Sec. 409A and stock options: a cause for concern?

• Author: Wood, Susan

As the tax filing deadline approaches, questions always arise about clients who exercised stock options last year and are now in shock over their tax bills. These clients forgot to consider how exercising their options could affect their compensation or capital gain.

Sec. 409A was added to the Code as part of the American Jobs Creation Act of 2004 (AJCA), effective as of Jan. 1, 2005. What is the impact of Sec. 409A on stock options for 2005 and beyond?

ISOs

Incentive stock options (ISOs) are options granted to individuals for any reason connected with their employment by a corporation to purchase the stock of such corporation. To be treated as an ISO, an option must meet certain requirements under Sec. 422, which include, among others, (1) an option price that is greater than or equal to the fair market value (FMV) of the corporation's stock at the time the option is granted and (2) an individual who, at the time the option is granted, does not own more than 10% of the total combined voting power of all classes of stock.

When a corporation grants an ISO to an employee, there is no tax effect for either the employee or the corporation at the grant date. Once the ISO is exercised, the employee does not recognize any income at the exercise date, according to Sec. 421. Further, the corporation cannot deduct the transfer of its stock to the employee. The employee's basis in the stock received will be equal to the amount paid under the option at the exercise date.

Qualifying Dispositions

When employees sell the stock they acquired through stock options, their goal is a long-term capital gain. A disposal of shares acquired through an ISO must meet employment and holding period requirements to be a qualifying disposition, which would also qualify for capital gain treatment. The holding period requirement defined in Sec. 422(a)(1) states that an employee must hold the stock for at least two years from the ISO's grant date, and; if later, at least one year following the exercise date before disposal. The employment requirement under Sec. 422(a)(2) states that the employee must have been an employee beginning on the date that the option was granted and up to three months prior to exercising the option. If the ISO meets both of the requirements, the disposition will be a qualifying disposition and receive capital gain treatment.

Note: Sec. 56(b)(3) can disallow the benefit of Sec. 421 for alternative minimum tax (AMT) purposes. The spread between the...