grants a stock option to A, an employee of Corporation X since Jan. 4,2011, entitling A to purchase 100 shares of Corporation A voting common stock for $15 per share. The stock option qualifies as an ISO, as defined in Sec. 422. On Dec. 30,2011, A exercises the option when the fair market value (FMV) of Corporation X stock is $25 per share, and 100 shares of Corporation X voting common stock are transferred to A on that date. On Jan. 3,2012, Corporation X and Corporation Y enter into an agreement (the merger agreement) pursuant to which Corporation Y will acquire Corporation X by forming a new subsidiary (Corporation Z) that will...