Potential income deferral on the exercise of nonqualified options.

• Author: Lerman, Jerry L.

A grant of nonstatutory stock options is not taxable to a recipient, as long as the options do not have a readily ascertainable fair market value (FMV). The regulations define "readily ascertainable FMV" in such a fashion that, in most instances, the grant is not a taxable event. This leaves the determination of ordinary income open until the employee exercises the options, at which time the compensation-recognition event occurs. In today's volatile stock market, employees can get whipsawed if they are required to hold stock acquired through the exercise of these options for a specified period of time. Although the exercise creates ordinary (compensation) income, if the per-share price spirals downward during the period within which the employee is restricted from selling the stock, the ultimate sale will cause the employee to recognize a capital loss. Since the loss will not offset the ordinary income recognized at the time of the exercise, the question is whether alternatives might be available to reduce the impact of this adverse result.

Two common restrictions placed on the sale of stock acquired through the exercise of nonstatutory options are SEC Rule 144 and Section 16(b) of the Securities Exchange Act of 1934. Rule 144 generally requires corporate insiders to hold the stock for one year from the acquisition date before it can be sold. Section 16(b) attempts to prevent speculative "short-swing" transactions by making the profits of insiders' purchase and sale transactions subject to recovery by the company. Both of these limits on sale can make an employee who exercises nonstatutory options unable to sell the stock, even while watching its price plummet. To lessen the adverse impact, the employee may look to either delay income recognition or value the stock at a price more in line with the price at which the employee could actually sell it, when the SEC restrictions are first relieved.

To delay the taxable event, the stock received on the exercise must be subject to a substantial risk of forfeiture and nontransferable. To discount the stock's value from its listed trading price at the exercise date, the stock must be subject to a restriction which, by its terms, never lapses.

Rule 144

Rule 144 does not contain a forfeiture provision, which is typically established by a company to ensure that, for a specified period of time after exercise, an employee continues to provide services to the company. Unless the company imposes such a...