Income from ISO exercise includible in AMTI on transfer of purchased shares.

• Author: O'Driscoll, David
• Position: Incentive stock options, alternative minimum tax income

A was granted incentive stock options (ISOs) under Company S's plan on August 27 and November 18 of year 1. Liability under Section 16(b) of the Securities Exchange Act of 1934 ('34 Act) expired on February 27 and May 18 of year 2, respectively. S sold common stock in an initial public offering on May 5 of year 2. A agreed not to sell, otherwise dispose of or hedge any S common shares, options, warrants or convertible securities from May 5-November 2 of year 2 (lock-up period), as required under the underwriting agreement (and other agreements).

Under S's insider trading compliance program, insiders (such as A) could trade S stock only between November 5 and November 30 of year 2 (the trading window). After that, S denied A the right to trade in S shares from December 1 of year 2 until May of year 3. If A traded S shares without S's consent, S had the right to terminate his employment. However, the referenced agreements did not prohibit the exercise of ISOs. A exercised ISOs in July, August and November of year 2, and in April, June and August of year 3. A sold the shares he acquired via the ISOs in August and December of year 3. On their year 2 joint return, A and B reported a tax preference item of $499,521 attributable to the ISOs, and an overall alternative minimum tax (AMT) liability of $151,053. However, A and B filed an amended year 2 return, seeking a $148,758 abatement, claming that (1) the original AMT calculation was based on the market price of S stock when acquired by A; (2) the fair market value (FMV) was mistakenly assigned the market price; (3) the FMV should have reflected the three-week window restriction in year 2; and (4) the AMT preference had to he adjusted to reflect the stock's true FMV.

A further contends that rights in the S shares he purchased through his ISOs were substantially nonvested, because he would have been subject to penalties under Securities and Exchange Commission (SEC) Rule 10b-5 (Rule 10b-5) if he had sold S shares anytime during the period beginning in January of year 2 and ending in May of year 3.

Analysis

Sec. 55 imposes the AMT on certain tax preference items, such as ISOs. For AMT purposes, Sec. 83 applies to determine the compensation income (if any) attributable to ISOs. Property is not taxable under Sec. 83 until it is "transferred" to and "substantially vested" in the service provider (or beneficiary thereof).

Transfer

A transfer of property occurs when a person acquires a beneficial...