New Proposed Regulations Regarding Statutory Stock Options

The Internal Revenue Service (“IRS”) recently published new proposed regulations1 under Sections 421, 422, and 424 of the Internal Revenue Code (the “Code”) regarding statutory stock options. The new proposed regulations supplant a previous set of proposed regulations issued almost twenty years ago (on February 7, 1984, to be precise)2 and update the existing final regulations, certain sections of which date back to the 1960s.

The new regulations are an attempt by the IRS to provide a complete and comprehensive set of rules governing incentive stock options (“ISOs”) and to update the references in the rules regarding qualified options exercised under employee stock purchase plans (“ESPPs”). Those already familiar with the existing rules, in both final and proposed form, will recognize the incorporation of many of the same rules in the new proposed regulations, although the provisions have been reorganized and renumbered. Certain obsolete rules and cross-references have been removed. After a brief overview of the relevant income tax treatment afforded these types of options and the stock acquired upon the exercise of such options, this article will focus on certain of the changes that have been incorporated into the rules with the issuance of the new proposed regulations.


Code section 421 provides special tax treatment for stock transferred to an employee pursuant to the exercise of an ISO (as defined in Code section 422) or the exercise of an option obtained pursuant to an ESPP (which satisfies the requirements of Code section 423). Generally, with respect to either of these “statutory” options, there is no recognition of income on the part of an employee upon the grant of the option or upon its exercise. (The principal exception to this general rule is the alternative minimum tax (“AMT”) regime of Code section 55. Exercise of an ISO may give rise to AMT liability). In addition, if the stock received upon the exercise is held for the statutorily prescribed holding period, the stock will be treated as a capital asset and any appreciation in value following the exercise is taxed as capital gain upon subsequent sale or disposition.3 To satisfy the holding period, the employee must retain the stock for a minimum of one year from the date of transfer and two years from the date the option to acquire the stock was granted to the employee, whichever is longer.

A disposition of stock before the end of this required holding period is known as a “disqualifying disposition” because the tax advantages of Section 421 treatment are lost. In general, the employee is deemed to receive compensation (i.e., ordinary income) equal to the amount of the fair market value of the stock on the date the option is exercised less the amount, if any, the employee paid for the stock. Only upon a disqualifying disposition is the employer entitled to any deduction with respect to an employee’s exercise of a statutory stock option.

Highlights of Changes

Revised definitions:

Many of the definitions in the new proposed regulations are the same as those provided in the existing final and proposed regulations. The definitions of the terms “option,” “statutory option,” and “corporation,” however, have been revised in certain significant ways. The definition of “option” has been expanded to include a warrant4 that otherwise meets the applicable requirements. The requirement that an “option” (and the plan pursuant to which such options are to be granted) must be in writing remains. Under the revised definition, however, an option can be evidenced in electronic form, so long as the right or privilege granted by the option is enforceable under applicable law.

The term “statutory option” continues to encompass both ISOs and options granted under an ESPP. In general, an option qualifies as a statutory option only if the individual cannot transfer the option during his or her lifetime. The new proposed regulations offer the optionee a degree more flexibility than was previously available. The definition of “statutory option” has been revised to permit such options to be transferred to a grantor trust. A “statutory option” will continue to qualify as such if, under Code section 671 and applicable state law, the individual to whom the option was granted remains its beneficial owner.

Finally, under the new proposed regulations it is clear that any entity that is classified as a corporation for federal tax purposes may grant statutory options. Thus, a “corporation” that may offer statutory options includes a C corporation, an S corporation, a foreign corporation, and a limited liability company that has elected to be treated as a corporation for federal income tax purposes.

Stockholder Approval of Incentive Stock Option Plan:

A corporation must obtain the approval of its stockholders as a prerequisite for the issuance of statutory options. To qualify as a statutory option, an option must be granted pursuant to a plan that is approved by the issuer’s stockholders within the period that begins 12 months before and ends 12 months after the date the plan is adopted. Code section 422(b)(1) and Code section 423(b)(2).

With respect to ISOs, the maximum aggregate number of shares to be issued under the plan and the employees eligible to receive the ISOs under the plan are essential plan provisions for which stockholder approval is required. As under the existing rules, any change to these provisions, e.g., an increase in the aggregate number of shares or a change to the classes of the employees eligible to be granted ISOs, is considered a new plan for which stockholder approval is required. The new proposed regulations clarify these requirements and provide that other changes in the terms of an ISO plan are not considered a new plan and, thus, do not require stockholder approval.

A distinction to note, however, arises with the discussion in the regulations of what constitutes a “new” plan. A change in the corporation whose stock is to be issued pursuant to the ISOs is deemed to cause the establishment of a new plan, and will require approval by the stockholders of the corporation issuing the stock. This situation could arise if a corporation with an existing plan decides to offer its parent’s stock (rather than its own subsidiary stock) under the plan. The regulations make clear that timely approval by the parent’s stockholders would be required.

$100,000 LIMITATION:

The Tax Reform Act of 1986 amended Code section 422 to provide an individual limit on the stock capable of receiving favorable tax treatment under the ISO rules. As amended, Section 422(d)(1) provides that an option will not be treated as an ISO to the extent that the “$100,000 limitation” is exceeded during a single calendar year. The existing final and proposed regulations do not include any rules concerning the operation of the $100,000 limitation because those regulations predated the statutory change. The IRS previously issued general guidance in the form of a notice,5 the substance of which has been expanded and incorporated into the new proposed regulations.

The “$100,000 limitation” refers to the aggregate fair market value of the stock subject to ISOs that are exercisable for the first time during a calendar year. An option that otherwise qualifies as an ISO will fail to be an ISO to the extent that the $100,000 limitation is exceeded. To determine if the $100,000 limitation has been exceeded, the value of stock is determined as of the date each ISO was granted and options are generally taken into account in the order in which they were granted. An option that does not qualify as an ISO when granted is disregarded for this purpose. In addition, a disqualifying disposition has no effect on the determination of whether an option exceeds the $100,000 limitation. (An employee should carefully plan the timing of his or her exercise of ISOs and the disposition of the underlying stock for any year in which the $100,000 limit might be a factor.)

The new proposed regulations also specify how to determine whether the $100,000 limitation has been exceeded in the event an accelerated exercise provision of the ISO is triggered. An ISO that becomes exercisable for the first time during a calendar year by operation of an acceleration provision does not affect the application of the $100,000 limitation with respect to an option (or portion thereof) exercised prior to such acceleration. This is best illustrated through an example:

In 2006 an employee of YCorporation is granted Option1 for stock of Y with a fair market value on the date of the grant of $75,000. Option1 is scheduled to be exercisable in 2008, but will become immediately exercisable if the corporation undergoes a change of control. In 2007 the same employee is granted Option2 for stock of Y with a fair market value of $50,000. Option2 is immediately exercisable, and the employee exercises Option 2 in June 2007. In August 2007, YCorporation has a change of control, Option1 becomes exercisable and the employee exercises Option1. Option2 is accounted for before Option 1 for purposes of the $100,000 limitation. Option 2 is treated entirely as an ISO even though it was granted after Option1. Option1 is bifurcated into an ISO for two-thirds of the shares subject to the option and a nonstatutory option for the remaining one-third of the shares.


In general, any modification, extension, or renewal of a statutory option is treated as the grant of a new option. A “modification” is any change in the terms of an option (or the plan pursuant to which it was granted) that gives the optionee additional benefits under the option.6 For example, a change extending the period during which an option may be exercised or a change providing an alternative to the exercise of the option (such as a stock appreciation right) is a modification. To be treated as a statutory option, the “new” option must meet all of the same qualification requirements (including pricing) on the date it becomes effective.

A significant exception to this general rule is that a change in the terms of an option attributable to a substitution or an assumption that meets the requirements of Code section 424(a) will not be considered a modification of an option. This rule permits certain substitutions or assumptions arising from a corporate reorganization, merger, or liquidation to be made without requiring that the substituted (or assumed) option qualify as a new option. Key terms in applying this rule are that the substitution or assumption occurs “by reason of” a “corporate transaction.”

The new proposed regulations clarify and expand the scope of the rule by defining a “corporate transaction” to include a stock dividend, a stock split, a change in the name of the corporation whose stock is purchasable under the option and “such other corporate events prescribed by the Commissioner in published guidance.” The new proposed regulations also eliminate the requirement in the existing regulations that the “corporate transaction” result in a significant number of employees being transferred to a new employer (or discharged), or in the creation (or severance) of a parent-subsidiary relationship. Reg. section 1.425-1(a)(1)(ii). Finally, the new proposed regulations provide that a change will be considered to be “by reason of” a corporate transaction, unless the relevant facts and circumstances demonstrate that such change was made for reasons unrelated to the corporate transaction. Two examples of the latter are cited in the regulations: an unreasonable delay between the corporate transaction and the change to the options, and a corporate transaction that serves no substantial corporate business purpose independent of the change in the options. These examples suggest that changes that would run afoul of the rule are those where the corporate transaction was not the primary impetus for the change, but rather the intent behind the change was to modify the option. Consequently, changes arising from corporate transactions should generally pass muster under the new rules.

Effective Date

The new proposed regulations will be effective 180 days after publication in the Federal Register as final regulations. Taxpayers, however, may rely on the proposed regulations for the treatment of statutory options granted after June 9, 2003. Thus, the proposed regulations currently offer reliance regarding the treatment of statutory options, and this article highlights some of the recent changes that issuers of options and optionees may find worth noting.