In Search Of . . . Proposed Regulations for ISOs and ESPPs

The Internal Revenue Service published on June 9, 2003 comprehensive proposed regulations governing statutory stock options including both incentive stock options ("ISOs") and options offered under employee stock purchase plans ("ESPPs"). These new proposed regulations (the "Proposed Regulations") replace the existing proposed regulations under Code section 422 governing ISOs that were originally published in 1984. In addition, they reorganize the Code sections 421 and 424 regulations, update cross-references and remove obsolete provisions. In some areas, the Proposed Regulations also provide additional guidance and clarification by incorporating existing interim guidance and adding new provisions.

As a general rule, the grant of an option by an employer corporation to an employee to purchase stock in connection with the performance of services and the transfer of stock pursuant to the exercise of this option are taxable events under Code section 83. However, Code section 421 provides special tax treatment for transfers of shares of stock pursuant to the exercise of a statutory option. Code section 421 states that if a share of stock is transferred to an individual pursuant to the exercise of a statutory option, then the individual will not recognize income at the time of the exercise of the option. In addition, the employer corporation will not be allowed a compensation deduction upon the exercise of a statutory option.

In order for the above rules to apply, Code section 422(a) requires that (i) no disposition of the shares be made within two years from the date of the grant of the option or within one year from the date of the transfer of the shares, and (ii) at all times during the period beginning on the date of the grant and ending on the date that is three months before the exercise of the option, the individual is an employee of the corporation granting the option or of a corporation affiliated with the granting corporation.

Modification of Definitions. The special tax treatment afforded statutory stock options only applies to "options" for the purchase of "stock" of a "corporation." These definitions have been expanded by the Proposed Regulations as follows –

• "Option" is defined to include warrants if the warrants otherwise meet the requirements in the regulations.

• "Corporation" is defined to include C corporations, S corporations, foreign corporations and limited liability corporations that have elected to be treated as corporations for federal income tax purposes. However, a "Corporation" does not include entities that are treated as partnerships for federal income tax purposes, including limited liability companies, limited liability partnerships or limited partnerships.

• "Stock" is defined to include capital stock of any class, including voting or nonvoting common or preferred stock. Special classes of stock that are authorized to be issued only to employees are also within the definition of stock as used in the Proposed Regulations as long as the stock otherwise possesses the rights and characteristics of capital stock.

Electronic Form Allowed. Section 421 requires statutory options and the plans under which they are granted to be in writing. The Proposed Regulations clarify that the writing can be in paper or electronic form as long as such form is enforceable under applicable law.

Stockholder Approval. In general, an ISO plan must be approved by the stockholders of the granting corporation within 12 months before or after the date the plan is adopted. The Proposed Regulations provide the same basic requirements for stockholder approval as those included in the 1984 proposed regulations. However, they also provide that with respect to ISOs, if the board of directors of the granting corporation subjects its adoption of the plan to a condition (e.g., stockholder approval), the plan will be considered to be adopted on the date the condition is satisfied. The Proposed Regulations also provide additional guidance indicating the circumstances in which changes in the terms of an ISO plan will be considered the adoption of a new plan, thereby requiring stockholder approval, including a change in the granting corporation, an increase in the maximum aggregate number of shares that may be issued under the plan (other than a stock dividend or stock split) and a change in the designation of employees eligible to receive options under the plan. Also, the proposed regulations address the spin-off of the stock of a subsidiary, S, by its parent, P, and provide that if P, as the sole stockholder of S, approves the plan prior to the spin-off, S will not be required to seek approval of the plan from the stockholders of S after the spin-off. This additional guidance is welcome because although practitioners have generally interpreted the regulations to achieve this result, a recent IRS ruling suggested new stockholder approval would be required following the spin-off (i.e., see IRS Private Letter Ruling 200139001).

Maximum Aggregate Number of Shares. Code section 422(b)(1) provides that the plan pursuant to which an ISO is granted must include the aggregate number of shares which may be issued through options. The Proposed Regulations interpret this requirement to mean that the plan must designate the maximum aggregate number of shares that may be issued under the plan for ISOs, nonstatutory options and all other stock-based awards to be granted. The Proposed Regulations contain the following example:

X Corporation maintains a plan under which statutory options and nonstatutory options may be granted. The plan only designates the number of shares that may be used for ISOs. Because the maximum aggregate number of shares that will be used for both statutory and nonstatutory options is not designated in the plan, the requirements under paragraph (b)(3) [of the Proposed Regulations] are not satisfied.

Other examples in the Proposed Regulations clarify that it is permissible to establish the aggregate number of shares as a percentage of shares outstanding on the date of the adoption of the plan or to provide that the aggregate number of shares will increase each year by a certain percentage of the shares outstanding on each anniversary date of the adoption of the plan. However, establishing an aggregate number of shares based on the number of shares outstanding at a future date would not satisfy the ISO plan requirements.

$100,000 Limitation. The Proposed Regulations incorporate and expand IRS Notice 87-49, which provides guidance on the operation of the $100,000 limitation. The $100,000 limitation provides that options will be treated as ISOs only to the extent that the fair market value of the stock with respect to which ISOs are exercisable for the first time by an individual during any calendar year does not exceed $100,000. The regulations provide the following guidance with respect to the computation of the $100,000 limit –

• Options that do not qualify as ISOs at the time of their granting are disregarded.

• Options are taken into account in the order they are granted.

• An option is considered to be first exercisable during a calendar year if the option will first become exercisable at any time during that year.

• If an individual is able to exercise an option in a year only if an acceleration provision (e.g., a provision that accelerates exercisability on a change in control or the attainment of a performance goal) is satisfied, then the option is exercisable in the year the acceleration provision is triggered. However, because an acceleration provision is not taken into account before it is triggered, it will not affect the application of the $100,000 limitation with respect to options exercised prior to such acceleration.

• A disqualifying disposition will have no effect on the determination of whether an option exceeds the $100,000 limitation.

Permissible Provisions. The Proposed Regulations give several examples of additional provisions that may be included in an ISO plan without disqualifying it as an ISO, including permitting cashless exercises, providing the right to receive additional compensation and providing alternative rights.

Substitution, Assumption and Modification of Options. The Proposed Regulations redesignate the regulations under Code section 425 as regulations under Code section 424 and provide updates. In general, under Code section 424, if a statutory option is modified, extended or renewed, such modification, renewal or extension is treated as the grant of a new option, which will often result in the option no longer qualifying as a statutory stock option. A change in the terms of an option attributable to an eligible corporation’s substitution or assumption of options pursuant to certain corporate transactions, however, will not be deemed a modification of an option and will not be considered a grant of a new option. The Proposed Regulations generally follow the existing regulations regarding assumption and substitution of options with expanded definitions of an "eligible corporation" and a "corporate transaction." The Proposed Regulations also eliminate the requirement 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.

Under both the existing regulations and the Proposed Regulations, a modification will be deemed to occur when an option is amended to provide that the individual will receive additional benefits (presently or in the future). In addition, the Proposed Regulations offer additional guidance with respect to when a change to an option constitutes a modification, including the following –

• There is no modification to an option when the granting corporation exercises discretion related to the payment of a bonus at the time of the exercise of the option, the availability of a loan at exercise, or the right to tender previously-owned stock for the stock purchasable under the option if the option permits such discretion. A change to an option to add such discretion, however, will constitute a modification.

• Any change to the stock on which the option is granted that affects the value of the stock will constitute a modification of the option unless the option is also appropriately modified or a substitute option is granted in accordance with the regulations relating to the assumption and substitution of options.

Written Statement Requirement. The Proposed Regulations also provide guidance on the statements required under Code section 6039. In general, these provisions require every granting corporation that transfers stock to an individual due to the individual’s exercise of a statutory stock option to furnish a written statement that includes certain information with respect to the transfer. However, the Proposed Regulations reserve the issue of whether an electronic form for these statements is allowed. The preamble indicates that the issue of whether electronic filing methods are appropriate for information statements in general is under review and comments are requested.

Effective Date and Good Faith Reliance. The preamble indicates that the original 1984 proposed regulations under Code section 422 are withdrawn. The Proposed Regulations are proposed to be effective as of the date that is 180 days after publication of final regulations and would apply to any statutory option that is granted on or after that date. In the interim, the IRS stated in the preamble that taxpayers may rely on the Proposed Regulations for the treatment of any statutory option that is granted after June 9, 2003.