Income recognized when stock options exercised.

• Author: Palahnuk, Jonathan

An employee's income from employer stock options was taxable in the year the employee exercised them, not when he paid off the margin loan used to purchase the stock.

Background

P entered into two agreements with his employer, M, giving him options to purchase shares of M's stock. P exercised the options, financing the stock purchase with a loan from Q a third-party investment company. The shares were deposited in an account maintained by O in P's name. However, P became the registered owner and acquired the right to vote the shares, receive dividends and pledge the stock as collateral for a loan. O obtained a security interest in the shares; M was completely divested of any interest in the shares, because it had been paid in full with the funds from the margin loan.

Per his agreement with O, P was not required to make any periodic principal or interest payments on the margin loan. Rather, he merely was required to maintain a predetermined minimum balance of cash and/or collateral in the account. The loan agreement included deficiency clauses, under which O was authorized to liquidate the stock if the account balance fell below this minimum threshold; P agreed to be liable for any deficiency in his accounts.

In March 2001, P paid off the O margin loans. P asserts that the stock transactions were taxable when he paid off the margin loan in 2001, rather than when he obtained ownership of the stock from M in 2000.

Analysis

Under Sec. 83(a), the financial gain realized by an employee on exercising stock options is taxable as gross income in the year the options were exercised if two prerequisites are met. First, under Regs. Sec. 1.83-1(a)(1) and -3(a)(1), the shares must be "transferred" to the employee, which occurs when the employee acquires "a beneficial ownership interest" in the stock. Second, the shares must become "substantially vested" in the employee, which happens when the stock becomes "either transferable or not subject to a substantial risk of forfeiture." If both conditions are satisfied, the employee realizes gross income equal to the difference between the stock's fair market value at the moment it became substantially vested and the amount paid to exercise the options.

Transfer: Whether a transaction is a stock transfer or the grant of an option to purchase the stock in the future is a question of fact under Kegs. Sec. 1.83-3(a)(2). This determination is made by analyzing "the type of property involved, the extent to which the...