Treasury and IRS Finalize Regulations for Incentive Stock Options

Upper Saddle River, N.J. - August 31, 2004 - Earlier this month, the Treasury Department and the IRS issued final regulations on Incentive Stock Options ("ISOs"). These regulations finalize, with modest changes, regulations proposed in 2003.

ISOs provide employees with the ability to acquire employer stock without realizing income when the option is exercised. If the employee holds the stock for the required period, any gains on the sale of the stock are treated as capital gains. The exercise price for an ISO must be no less than the fair market value of the underlying stock on the date the ISO is granted.

Shareholders must approve an ISO plan, and the amount of ISOs that can be granted to an employee is limited. If the employee meets the holding period requirements for capital gains treatment on the sale of the stock, the employer is not entitled to a deduction with respect to the ISO.

The final regulations include a number of minor changes from the proposed regulations, including revisions to the rules regarding maximum aggregate number of shares in an ISO plan, substitution and assumption of ISOs, and modification of ISOs.

The final regulations generally will be effective on the earlier of January 1, 2006, or the first regularly scheduled stockholders meeting of the granting corporation occurring at least 6 months after the publication of the final regulations.

The major changes of interest are as follows:

Maximum number of shares: One of the conditions for an ISO is that it be issued under a plan "which includes the aggregate number of shares which may be issued under options." The final regulations reverse this stance, requiring a separate ISO limit.

This change in particular will require companies maintaining equity compensation plans to take action. A plan that states merely an overall plan limit on shares that is not specific to ISOs will have to be amended to provide for a limit specific to ISOs. Furthermore, such an amendment will need to be submitted for shareholder approval, since shareholder approval is required for amendments changing the number of shares that can be issued. However, since the final regulations are not effective until 1/1/2006, action is not required immediately.

"Net" shares and the overall plan limit: The final regulations change the rule for how shares are counted against the aggregate limit for ISOs. The final regulations provide that only the net number of shares issued as a result of the exercise of the option is counted against the maximum limit under the plan.

For example, if an employee uses 50 shares he or she owns to pay the exercise price of 150 options, the employee will have received only 100 additional shares. The final regulations clarify that only the net shares issued (100 in this case) count against the overall limit in the plan on ISOs.

Corporate transactions and shareholder vote and modification rules: The final regulations provide that in a corporate transaction, ISOs (and ESPPs) existing at the time of the transaction that are substituted or assumed by the acquiring company are not required to be submitted for additional approval by the shareholders of the acquiring company. However, future option grants under the plan qualify only if the acquiring company's shareholders approve the plan.
Nonvested stock and disqualifying dispositions: The final regulations elaborate on a number of points:

The final regulations clarify that a "transfer" is considered to have occurred even if the individual receives nonvested shares upon the exercise of an ISO. Under Section 422(a)(1), an individual must hold the stock for one year following the date of transfer (as well as two years after the grant of the option) in order to receive favorable ISO treatment. As a result, the holding period starts when the stock is transferred, regardless of whether the stock received is subject to restrictions.

The final regulations clarify the effect of elections under Section 83(b) when the individual receives restricted stock. The final regulations clarify that a Section 83(b) election will have no effect for "regular" income tax purposes, but will be recognized for purposes of the Alternative Minimum Tax. As a result, if there is a subsequent disqualifying disposition, the amount of compensation income the individual is required to recognize is based on the value of the stock at the date it vests, rather than the date it was originally transferred.

The final regulations clarify that the corporation's deduction allowable upon a disqualifying disposition is allowed provided that the requirements of Section 83(h) and Reg. 1.83-6(a) are satisfied.

Inadvertent modifications: The final regulations provide that if an ISO or an ISO plan is inadvertently modified in such a way as to disqualify the ISOs or the plan, then if the modification is cancelled before the earlier of the exercise of the ISO or the end of the calendar year of the modification, the ISO is not disqualified.