Stock options and SEC Section 16(b).

• Author: Coscia, Matthew R.

Stock options are a popular way to attract talent. Generally, they can either be statutory (incentive stock options (ISOs)) or nonstatutory (nonqualified stock options (NQSOs)).The tax treatment of each differs. Under Sec. 83, NQSOs are taxed to the employee on the date exercised. The amount included in income is the difference between the stock's fair market value (FMV) on the vesting date and the amount the employee paid for the stock.

Income realized from the exercise of ISOs is not included in regular taxable income when exercised by the employee. Rather, assuming the requirements of Sec. 422 are met, the employee is taxed on the income realized when he or she sells the underlying stock; it is capital gain, not ordinary income. For alternative minimum tax (AMT) purposes, Sec. 56(b) (3) provides that ISOs are treated like NQSOs and taxed when exercised.

There are horror stories in which taxpayers exercised options in a high-flying stock and failed to sell the stock before the price dropped, due to Securities and Exchange Commission (SEC) and/or corporate insider trading restrictions. The taxpayer then faced a large AMT bill with no money to pay it, or had large ordinary income and a capital loss.

How are corporate insiders taxed on the exercise of stock options subject to SEC and corporate sale restrictions? Rev. Rul. 2005-48 and two TAMs provide guidance.

Rev. Rul. 2005-48

Facts: Employee E was granted NQSOs of Company M on Jan. 2, 2005. On May 1, 2005, M sold its common stock in an initial public offering. The underwriting agreement provided that E could not sell, otherwise dispose of or hedge any M common shares, options, warrants or convertible securities from May 1, 2005-Nov. 1, 2005 (lock-up period).

M also adopted an insider trading compliance program under which insiders could trade M shares only between November 5 and November 30 of that year (trading window). Failure to abide by these rules would result in termination. The exercise of the NQSOs was not prohibited.

On Aug. 15, 2005, E exercised the fully vested option. Also on that date, E possessed material nonpublic information about M that would subject him to liability under Rule 10b-5 under the Securities and Exchange Act of 1934 ('34 Act) if E sold the shares while in possession of such information.

Law: Sec. 83(a) provides that, when property is transferred to a taxpayer in connection with the performance of services, its FMV (determined without regard to any lapse...