Exchange of shares in ISO exercise.

• Author: Wong, Alan
• Position: Incentive stock options

Incentive stock options (ISOs) are granted to a corporation's employees and provide the privilege of purchasing the company's stock at a fixed price during a specific time frame. Under Regs. Sec. 1.6045-l(d) (2), which requires that broker statements disclose securities' adjusted basis beginning January 1, 2011, basis tracking of ISOs is more relevant than ever.

Example 1: F, a single employee of ABC, Inc., receives ISOs in June 2006 to purchase 1,000 shares of ABC stock at $20 per share. F exercises her stock options in September 2007 when the stock's fair market value (FMV) is $50 per share. F pays $20,000 cash ($20 option price x 1,000 shares) for stock worth $50,000 ($50 FMV X 1,000 shares). Exhibit 1: F's basis after swap Lot# Shares Holding Shares Cost Issued Period Basis Date Begins per Share 1 September September 400 $20 2007 2007 2 January September 600 $20 2009 2007 3 January January 400 $ 0 2009 2009 Exhibit 2: F's basis for A WIT purposes after swap Lot# Shares Holding Shares AMT Issued Period Cost Date Begins Basis per Share 1 September September 400 $50 2007 2007 2 January September 600 $50 2009 2007 3 January January 400 $60 2009 2009 Given that certain requirements provided for in Sec. 422 are met, under Sec. 421(a) there is no income tax result upon exercise of an ISO. For regular income tax purposes, F will not have any income tax ramifications upon receipt of the stock, and her cost basis is $20,000 ($20 per share).

In determining her alternative minimum taxable income (AMTI), F will incur an additional $30,000 ISO adjustment as required by Sec. 56(b)(3), and her AMT cost basis will be $50,000 ($50 per share).

Example 2: In December 2007, F receives another ISO to purchase 1,000 shares at $36 per share. She exercises this option in January 2009 when the stock value is $60 per share. F swaps 600 shares of her ABC shares purchased in September 2007, valued at $36,000, to purchase an additional 1,000 shares. After the swap, F owns 1,400 ABC shares. Regs. Sec. 1.422-5(b) provides for cashless exercise of incentive stock options under Sec. 1036(a), which allows nonrecognition treatment in an exchange of common stock for common stock of the same corporation. Regs. Sec. 1.422-5(b)(3)(i) provides for transferred basis in the options received under the Sec. 1036 exchange and for holding period determination under Sec. 1223. F's cost basis and holding period in the 600 shares she acquired in September 2007 will transfer to the...