Stock Options

If you receive a nonstatutory option to buy or sell stock or other property as payment for your services, you usually will have income either when you receive the option or when you exercise the option (use it to buy or sell the stock or other property). However, if your option is a statutory stock option (defined later), you usually will not have any income until you sell or exchange your stock. Your employer can tell you which kind of option you hold.

Nonstatutory Stock Options

If you are granted a nonstatutory stock option, the amount of income to include and the time to include it depend on whether the fair market value of the option can be readily determined. The fair market value of an option can be readily determined if it is actively traded on an established market.

The fair market value of an option that is not traded on an established market can be readily determined only if all of the following conditions exist.

• You can transfer the option.
• You can exercise the option immediately in full.
• The option or the property subject to the option is not subject to any condition or restriction (other than a condition to secure payment of the purchase price) that has a significant effect on the fair market value of the option.
• The fair market value of the option privilege can be readily determined.

The option privilege for an option to buy is the opportunity to benefit during the option's exercise period from any increase in the value of property subject to the option without risking any capital. For example, if during the exercise period the fair market value of stock subject to an option is greater than the option's exercise price, a profit may be realized by exercising the option and immediately selling the stock at its higher value. The option privilege for an option to sell is the opportunity to benefit during the exercise period from a decrease in the value of the property subject to the option.

Option with readily determined value.   If you receive a nonstatutory stock option that has a readily determined fair market value at the time it is granted to you, the option is treated like other property received as compensation. See Restricted Property, later, for rules on how much income to include and when to include it. However, the rule described in that discussion for choosing to include the value of property in your income for the year of the transfer does not apply to a nonstatutory option.

Option without readily determined value.   If the fair market value of the option is not readily determined at the time it is granted to you (even if it is determined later), you do not have income until you transfer or exercise the option. When you exercise this kind of option, the restricted property rules apply to the property received. The amount to include in your income is the difference between the amount you pay for the property and its fair market value when it becomes substantially vested. Your basis in the property you acquire under the option is the amount you pay for it plus any amount you must include in your gross income under this rule. For more information on restricted property, see Restricted Property, later.

If you transferred this kind of option in an arm's-length transaction, you must include in your income the money or other property you received for the transfer, as if you had exercised the option.

Statutory Stock Options

There are two kinds of statutory stock options.

• Incentive stock options (ISOs), and
• Options granted under employee stock purchase plans.

For either kind of option, you must be an employee of the company granting the option, or a related company, at all times beginning with the date the option is granted, until 3 months before you exercise the option (for an incentive stock option, 1 year before if you are disabled). Also, the option must be nontransferable except at death. If you do not meet the employment requirements, or you receive a transferable option, your option is a nonstatutory stock option. See Nonstatutory Stock Options, earlier in this discussion.

If you receive a statutory stock option, do not include any amount in your income either when the option is granted or when you exercise it. You have taxable income or deductible loss when you sell the stock that you bought by exercising the option. Your income or loss is the difference between the amount you paid for the stock (the option price) and the amount you receive when you sell it. You generally treat this amount as capital gain or loss and report it on Schedule D (Form 1040), Capital Gains and Losses, for the year of the sale.

However, you may have ordinary income for the year that you sell the stock in either of the following situations.

• You do not meet the holding period requirement. This situation applies only if you sell the stock within 1 year after its transfer to you or within 2 years after the option was granted.
• You meet the holding period requirement but the option was granted under an employee stock purchase plan for an option price that was less than the stock's fair market value at that time.

Report your ordinary income as wages on line 7, Form 1040, for the year of the sale.

Incentive stock options (ISOs).   If you sell stock acquired by exercising an ISO and meet the holding period requirement, your gain or loss from the sale is capital gain or loss.

If you do not meet the holding period requirement and you have a gain from the sale, the gain is ordinary income up to the amount by which the stock's fair market value when you exercised the option exceeded the option price. Any excess gain is capital gain. If you have a loss from the sale, it is a capital loss and you do not have any ordinary income.

Example.   Your employer, X Corporation, granted you an ISO on March 11, 2000, to buy 100 shares of X Corporation stock at $10 a share, its fair market value at the time. You exercised the option on January 19, 2001, when the stock was selling on the open market for $12 a share. On January 25, 2002, you sold the stock for $15 a share. Although you held the stock for more than a year, less than 2 years had passed from the time you were granted the option. In 2002, you must report the difference between the option price ($10) and the value of the stock when you exercised the option ($12) as wages. The rest of your gain is capital gain, figured as follows:

Selling price ($15 × 100 shares)	$ 1,500
Purchase price ($10 × 100 shares)	- 1,000
Gain	$ 500
Amount reported as wages [($12 × 100 shares) - $1,000]	- 200
Amount reported as capital gain	$ 300

Alternative minimum tax (AMT).   For the AMT, you must treat stock acquired through the exercise of an ISO as if no special treatment applied. This means that, when your rights in the stock are transferable and no longer subject to a substantial risk of forfeiture, you must include as an adjustment in figuring alternative minimum taxable income the amount by which the fair market value of the stock exceeds the option price. Enter this adjustment on line 13 of Form 6251, Alternative Minimum Tax - Individuals. Increase your AMT basis in any stock you acquire by exercising the ISO by the amount of the adjustment. However, no adjustment is required if you dispose of the stock in the same year you exercise the option.

See Restricted Property, later, for more information.

Your AMT basis in stock acquired through an ISO is likely to differ from your regular tax basis. Therefore, keep adequate records for both the AMT and regular tax so that you can figure your adjusted gain or loss.

Example.   The facts are the same as in the previous example. On January 19, 2002, when the stock was selling on the open market for $14 a share, your rights to the stock first became transferable. You include $400 ($1,400 value when your rights first became transferable minus $1,000 purchase price) as an adjustment on line 13 of Form 6251.

Employee stock purchase plan.   If you sold stock acquired by exercising an option granted under an employee stock purchase plan, determine your ordinary income and your capital gain or loss as follows.

Option granted at discount.   If you meet the holding period requirement and you have a gain from the sale, the gain is ordinary income up to the amount by which the stock's fair market value when the option was granted exceeded the option price. Any excess gain is capital gain. If you have a loss from the sale, it is a capital loss, and you do not have any ordinary income.

Example.   Your employer, Y Corporation, granted you an option under its employee stock purchase plan to buy 100 shares of stock of Y Corporation for $20 a share at a time when the stock had a value of $22 a share. Eighteen months later, when the value of the stock was $23 a share, you exercised the option, and 14 months after that you sold your stock for $30 a share. In the year of sale, you must report as wages the difference between the option price ($20) and the value at the time the option was granted ($22). The rest of your gain ($8) is capital gain, figured as follows:

Selling price ($30 × 100 shares)	$ 3,000
Purchase price (option price) ($20 × 100 shares)	- 2,000
Gain	$ 1,000
Amount reported as wages [($22 × 100 shares) - $2,000]	- 200
Amount reported as capital gain	$ 800

Holding period requirement not met.   If you do not meet the holding period requirement, your ordinary income is the amount by which the stock's fair market value when you exercised the option exceeded the option price. This ordinary income is not limited to your gain from the sale of the stock. Increase your basis in the stock by the amount of this ordinary income. The difference between your increased basis and the selling price of the stock is a capital gain or loss.

Example.   The facts are the same as in the previous example, except that you sold the stock only 6 months after you exercised the option. You did not hold the stock long enough, so you must report $300 as wages and $700 as capital gain, figured as follows:

Selling price ($30 × 100 shares)	$3,000
Purchase price (option price) ($20 × 100 shares)	- 2,000
Gain	$1,000
Amount reported as wages [($23 × 100 shares) - $2,000]	- 300
Amount reported as capital gain [$3,000 - ($2,000 + $300)]	$700

Restricted Property

Generally, if you receive property for your services, you must include its fair market value in your income in the year you receive the property. However, if you receive stock or other property that has certain restrictions that affect its value, you do not include the value of the property in your income until it has been substantially vested. (You can choose to include the value of the property in your income in the year it is transferred to you, as discussed later, rather than the year it is substantially vested.)

Until the property becomes substantially vested, it is owned by the person who makes the transfer to you, usually your employer. However, any income from the property, or the right to use the property, is included in your income as additional compensation in the year you receive the income or have the right to use the property.

When the property becomes substantially vested, you must include its fair market value, minus any amount you paid for it, in your income for that year.

Example.   Your employer, the RST Corporation, sells you 100 shares of its stock at $10 a share. At the time of the sale the fair market value of the stock is $100 a share. Under the terms of the sale, the stock is under a substantial risk of forfeiture (you have a good chance of losing it) for a 5-year period. Your stock is not substantially vested when it is transferred, so you do not include any amount in your income in the year you buy it. At the end of the 5-year period, the fair market value of the stock is $200 a share. You must include $19,000 in your income [100 shares × ($200 fair market value - $10 you paid)]. Dividends paid by the RST Corporation on your 100 shares of stock are taxable to you as additional compensation during the period the stock can be forfeited.

Substantially vested.   Property is substantially vested when:

• It is transferable, or
• It is not subject to a substantial risk of forfeiture. (You do not have a good chance of losing it.)

Transferable property.   Property is transferable if you can sell, assign, or pledge your interest in the property to any person (other than the transferor), and if the person receiving your interest in the property is not required to give up the property, or its value, if the substantial risk of forfeiture occurs.

Substantial risk of forfeiture.   A substantial risk of forfeiture exists if the rights in the property transferred depend on the future performance (or refraining from performance) of substantial services by any person, or the occurrence of a certain condition related to the transfer, and the possibility of forfeiture is substantial if the condition is not satisfied.

Example.   The Spin Corporation transfers to you as compensation for services 100 shares of its corporate stock for $100 a share. Under the terms of the transfer, you must resell the stock to the corporation at $100 a share if you leave your job for any reason within 3 years from the date of transfer. You must perform substantial services over a period of time and you must resell the stock to the corporation at $100 a share (regardless of its value) if you do not perform the services, so your rights to the stock are subject to a substantial risk of forfeiture.

Choosing to include in income for year of transfer.   You can choose to include the value of the property at the time of transfer (minus any amount you paid for the property) in your income for the year it is transferred. If you make this choice, the substantial vesting rules do not apply and, generally, any later appreciation in value is not included in your compensation when the property becomes substantially vested. Your basis for figuring gain or loss when you sell the property is the amount you paid for it plus the amount you included in income as compensation.

If you make this choice, you cannot revoke it without the consent of the Internal Revenue Service. Consent will be given only if you were under a mistake of fact as to the underlying transaction.

If you forfeit the property after you have included its value in income, your loss is the amount you paid for the property minus any amount you realized on the forfeiture.

How to make the choice.   You make the choice by filing a written statement with the Internal Revenue Service center where you file your return. You must file this statement no later than 30 days after the date the property was transferred. A copy of the statement must be attached to your tax return for the year the property was transferred. You also must give a copy of this statement to the person for whom you performed the services and, if someone other than you received the property, to that person.

You must sign the statement and indicate on it that you are making the choice under section 83(b) of the Internal Revenue Code. The statement must contain all of the following information.

• Your name, address, and taxpayer identification number.
• A description of each property for which you are making the choice.
• The date or dates on which the property was transferred and the tax year for which you are making the choice.
• The nature of any restrictions on the property.
• The fair market value at the time of transfer (ignoring restrictions except those that will never lapse) of each property for which you are making the choice.
• Any amount that you paid for the property.
• A statement that you have provided copies to the appropriate persons.

Dividends received on restricted stock.   Dividends you receive on restricted stock are extra compensation to you. Your employer should include these payments on your Form W-2. If they are also reported on a Form 1099-DIV, Dividends and Distributions, you should list them on Schedule B (Form 1040) or Schedule 1 (Form 1040A), Interest and Ordinary Dividends for Form 1040A Filers, with a statement that you have included them as wages. Do not include them in the total dividends received.

Stock you chose to include in your income.   Dividends you receive on restricted stock you chose to include in your income in the year transferred are treated the same as any other dividends. You should receive a Form 1099-DIV showing these dividends. Do not include the dividends in your wages on your return. Report them as dividends.

Sale of property not substantially vested.   These rules apply to the sale or other disposition of property that you did not choose to include in your income in the year transferred and that is not substantially vested.

If you sell or otherwise dispose of the property in an arm's-length transaction, include in your income as compensation for the year of sale the amount realized minus the amount you paid for the property. If you exchange the property in an arm's-length transaction for other property that is not substantially vested, treat the new property as if it were substituted for the exchanged property.

If you sell the property in a transaction that is not at arm's length, include in your income as compensation for the year of sale the total of any money you received and the fair market value of any substantially vested property you received on the sale. In addition, you will have to report income when the original property becomes substantially vested, as if you still held it. Report as compensation its fair market value minus the total of the amount you paid for the property and the amount included in your income from the earlier sale.

Example.   In 1999, you paid your employer $50 for a share of stock that had a fair market value of $100 and was subject to forfeiture until 2002. In 2001, you sold the stock to your spouse for $10 in a transaction not at arm's length. You had compensation of $10 from this transaction. In 2002, when the stock had a fair market value of $120, it became substantially vested. For 2002, you must report additional compensation of $60, figured as follows:

Fair market value of stock at time of substantial vesting		$120
Minus: Amount paid for stock	$50
Minus: Compensation previously included in income from sale to spouse	10	- 60
Additional income		$60

Inherited property not substantially vested.   If you inherit property not substantially vested at the time of the decedent's death, any income you receive from the property is considered income in respect of a decedent and is taxed according to the rules for restricted property received for services. For information about income in respect of a decedent, get Publication 559.

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