[Federal Register Volume 68, Number 110 (Monday, June 9, 2003)]
[Proposed Rules]
[Pages 34344-34370]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-13581]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 14a

[REG-122917-02]
RIN 1545-BA75


Statutory Options

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking; withdrawal of previous 
rulemaking; and notice of public hearing.

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SUMMARY: This document contains proposed regulations relating to 
statutory options. These proposed regulations affect certain taxpayers 
who participate in the transfer of stock pursuant to the exercise of 
incentive stock options and the exercise of options granted pursuant to 
an employee stock purchase plan (statutory options). These proposed 
regulations provide guidance to assist these taxpayers in complying 
with the law in addition to clarifying rules regarding statutory 
options. This document also withdraws a previous notice of proposed 
rulemaking.

[[Page 34345]]


DATES: Written and electronically submitted comments and requests to 
speak, with outlines of topics to be discussed at the public hearing 
scheduled for September 2, 2003, must be received by August 12, 2003.

ADDRESSES: Send submissions to CC:PA:RU (REG-122917-02), room 5226, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Submissions may be hand delivered Monday through Friday 
between the hours of 8 a.m. and 5 p.m. to: CC:PA:RU (REG-122917-02), 
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, 
NW., Washington, DC or sent electronically, via the IRS Internet site 
www.irs.gov/regs. The public hearing will be held in the IRS 
Auditorium, Internal Revenue Building, 1111 Constitution Avenue, NW., 
Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Erinn 
Madden at (202) 622-6030 (not a toll-free number). To be placed on the 
attendance list for the hearing, please contact Guy Traynor at (202) 
622-7180.

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)). Comments on the collection of information should be 
sent to the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, W:CAR:MP:T:T:SP; 
Washington, DC 20224. Comments on the collection of information should 
be received by August 8, 2003. Comments are specifically requested 
concerning:
    Whether the proposed collection of information is necessary for the 
proper performance of the functions of the Internal Revenue Service, 
including whether the information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information (see below);
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collection of 
information may be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of service to provide information.
    The collection of information in this proposed regulation is in 
1.6039-1. Section 6039 of the Code requires all corporations that 
transfer stock to any person pursuant to the exercise of a statutory 
option to furnish that person with a written statement describing the 
transfer. Additionally, the corporation may be required to furnish the 
person a second written statement when the stock originally transferred 
pursuant to the exercise of the statutory option is subsequently 
disposed of by the person. The information on the statements required 
to be provided by the corporation will be used by recipients to 
complete their income tax returns in the year of the disposition of the 
statutory option stock. The likely respondents are for-profit 
corporations.
    Estimated total annual reporting burden: 16,650 hours.
    Estimated average annual burden hours per respondent: 20 minutes.
    Estimated number of respondents: 50,000.
    Estimated annual frequency of responses: annually.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    This document contains proposed amendments to 26 CFR part 1 under 
sections 421, 422, and, 424 of the Internal Revenue Code (Code). 
Changes to the applicable tax law concerning section 421 were made by 
sections 11801 and 11821 of the Omnibus Budget Reconciliation Act of 
1989, Public Law 101-508 (104 Stat. 1388). Changes to the applicable 
tax law concerning section 424 were made by section 1003 of the 
Technical and Miscellaneous Revenue Act of 1988 (TAMRA), Public Law 
100-647 (102 Stat. 3581), sections 11801 and 11821 of the Omnibus 
Budget Reconciliation Act of 1989 (OBRA 89), Public Law 101-508 (104 
Stat. 1388), which included re-designating section 425 as section 424 
of the Code, and section 1702(h) of the Small Business Job Protection 
Act of 1996, Public Law 104-188 (110 Stat. 1755). Changes concerning 
section 422 were made by section 251 of the Economic Recovery Tax Act 
of 1981 (95 Stat. 172), which added section 422A to the Code. Related 
changes to section 422A were made by section 102(j) of the Technical 
Corrections Act of 1982, Public Law 97-448, section 321(a) of Tax 
Reform Act of 1986 (96 Stat. 2365), Public Law 99-514 (100 Stat. 2807), 
section 1003(d) of TAMRA, and sections 11801 and 11821 of OBRA 89, 
which included re-designating section 422A as section 422 of the Code.
    Regulations under section 421 governing the requirements for 
restricted stock options and qualified stock options, as well as 
options granted under an employee stock purchase plan, were published 
in the Federal Register on December 9, 1957 (TD 6276), November 26, 
1960 (TD 6500), January 18, 1961 (TD 6527), January 20, 1961 (TD 6540), 
December 12, 1963 (TD 6696), June 23, 1966 (TD 6887), July 24, 1978 (TD 
7554), and November 3, 1980 (TD 7728). Temporary regulations under 
section 422A providing guidance and transitional rules related to 
incentive stock options were published in the Federal Register on 
December 17, 1981 (TD 7799) and September 18, 1992 (TD 8435). Final 
regulations under section 422 related to stockholder approval were 
published in the Federal Register on December 1, 1988 (TD 8235) and 
November 29, 1991 (TD 8374). Regulations under section 425 were 
published in the Federal Register on June 23, 1966 (TD 6887).
    Proposed changes to the final regulations under sections 421, 424, 
and 6039 and proposed regulations under section 422A were previously 
published in the Federal Register at 49 FR 4504 on February 7, 1984 
(the 1984 proposed regulations). With the exception of certain 
stockholder approval rules that were published in the Federal Register 
on June 23, 1966 (TD 6887) and amended by TD 7728 on October 31, 1980, 
the 1984 proposed regulations provided a comprehensive set of rules 
under section 422 of the Code. The 1984 proposed regulations are 
withdrawn.
    In general, the income tax treatment of the grant of an option to 
purchase stock in connection with the performance of services and of 
the transfer of stock pursuant to the exercise of such option is 
determined under section 83 of the Code and the regulations thereunder. 
However, section 421 of the Code provides special rules for determining 
the income tax treatment of the transfer of shares of

[[Page 34346]]

stock pursuant to the exercise of an option if the requirements of 
section 422(a) or 423(a), as applicable, are met. Section 422 applies 
to incentive stock options, and section 423 applies to options granted 
under an employee stock purchase plan (collectively, statutory 
options).
    Under section 421, if a share of stock is transferred to an 
individual pursuant to the exercise of a statutory option, there is no 
income at the time of exercise of the option with respect to such 
transfer, and no deduction under section 162 is allowed to the employer 
corporation with respect to such transfer. However, pursuant to section 
56(b)(3), section 421 does not apply with respect to the exercise of an 
incentive stock option for purposes of the individual alternative 
minimum tax.
    Section 422(a) of the Code provides that section 421 applies to the 
transfer of stock to an individual pursuant to the exercise of an 
incentive stock option if (i) no disposition of the share is made 
within 2 years from the date of grant of the option or within 1 year 
from the date of transfer of the share, and (ii) at all times during 
the period beginning on the date of grant and ending on the day 3 
months before the exercise of the option, the individual is an employee 
of either the corporation granting the option or a parent or subsidiary 
of such corporation, or a corporation (or a parent or subsidiary of 
such corporation) issuing or assuming a stock option in a transaction 
to which section 424(a) applies. Section 422(b) provides several 
requirements that must be met for an option to qualify as an incentive 
stock option. Section 422(c) provides special rules applicable to 
incentive stock options, and section 422(d) provides a $100,000 
limitation with respect to incentive stock options.
    Section 424 of the Code provides special rules applicable to 
statutory options, including rules concerning the modification of 
statutory options and the substitution or assumption of an option by 
reason of a corporate merger, consolidation, acquisition of property or 
stock, separation, reorganization, or liquidation. Section 424 also 
contains definitions of certain terms, including disposition, parent 
corporation, and subsidiary corporation. Finally, section 424 provides 
special rules related to attribution of stock ownership and the effect 
of stockholder approval on the date of grant of a statutory option.

Explanation of Provisions

Overview

    These proposed regulations would provide a set of comprehensive 
rules governing incentive stock options. These proposed regulations 
incorporate many of the rules contained in the 1984 proposed 
regulations, although these proposed regulations are re-numbered and 
re-organized. These proposed regulations would also make changes to the 
final regulations under sections 421 and 424 to provide additional 
guidance, as discussed below, in certain areas, to reflect the new 
organizational structure of the statutory option rules (including the 
re-designation of Sec.  1.425-1 as Sec.  1.424-1), and to remove 
obsolete rules and cross-references.

Section 421: General Rules

    The proposed regulations under section 421 would remove obsolete 
provisions and update the cross-references to reflect amendments to the 
applicable statutes and re-organization of the regulations. These 
proposed regulations also incorporate many provisions of the 1984 
proposed regulations. There are two sections of these proposed 
regulations under section 421: Sec.  1.421-1, which would provide rules 
concerning the meaning and use of terms, and Sec.  1.421-2, which would 
provide general rules regarding the application of section 421.
    The terms defined in Sec.  1.421-1 of these proposed regulations 
are the same as those previously defined in Sec.  1.421-7, but these 
proposed regulations make changes to the definitions of certain terms. 
For example, Sec.  1.421-1(a) of these proposed regulations expands the 
definition of option to include warrants.
    These proposed regulations would provide that an option must be 
evidenced in paper or in an electronic form. Under either form, 
however, the option must be enforceable under applicable law. 
Similarly, these proposed regulations provide that the plan pursuant to 
which incentive stock options are granted must be in paper or 
electronic form, provided that the paper or electronic form establishes 
an enforceable plan.
    In addition, as with any taxpayer record, the form used for the 
option or plan, whether paper or electronic, must be one that provides 
adequate substantiation of the applicability of section 421. Thus, for 
example, the form must be one that provides adequate substantiation of 
the applicable requirements, such as the date on which the option is 
granted, the number of shares subject to the option, and the option 
price. In addition, the taxpayer must retain records relating to the 
option that are sufficient to comply with section 6001 and the 
regulations thereunder. If these records are kept electronically, the 
records must meet the requirements of Rev. Proc. 97-22 (1997-1 C.B. 
652), or subsequent guidance, and if the records are kept in an ADP 
system, the records must meet the requirements of Rev. Proc. 98-25 
(1998-11 I.R.B. 7), or subsequent guidance.
    The definition of statutory option in Sec.  1.421-1(b) of these 
proposed regulations is revised to provide that a statutory option may 
include an option transferred to a trust if, under section 671 and 
applicable state law, the individual to whom the option was granted 
remains the beneficial owner. In contrast, these proposed regulations 
provide that a transfer of a statutory option incident to divorce will 
result in the option failing to qualify as a statutory option as of the 
date of transfer.
    Section 1.421-1(i) of these proposed regulations defines 
corporation to have the same meaning prescribed by section 7701(a)(3) 
and Sec.  301.7701-2(b). Thus, for example, a corporation includes an S 
Corporation, a foreign corporation, and a limited liability corporation 
that is treated as a corporation for all Federal tax purposes. In 
addition, section 1.421-1(d) of these proposed regulations provides 
that stock includes ownership interests other than capital stock. Thus, 
under these proposed regulations, it would be permissible for any 
entity that is classified as a corporation for federal tax purposes 
pursuant to the provisions of Sec.  301.7701-2(b) to grant statutory 
stock options with respect to ownership interests in that entity.
    Section 1.421-2 of these proposed regulations incorporates both the 
provisions of Sec.  1.421-8 and many of the related provisions of the 
1984 proposed regulations. These proposed regulations also provide 
further revisions, including specifying that the deduction in 
connection with a disqualifying disposition is allowed only if 
otherwise allowable under sections 83(h) and 162 and if the reporting 
requirements under Sec.  1.83-6(a) are met.

Section 422: Incentive Stock Options

    The proposed regulations under section 422 would provide a new set 
of comprehensive rules, with the exception of the rules regarding 
stockholder approval described in Sec.  1.422-5 of the final 
regulations (re-numbered as Sec.  1.422-3 by these proposed 
regulations). There are four sections under these proposed regulations: 
Sec.  1.422-1, general rules; Sec.  1.422-2, definition of incentive 
stock option; Sec.  1.422-4, the $100,000 limitation; and Sec.  1.422-
5, permissible provisions.

[[Page 34347]]

1. Special Rules Regarding Disqualifying Dispositions
    The 1984 proposed regulations provided rules concerning the 
consequences of disqualifying dispositions. The general disqualifying 
disposition rules for incentive stock options are provided in 
Sec. Sec.  1.421-2(b)(1) and 1.422-1(b)(1) of these proposed 
regulations. In addition, Sec.  1.422-1(b)(2) of these proposed 
regulations clarifies the operation of the special rules applicable to 
a disqualifying disposition of an incentive stock option under section 
422(c)(2) (section 422A(c)(2), prior to amendment by OBRA 89).
    The general rules concerning disqualifying dispositions are 
described in Sec.  1.421-2(b) of these proposed regulations. Under 
these rules, if there is a disqualifying disposition of a share of 
stock, the special tax treatment provided by section 421 and Sec.  
1.421-2(a) does not apply to the transfer of the share. Instead, the 
exercise of the option is treated as the exercise of a nonstatutory 
option under Sec.  1.83-7. Thus, in the taxable year in which the 
disqualifying disposition occurs, the individual must recognize 
compensation income equal to the fair market value of the stock on the 
date the stock is transferred less the exercise price (determined 
without reduction for any brokerage fees or other costs paid in 
connection with the disposition). A deduction attributable to the 
transfer of the share of stock pursuant to the exercise of the option 
is allowable for the taxable year in which such disqualifying 
disposition occurs, to the employer corporation, its parent or 
subsidiary corporation, or a corporation substituting or assuming an 
option in a transaction to which Sec.  1.424-1(a) applies, if otherwise 
allowable under sections 83(h) and 162 and if the requirements of Sec.  
1.83-6(a) are met.
    Section 422(c)(2), however, provides a special rule that is 
applicable if an individual makes a disqualifying disposition of stock 
acquired through the exercise of an incentive stock option and if the 
disposition is a sale or exchange with respect to which a loss (if 
sustained) would be recognized by the individual. Under this special 
rule, the amount includible in gross income on the disqualifying 
disposition, and the amount deductible, as compensation attributable to 
the exercise of the option, shall not exceed the excess (if any) of the 
amount realized on such sale or exchange over the adjusted basis of the 
share. Under section 422(c)(2), this special rule is not applicable if 
the disposition is a sale or exchange with respect to which a loss (if 
sustained) would not be recognized by the individual. Section 1.422A-
1(b)(2) of the 1984 proposed regulations described these special rules 
concerning the disqualifying disposition of an incentive stock option 
and this description is incorporated into Sec.  1.422-1(b)(2) of these 
proposed regulations.
    For example, if the disposition is a sale described in section 1091 
(relating to a loss from wash sales of stock or securities), a gift, or 
a sale described in section 267(a)(1) (relating to sales between 
related parties), any loss sustained would not be recognized. Because a 
loss in any of these transactions would not be recognized, under Sec.  
1.422-1(b)(2)(ii) of these proposed regulations, the special rule 
provided in Sec.  1.422-1(b)(2)(i) of these proposed regulations does 
not apply. Instead, the general rules for disqualifying dispositions 
described in Sec.  1.421-2(b) of these proposed regulations apply.
    For example, assume E, an employee of Corporation X, is granted an 
incentive stock option to acquire X stock. The option price on the date 
of grant is $100 (the fair market value of X stock on the date of 
grant). E exercises the option and is transferred X stock when the fair 
market value of the stock is $200. E later sells the stock for $150 to 
M before the applicable holding periods expire. Because the sale is a 
disqualifying disposition that meets the requirements of Sec.  1.422-
1(b)(2)(i) of these proposed regulations, in the taxable year of the 
disqualifying disposition, E is only required to include $50 (the 
excess of the amount realized on the sale, $150, over the adjusted 
basis of the share, $100) in gross income as compensation attributable 
to the exercise of the option. For its taxable year in which the 
disqualifying disposition occurs, X is allowed a compensation deduction 
of $50 attributable to E's exercise of the option, if otherwise 
allowable under sections 83(h) and 162 and if the requirements of Sec.  
1.83-6(a) are met.
    In this example, however, if 10 days after the sale to M, E 
purchases substantially identical stock, under section 1091, a loss 
would not be recognized on the sale to M. Thus, under Sec.  1.422-
1(b)(2)(ii) of these proposed regulations, the special rule in Sec.  
1.422-1(b)(2)(i) does not apply. Instead of including $50 in gross 
income in the taxable year of the disqualifying disposition, E must 
include $100 (the difference between the fair market value of X stock 
on the date of transfer, $200, and the exercise price, $100) in gross 
income as compensation attributable to the exercise of the option. In 
the taxable year in which the disqualifying disposition occurs, X is 
allowed a compensation deduction of $100 attributable to E's exercise 
of the option if otherwise allowable under sections 83(h) and 162 and 
if the requirements of Sec.  1.83-6(a) are met.
    Since the 1984 proposed regulations were issued, there have been no 
changes in section 422(c)(2) (other than the redesignation of section 
422A(c)(2) as 422(c)(2) by OBRA 89), and these proposed regulations do 
not make any substantive changes to the 1984 proposed regulations.
2. Stockholder Approval of Incentive Stock Option Plan
    Among other requirements, to qualify as an incentive stock option, 
the option must be granted pursuant to a plan which is approved by the 
stockholders of the granting corporation within 12 months before or 
after the date the plan is adopted. See section 422(b). These proposed 
regulations would provide the same basic requirements for stockholder 
approval as those included in the 1984 proposed regulations.
    These proposed regulations, however, would provide additional 
guidance concerning the circumstances in which stockholder approval is 
required. As under the 1984 proposed regulations, stockholder approval 
is required if there is a change in the aggregate number of shares or 
in the employees (or class or classes of employees) eligible to be 
granted options under the plan. In addition, while the standard for 
determining when stockholder approval is required is the same as under 
the 1984 proposed regulations, these proposed regulations clarify these 
requirements and provide a more complete list of situations that 
require new stockholder approval of the plan by specifically including 
a change in the shares with respect to which options are issued or a 
change in the granting corporation. Thus, for example, assume that S, a 
subsidiary of P, adopts an incentive stock option plan under which 
incentive stock options for S stock will be granted to S employees, and 
the plan is approved by the stockholders of S (in this case, P) within 
the applicable 24-month period. If S later amends the plan to provide 
for the grant of incentive stock options to acquire P stock (rather 
than S stock), S must obtain approval from the stockholders of S within 
12 months before or after the date of the amendment to the plan because 
the amendment of the plan to allow the grant of options for P stock is 
considered the adoption of a new plan.
    These proposed regulations also would provide additional guidance

[[Page 34348]]

regarding the application of the stockholder approval requirements in 
the context of the substitution or assumption of an option by reason of 
a corporate transaction. For a discussion of these rules, see the 
``Substitution, assumption, and modification of options'' portion of 
the preamble.
3. $100,000 Limitation
    Section 422(d)(1) provides that to the extent that the aggregate 
fair market value of stock with respect to which incentive stock 
options (determined without regard to section 422(d)) are exercisable 
for the first time by any individual during the calendar year (under 
all of plans of the employer corporation and any related corporation) 
exceeds $100,000, such options are not treated as incentive stock 
options. Under section 422(d)(2), options are taken into account in the 
order in which they are granted. Section 422(d)(3) provides that the 
fair market value of stock is determined at the time the option is 
granted.
    The 1984 proposed regulations provided no rules concerning the 
operation of the $100,000 limitation because these provisions were 
enacted in 1986. However, Notice 87-49 (1987-2 C.B. 355) provides 
general guidance about the operation of the $100,000 limitation, 
including examples illustrating the application of this limitation.
    Section 1.422-4 of these proposed regulations provides guidance on 
the operation of the $100,000 limitation that incorporates and expands 
on the guidance provided in Notice 87-49. Section 1.422-4(a)(1) of 
these proposed regulations provides that an option that otherwise 
qualifies as an incentive stock option nevertheless fails to be an 
incentive stock option to the extent the $100,000 limitation is 
exceeded.
    To determine whether the $100,000 limitation has been exceeded, the 
rules provided in Sec.  1.422-4(b) of these proposed regulations would 
apply. Under these proposed regulations, an option that does not 
qualify as an incentive stock option when granted (including an option 
which contains terms providing that it will not be treated as an 
incentive stock option) is disregarded. Additionally, the fair market 
value of stock is determined on the date of grant of the option. Except 
as described in the following paragraph, options are taken into account 
in the order in which 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 the 
year, assuming that any condition on the optionee's ability to exercise 
the option related to the performance of services is satisfied. If an 
optionee is able to exercise the option in a year only if an 
acceleration provision is satisfied, then the option is exercisable in 
that year only if the acceleration provision is triggered prior to the 
end of that year. After an acceleration provision is triggered, for 
purposes of applying the $100,000 limitation, the options subject to 
such provision and all other options first exercisable during a 
calendar year are then taken into account in the order in which 
granted. However, because an acceleration provision is not taken into 
account prior to its triggering, an incentive stock option that becomes 
exercisable for the first time during a calendar year by operation of 
such a provision does not affect the application of the $100,000 
limitation with respect to an option (or portion thereof) exercised 
prior to such acceleration. An acceleration provision includes, for 
example, a provision that accelerates the exercisability of an option 
on a change in ownership or control or a provision that conditions 
exercisability on the attainment of a performance goal. See Sec.  
1.422-4(d), Example 4 of these proposed regulations.
    For example, assume that in 2006, E, an employee of Y Corporation, 
is granted Option 1 for stock of Y with a fair market value on the date 
of grant of $75,000. Option 1 is first exercisable in 2008, except that 
the option provides that it will become immediately exercisable in the 
event of a change in control. In 2007, E is granted Option 2 for stock 
of Y with a fair market value on the date of grant of $50,000. Option 2 
is immediately exercisable, and E exercises Option 2. A change in 
control of Y occurs in 2007, after E has exercised Option 2, and Option 
1 becomes immediately exercisable. Notwithstanding the fact that Option 
1 was granted prior to Option 2, because the acceleration clause is not 
taken into account until it is triggered and because E exercised Option 
2 prior to the change in control, Option 2 is an incentive stock option 
in its entirety. Option 1 is bifurcated into an incentive stock option 
to acquire stock with a fair market value of $50,000 on the date of 
grant and a nonstatutory option to acquire stock with a fair market 
value of $25,000 on the date of grant.
    If the change in control instead occurred prior to E's exercise of 
Option 2, then Option 1, which was granted first, is treated as an 
incentive stock option in its entirety, and Option 2 is bifurcated into 
an incentive stock option to acquire stock with a fair market value of 
$25,000 on the date of grant and a nonstatutory option to acquire stock 
with a fair market value of $25,000 on the date of grant.
    These proposed regulations also would provide that an option is 
disregarded for purposes of the $100,000 limitation if, prior to the 
calendar year during which it would have otherwise become exercisable 
for the first time, the option is modified and thereafter ceases to be 
an incentive stock option, is transferred in violation of the 
nontransferability requirements, or is canceled. In all other 
situations, a modified, transferred, or canceled option (or portion 
thereof) is treated as outstanding until the end of the calendar year 
during which it would otherwise have become exercisable for the first 
time.
    Finally, under these proposed regulations, a disqualifying 
disposition has no effect on the determination of whether an option 
exceeds the $100,000 limitation. Thus, for example, assume Corporation 
X grants E, an employee of X, Option 1 to acquire X stock with a fair 
market value on the date of grant of $75,000. Option 1 is exercisable 
on January 1, 2005. On January 5, 2005, E exercises the option and 
sells the stock in a disqualifying disposition. On January 15, 2005, X 
grants E Option 2 to acquire X stock with a fair market value on the 
date of grant of $50,000. Option 2 is immediately exercisable. Under 
Sec.  1.422-4(b)(6) of the proposed regulations, the disqualifying 
disposition of Option 1 has no effect on the application of the 
$100,000 limitation. Thus, Option 2 is bifurcated into an incentive 
stock option to acquire stock with a fair market value of $25,000 on 
the date of grant and a nonstatutory option to acquire stock with a 
fair market value of $25,000 on the date of grant.
4. Permissible Provisions
    These proposed regulations also provide guidance on additional 
provisions that may be included in an incentive stock option. Because 
these provisions are not part of the requirements for an incentive 
stock option, they are addressed separately in Sec.  1.422-5 of these 
proposed regulations (many of these rules were previously in Sec.  
1.422A-2(i) of the 1984 proposed regulations). Section 1.422-5 of these 
proposed regulations addresses provisions permitting cashless exercise, 
providing the right to receive additional compensation, and providing 
alternative rights. In each case, these proposed regulations 
essentially retain the rules described in the 1984 proposed 
regulations.

[[Page 34349]]

Section 424: Definitions and Special Rules

    These proposed regulations re-designate the regulations under 
section 425 as regulations under section 424 and update the 
regulations. For example, these proposed regulations amend the 
definition of disposition to exclude a transfer of a share of stock 
acquired pursuant to the exercise of a statutory option if the transfer 
is described in section 1041(a) (concerning transfers between spouses 
or former spouses incident to divorce).
Substitution, Assumption, and Modification of Options
    Section 424(h)(1) provides that if the terms of an option are 
modified, extended, or renewed, such modification, renewal, or 
extension is treated as the grant of a new option. Under section 
424(h)(3), the term modification (with certain exceptions) means any 
change in the terms of an option which gives the optionee additional 
benefits under the option. One exception to this definition is that a 
change in the terms of an option attributable to a substitution or an 
assumption that meets the requirements of section 424(a) is not a 
modification of an option.
    These proposed regulations would provide that an eligible 
corporation (as defined in Sec.  1.424-1(a)(2) of these proposed 
regulations) may by reason of a corporate transaction (as defined in 
Sec.  1.424-1(a)(3) of these proposed regulations) substitute a new 
statutory option (new option) for an outstanding statutory option (old 
option) or assume an old option without the substitution or assumption 
being considered a modification of the old option under section 424(h).
    An eligible corporation is defined as a corporation that is the 
employer of an optionee or a related corporation of such corporation. 
The determination of whether a corporation is the employer of the 
optionee or a related corporation of such corporation is based upon the 
circumstances existing immediately after the corporate transaction.
    Under the proposed regulations, a corporate transaction is (i) a 
corporate merger, consolidation, acquisition of property or stock, 
separation, reorganization, or liquidation; (ii) a distribution 
(excluding ordinary dividends), or change in the terms or number of 
outstanding shares of such corporation, such as a stock split or stock 
dividend (a change in capital structure); (iii) a change in the name of 
a corporation whose stock is purchasable under the old option; and (iv) 
such other corporate events as may be prescribed by the Commissioner in 
published guidance.
    The definitions of eligible corporation and corporate transaction 
would be expanded under these proposed regulations. Specifically, these 
proposed regulations permit corporations with outstanding options to 
substitute or assume an option under Sec.  1.424-1(a) if there is a 
corporate transaction. Additionally, the definition of corporate 
transaction includes events, such as a stock dividend or stock split, 
that were previously addressed in Sec.  1.425-1(e) of the final 
regulations, and is otherwise expanded so that events or transactions 
with similar consequences are treated the same. Because of these 
changes, the rules in Sec.  1.425-1(e)(5)(ii) of the current 
regulations would be removed.
    These proposed regulations also would eliminate the requirement 
contained in Sec.  1.425-1(a)(1)(ii) of the final 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. However, Sec.  1.424-
1(a)(4) of these proposed regulations would continue to impose, and 
provide additional guidance concerning, the requirement that the 
substitution or assumption be ``by reason of'' the corporate 
transaction.
    Under these proposed regulations, a change in an option or issuance 
of a new option is considered to be by reason of a corporate 
transaction unless the relevant facts and circumstances demonstrate 
that such change or issuance is made for reasons unrelated to such 
corporate transaction. For example, a change in an option or issuance 
of a new option is considered to be made for reasons unrelated to such 
a corporate transaction if there is an unreasonable delay between the 
corporate transaction and such change in the option or issuance of a 
new option or if the corporate transaction serves no substantial 
corporate business purpose independent of the change in options. A 
change in an option or issuance of a new option is not by reason of a 
distribution or change in the terms or number of outstanding shares 
unless the option as changed, or the new option, is issued on the stock 
of the same corporation, or if such class of stock is eliminated by the 
change in capital structure, on other stock of the same corporation. 
For purposes of a change in name of the corporation, the issuance of a 
new option is by reason of the change in name of the corporation only 
if the option issued is on stock of the successor corporation.
    These proposed regulations do not otherwise revise the requirements 
that must be met for a change in an option to qualify as a substitution 
or an assumption. For example, no changes are proposed with respect to 
the requirements that no additional benefits be granted to the optionee 
in connection with a substitution or assumption or that certain spread 
and ratio tests must be met.
    These proposed regulations also continue to impose the requirement 
contained in the final regulations that the new or assumed option must 
otherwise qualify as a statutory option. See Sec.  1.424-1(a)(5)(vi) of 
these proposed regulations. Thus, except as necessary to comply with 
the specific requirements regarding substitution or assumption, such as 
the restrictions on ratio and spread, the option must comply with the 
requirements of Sec.  1.422-2 of these proposed regulations or 1.423-2, 
as applicable. Accordingly, for example, the new option must be 
granted, or the old option must be assumed, under a plan approved by 
the stockholders of the corporation substituting or assuming the 
option.
    The proposed regulations do not impose any additional stockholder 
approval requirement, however, merely because there is a corporate 
transaction. In Rev. Rul. 71-474 (1971-2 C.B. 215) involving qualified 
stock options,\1\ the IRS held that qualified stock options assumed by 
a corporation in a merger with the granting corporation retained their 
status as qualified stock options without approval of the assuming 
corporation's stockholders. In the ruling, the IRS indicated that 
approval of the persons who owned stock of the granting corporation at 
the time the plan was approved was sufficient to satisfy the 
stockholder approval requirements. Similarly, the 1984 proposed 
regulations provided that the stockholders of the granting corporation 
must approve the plan within 12 months before or after its adoption 
without additional requirements.
---------------------------------------------------------------------------

    \1\ Qualified stock options are no longer permitted under 
section 422, but the stockholder approval provisions applicable to a 
plan under which qualified stock options were granted were the same 
as those that apply to a plan uder which incentive stock options are 
granted.
---------------------------------------------------------------------------

    Section 1.422-2(b)(2) of these proposed regulations would provide 
that the plan must be approved during the applicable 24-month period by 
the stockholders of the corporation granting the incentive stock 
option. There is no requirement that additional stockholder approval be 
obtained because of post-approval changes in the stockholders. For 
example, assume S, a subsidiary of

[[Page 34350]]

P, adopts a plan under which incentive stock options for S stock will 
be granted to S employees. Under the proposed regulations, the 
stockholders of S must approve the plan within 12 months before or 
after the adoption of the plan. If P later completely disposes of its 
interest in S, outstanding S options and new grants of S options under 
the plan are treated as options granted under a plan that meets the 
stockholder approval requirement of Sec.  1.422-2(b)(2) of these 
proposed regulations without regard to whether S seeks approval of the 
plan from the stockholders of S after the spin-off. Assuming all other 
applicable requirements are met, the outstanding S options and new 
options granted by S pursuant to the plan with respect to S stock will 
be treated as incentive stock options.
    These proposed regulations also would provide additional guidance 
with respect to when a change to an option constitutes a modification. 
Under these proposed regulations, as under the 1984 proposed 
regulations, both a provision under an option that provides that the 
optionee may receive an additional benefit at the future discretion of 
the granting corporation and the exercise of that discretion are 
considered modifications of the option. However, under these proposed 
regulations, it is not a modification for the granting corporation to 
exercise 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. A change to an option adding such discretion, 
however, would be a modification.
    In addition, these proposed regulations address more clearly 
changes related to an option, including changes not only to the option 
or the option plan, but also changes to any other related agreements. 
In the case of a change to the stock on which the option is granted 
that affects the value of the stock, there would be a modification 
unless a new option is substituted for the old option by reason of the 
change in the terms of the stock in accordance with the requirements of 
Sec.  1.424-1(a) of these proposed regulations.

Section 6039

    These proposed regulations also would provide guidance on the 
statements required under section 6039 of the Code. Under these 
proposed regulations, Sec.  1.6039-1 of the final regulations would be 
deleted, and Sec.  1.6039-2 would be re-designated as Sec.  1.6039-1. 
These proposed regulations take the same approach toward providing 
notice as that taken in the 1984 proposed regulations.
    Section 1.6039-1(f) of these proposed regulations states that the 
matter of furnishing statements in electronic form is reserved. 
Temporary and proposed regulations have been issued under sections 6041 
and 6051 (relating to voluntary electronic furnishing of payee 
statements on Form W-2) and section 6050S (relating to voluntary 
electronic furnishing of statements to individuals for whom Forms 1098-
T, ``Tuition Payments Statement,'' and 1098-E, ``Student Loan Interest 
Statement'' are filed). See 66 FR 10191 and 10247 (Feb. 14, 2001). The 
preamble to those temporary and proposed regulations requested comments 
regarding, among other things, the extent to which the proposed method 
of electronic filing is appropriate for information statements required 
under other sections of the Code. In addition, section 401 of the Job 
Creation and Worker Assistance Act of 2002 authorized all statements 
required by sections 6041 through 6050T of the Code to be furnished 
electronically under certain conditions. The issue of electronic 
statements in general is under review, and comments are requested.

Proposed Effective Date

    The regulations under sections 421, 422, and 424 are proposed to 
apply as of the date that is 180 days after publication of final 
regulations in the Federal Register and apply to any statutory option 
that is granted on or after that date. The regulations under section 
6039 are proposed to apply to transfers on or after the date that is 
180 days after publication of final regulations in the Federal Register 
of stock acquired pursuant to a statutory option. The 1984 proposed 
regulations are withdrawn. Taxpayers may rely on these proposed 
regulations for the treatment of any statutory option granted after 
June 9, 2003.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. Section 
1.6039-1 of these proposed regulations provides for the collection of 
information. It is hereby certified that the collection of information 
in these regulations will not have a significant economic impact on a 
substantial number of small entities. This certification is based on 
the fact that the provision of employee statements provided under these 
proposed regulations will impose a minimal paperwork burden on most 
small entities (see the discussion under the heading ``Paperwork 
Reduction Act'' earlier in this preamble). Therefore, an analysis under 
the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. 
Pursuant to section 7805(f) of the Code, this notice of proposed 
rulemaking is being submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on its impact on small 
business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written or electronic comments (a 
signed original and eight (8) copies) that are submitted timely to the 
IRS. All comments will be available for public inspection and copying.
    A public hearing has been scheduled for September 2, 2003, 
beginning at 10 a.m. in the IRS Auditorium of the Internal Revenue 
Building, 1111 Constitution Avenue, NW., Washington, DC. All visitors 
must come to the Constitution Avenue entrance and present photo 
identification to enter the building. Because of access restrictions, 
visitors will not be admitted beyond the immediate entrance area more 
than 30 minutes before the hearing starts. For information about having 
your name placed on the building access list to attend the hearing, see 
the FOR FURTHER INFORMATION CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit written 
comments and an outline of the topics to be discussed and the time to 
be devoted to each topic (signed original and eight (8) copies) by 
August 12, 2003. A period of 10 minutes will be allotted to each person 
for making comments. An agenda showing the schedule of speakers will be 
prepared after the deadline for receiving outlines has passed. Copies 
of the agenda will be available free of charge at the hearing.

Drafting Information

    The principal author of these proposed regulations is Erinn Madden, 
Office of the Division Counsel/Associate Chief Counsel (Tax Exempt and 
Government Entities). However, other personnel from the IRS and 
Treasury Department participated in their development.

List of Subjects in 26 CFR Parts 1 and 14a

    Income taxes, Reporting and recordkeeping requirements.

[[Page 34351]]

Proposed Amendments to the Regulations

    Accordingly, 26 CFR parts 1 and 14a are proposed to be amended as 
follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *


Sec. Sec.  1.421-1 through 1.421-6  [Removed]

    Par. 2. Sections 1.421-1 through 1.421-6 are removed.
    Par. 3. Section 1.421-7 is re-designated as Sec.  1.421-1 and is 
amended as follows:
    1. In paragraph (a)(1), first sentence, the language ``sections 421 
through 425'' is removed and ``Sec. Sec.  1.421-1 through 1.424-1'' is 
added in its place.
    2. In paragraph (a)(1), first sentence, the language ``includes'' 
is removed, and ``means'' is added in its place.
    3. In paragraph (a)(1), removing the second sentence.
    4. Removing the last sentence of paragraph (a)(1) and adding two 
sentences in its place.
    5. Revising paragraph (a)(3).
    6. Revising paragraphs (b)(1) and (b)(2).
    7. In paragraph (b)(3)(i), third sentence, removing the language 
``1.425-1'' and inserting ``1.424-1'' in its place.
    8. In the list below, for each section indicated in the left 
column, remove the language in the middle column and add the language 
in the right column:

------------------------------------------------------------------------
                 Newly designated section                  Remove   Add
------------------------------------------------------------------------
1.421-1(b)(3)(ii), Example 1, first, second, third and        S-1      X
 fourth sentences........................................
1.421-1(b)(3)(ii), Example 1, second sentence............    1964   2004
1.421-1(b)(3)(ii), Example 1, third and fourth sentences.    1965   2005
1.421-1(b)(3)(ii), Example 2, first and second sentences.    1964   2004
1.421-1(b)(3)(ii), Example 2, first, third, and fourth        S-1      X
 sentences...............................................
1.421-1(b)(3)(ii), Example 2, third and fourth sentences.    1965   2005
------------------------------------------------------------------------

    9. Revising the last sentence of paragraph (b)(3)(ii), Example 1.
    10. Removing the last sentence of paragraph (b)(3)(ii), Example 2 
and adding two sentences in its place.
    11. Removing the first sentence of paragraph (c)(1) and adding two 
new sentences in its place.
    12. In paragraph (c)(2), second sentence, the language ``425'' is 
removed and ``424'' is added in its place.
    13. In paragraph (c)(3), second and last sentences, the language 
``1964'' is removed and ``2004'' is added in its place.
    14. In paragraph (c)(3), second sentence, the language ``1965'' is 
removed and ``2005'' is added in its place.
    15. Revising paragraphs (d) and (e).
    16. In paragraph (f), in the first sentence, the language 
``sections 421 through 425'' is removed and ``this section and 
Sec. Sec.  1.421-2 through 1.424-1'' is added in its place.
    17. Revising the last sentence of paragraph (f).
    18. In paragraph (g), first sentence, the language ``sections 421 
through 425'' is removed and ``this section and Sec. Sec.  1.421-2 
through 1.424-1'' is added in its place.
    19. Adding a new third sentence to paragraph (g).
    20. Revising the first, second, and third sentences of paragraph 
(h)(1).
    21. Revising paragraph (h)(2).
    22. In paragraph (h)(3), first sentence, the language ``425'' is 
removed and ``424'' is added in its place.
    23. In paragraph (h)(3), last sentence, the language ``or 
assuming'' is removed and ``the option or substituting or assuming the 
option'' is added in its place.
    24. In the list below, for each section indicated in the left 
column, remove the language in the middle column and add the language 
in the right column:

------------------------------------------------------------------------
  Newly designated section           Remove                  Add
------------------------------------------------------------------------
1.421-1(h)(4), Example 1,     1964................  2004.
 first sentence.
1.421-1(h)(4), Example 1,     1965................  2005.
 second and last sentences.
1.421-1(h)(4), Example 2,     425.................  424.
 first sentence.
1.421-1(h)(4), Example 2,     issuing.............  substituting.
 first sentence.
1.424-1(h)(4), Example 2,     1965................  2005.
 last sentence.
1.421-1(h)(4), Example 2,     for A is then         to the transfer of
 last sentence.                employed by a         the M stock
                               corporation which     because, at all
                               issued an option      times during the
                               under section         period beginning
                               425(a).               with the date of
                                                     grant of the X
                                                     option and ending
                                                     with the date of
                                                     exercise of the M
                                                     option, A was an
                                                     employee of the
                                                     corporation
                                                     granting the option
                                                     or substituting or
                                                     assuming the option
                                                     under Sec.   1.424-
                                                     1(a).
1.421-1(h)(4), Example 3,     1964................  2004.
 second sentence.
1.421-1(h)(4), Example 3,     1965................  2005.
 third, fourth, and fifth
 sentences.
1.421-1(h)(4), Example 4,     425(a)..............  424(a).
 first sentence.
1.421-1(h)(4), Example 5,     qualified stock.....  statutory.
 first sentence.
1.421-1(h)(4), Example 6,     an employment         a right to
 first sentence.               contract with M       reemployment with M
                               which provides that   or a related
                               upon the              corporation on the
                               termination of any    termination of any
                               military duty E may   military duty E may
                               be required to        be required to
                               serve, E will be      serve.
                               entitled to
                               reemployment with M
                               or a parent or
                               subsidiary of M.
1.421-1(h)(4), Example 6,     of M................  of M or a related
 third sentence.                                     corporation.

[[Page 34352]]

 
1.421-1(h)(4), Example 6,     can apply...........  applies.
 last sentence.
1.421-1(h)(4), Example 7,     a qualified stock...  an incentive.
 first and last sentences.
1.421-1(h)(4), Example 7,     parent or subsidiary  related corporation.
 first sentence.
1.421-1(h)(4), Example 7,     its parent and        related
 last sentence.                subsidiary            corporations.
                               corporation.
1.421-1(h)(4), Example 7,     terminated..........  deemed terminated.
 last sentence.
------------------------------------------------------------------------

    25. Revising paragraph (i).
    26. Adding paragraph (j).
    The additions and revisions read as follows:


Sec.  1.421-1  Meaning and use of certain terms.

    (a) * * * (1) * * * While no particular form of words is necessary, 
the option must express, among other things, an offer to sell at the 
option price, the maximum number of shares purchasable under the 
option, and the period of time during which the offer remains open. The 
term option includes a warrant that meets the requirements of this 
paragraph (a)(1).
* * * * *
    (3) An option must be in writing (in paper or electronic form), 
provided that such writing is adequate to establish an option right or 
privilege that is enforceable under applicable law.
    (b) Statutory options. (1) The term statutory option, for purposes 
of this section and Sec. Sec.  1.421-2 through 1.424-1, means an 
incentive stock option, as defined in Sec.  1.422-2(a), or an option 
granted under an employee stock purchase plan, as defined in Sec.  
1.423-2.
    (2) An option qualifies as a statutory option only if the option is 
not transferable (other than by will or by the laws of descent and 
distribution) by the individual to whom the option was granted, and is 
exercisable, during the lifetime of such individual, only by such 
individual. See Sec. Sec.  1.422-2(a)(2)(v) and 1.423-2(j). 
Accordingly, an option which is transferable or transferred by the 
individual to whom the option is granted during such individual's 
lifetime, or is exercisable during such individual's lifetime by 
another person, is not a statutory option. However, if the option or 
the plan under which the option was granted contains a provision 
permitting the individual to designate the person who may exercise the 
option after such individual's death, neither such provision, nor a 
designation pursuant to such provision, disqualifies the option as a 
statutory option. A pledge of the stock purchasable under an option as 
security for a loan that is used to pay the option price does not cause 
the option to violate the nontransferability requirements of this 
paragraph (b). Also, the transfer of an option to a trust does not 
disqualify the option as a statutory option if, under section 671 and 
applicable State law, the individual is considered the sole beneficial 
owner of the option while it is held in the trust. If an option is 
transferred incident to divorce (within the meaning of section 1041) or 
pursuant to a qualified domestic relations order (within the meaning of 
section 414(p)), the option does not qualify as a statutory option as 
of the day of such transfer. For the treatment of nonstatutory options, 
see Sec.  1.83-7.
    (3)(ii) * * * * *

    Example 1. * * * Because X was a subsidiary of P on the date of 
the grant of the statutory option, the option does not fail to be a 
statutory option even though X ceases to be a subsidiary of P.
    Example 2. * * * Because X was not a subsidiary of P on the date 
of the grant of the option, the option is not a statutory option 
even though S later becomes a subsidiary of P. See Sec. Sec.  1.422-
2(a)(2) and 1.423-2(b).

    (c) Time and date of granting option. (1) For purposes of this 
section and Sec. Sec.  1.421-2 through 1.424-1, the language ``the date 
of the granting of the option'' and ``the time such option is 
granted,'' and similar phrases refer to the date or time when the 
granting corporation completes the corporate action constituting an 
offer of stock for sale to an individual under the terms and conditions 
of a statutory option. A corporate action constituting an offer of 
stock for sale is not considered complete until the date on which the 
maximum number of shares that can be purchased under the option and the 
minimum option price are fixed or determinable. * * *
* * * * *
    (d) Stock and voting stock. (1) For purposes of this section and 
Sec. Sec.  1.421-2 through 1.424-1, the term stock means capital stock 
of any class, including voting or nonvoting common or preferred stock. 
Except as otherwise provided, the term includes both treasury stock and 
stock of original issue. Special classes of stock authorized to be 
issued to and held by employees are within the scope of the term stock 
as used in such sections, provided such stock otherwise possesses the 
rights and characteristics of capital stock.
    (2) For purposes of determining what constitutes voting stock in 
ascertaining whether a plan has been approved by stockholders under 
Sec.  1.422-2(b) or 1.423-2(c) or whether the limitations pertaining to 
voting power contained in sections Sec. Sec.  1.422-2(f) and 1.423-2(d) 
have been met, stock which does not have voting rights until the 
happening of an event, such as the default in the payment of dividends 
on preferred stock, is not voting stock until the happening of the 
specified event. Generally, stock which does not possess a general 
voting power, and may vote only on particular questions, is not voting 
stock. However, if such stock is entitled to vote on whether a stock 
option plan may be adopted, it is voting stock.
    (3) In general, for purposes of this section and Sec. Sec.  1.421-2 
through 1.424-1, ownership interests other than capital stock are 
considered stock.
    (e) Option price. (1) For purposes of this section and Sec. Sec.  
1.421-2 through 1.424-1, the term option price, price paid under the 
option, or exercise price means the consideration in cash or property 
which, pursuant to the terms of the option, is the price at which the 
stock subject to the option is purchased. The term option price does 
not include any amounts paid as interest under a deferred payment 
arrangement or treated as interest.
    (2) Any reasonable valuation method may be used to determine 
whether, at the time the option is granted, the option price satisfies 
the pricing requirements of sections 422(b)(4), 422(c)(5), 422(c)(7), 
and 423(b)(6) with respect to the stock subject to the option. Such 
methods include, for example, the valuation method described in Sec.  
20.2031-2 of this chapter (Estate Tax Regulations).

[[Page 34353]]

    (f) Exercise. * * * An agreement or undertaking by the employee to 
make payments under a stock purchase plan does not constitute the 
exercise of an option to the extent the payments made remain subject to 
withdrawal by or refund to the employee.
    (g) Transfer. * * * A transfer does not fail to occur merely 
because, under the terms of the arrangement, the individual may not 
dispose of the share for a specified period of time or the share is 
subject to a right of first refusal at the share's fair market value at 
the time of sale.
    (h) Employment relationship. (1) An option is a statutory option 
only if, at the time the option is granted, the optionee is an employee 
of the corporation granting the option, or a related corporation of 
such corporation. If the option has been assumed or a new option has 
been substituted in its place under Sec.  1.424-1(a), the optionee 
must, at the time of such substitution or assumption, be an employee of 
the corporation so substituting or assuming the option, or a related 
corporation of such corporation. The determination of whether the 
optionee is an employee at the time the option is granted (or at the 
time of the substitution or assumption under Sec.  1.424-1(a)) is made 
in accordance with section 3401(c) and the regulations thereunder. * * 
*
    (2) In addition, Sec.  1.421-2(a) is applicable to the transfer of 
a share pursuant to the exercise of the statutory option only if the 
optionee is, at all times during the period beginning with the date of 
the granting of such option and ending on the day 3 months before the 
date of such exercise, an employee of either the corporation granting 
such option, a related corporation of such corporation, or a 
corporation (or a related corporation of such corporation) substituting 
or assuming a stock option in a transaction to which Sec.  1.424-1(a) 
applies. For purposes of the preceding sentence, the employment 
relationship is treated as continuing intact while the individual is on 
military leave, sick leave, or other bona fide leave of absence (such 
as temporary employment by the Government) if the period of such leave 
does not exceed 90 days, or if longer, so long as the individual's 
right to reemployment with the corporation granting the option (or a 
related corporation of such corporation) or a corporation (or a related 
corporation of such corporation) substituting or assuming a stock 
option in a transaction to which Sec.  1.424-1(a) applies, is 
guaranteed either by statute or by contract. If the period of leave 
exceeds 90 days and the individual's right to reemployment is not 
guaranteed either by statute or by contract, the employment 
relationship is deemed to terminate on the 91st day of such leave. 
Thus, if the option is not exercised before such deemed termination of 
employment, Sec.  1.421-2(a) applies to the transfer of a share 
pursuant to an exercise of the option only if the exercise occurs 
within 3 months from the date the employment relationship is deemed 
terminated.
* * * * *
    (i) Additional definitions. (1) Corporation. For purposes of this 
section and Sec. Sec.  1.421-2 through 1.424-1, the term corporation 
has the meaning prescribed by section 7701(a)(3) and Sec.  301.7701-
2(b) of this chapter. For example, a corporation for purposes of the 
preceding sentence includes an S corporation (as defined in section 
1361), a foreign corporation (as defined in section 7701(a)(5)), and a 
limited liability company that is treated as a corporation for all 
Federal tax purposes.
    (2) Parent corporation and subsidiary corporation. For the 
definition of the terms parent corporation (and parent) and subsidiary 
corporation (and subsidiary), for purposes of this section and 
Sec. Sec.  1.421-2 through 1.424-1, see Sec.  1.424-1(f)(i) and (ii), 
respectively. Related corporation as used in this section and in 
Sec. Sec.  1.421-2 through 1.424-1 means either a parent corporation or 
subsidiary corporation.
    (j) Effective date. This section applies to any statutory option 
granted on or after the date that is 180 days after publication of 
final regulations in the Federal Register. Taxpayers can rely on these 
regulations for the treatment of any statutory option granted on or 
after June 9, 2003.
    Par. 4. Section 1.421-8 is re-designated as 1.421-2 and is amended 
by:
    1. Revising paragraphs (a)(1), (b), and (c)(1).
    2. In the list below, for each section indicated in the left 
column, remove the language in the middle column and add the language 
in the right column:

------------------------------------------------------------------------
       Newly designated section                 Remove             Add
------------------------------------------------------------------------
1.421-2(c)(2), second sentence.......  or 424(c)(1)............  .......
Add 1.421-2(c)(2), third sentence....  or 424(c)(1)............  .......
1.421-2(c)(3)(i), first, second, and   422(c)(1), 423(c), or      423(c)
 third sentences.                       424(c)(1).
1.421-2(c)(3)(ii), Example, first      1964....................     2004
 sentence.
1.421-2(c)(3)(ii), Example, third,     1966....................     2006
 fifth, and sixth sentences.
------------------------------------------------------------------------

    3. In paragraph (c)(2), first sentence, add the phrase ``for 
purposes of section 423(c)'' at the end of the first sentence.
    4. Removing paragraph (c)(4)(i) and redesignating paragraphs 
(c)(4)(ii) through (c)(4)(iv) as paragraphs (c)(4)(i) through 
(c)(4)(iii), respectively.
    5. In newly designated paragraph (c)(4)(i)(a), first sentence, 
removing the phrase ``In the case of an employee dying after December 
31, 1956'' and adding ``In the case of the death of an optionee'' in 
its place.
    6. Removing Example (1) in newly designated paragraph (c)(4)(iii) 
and redesignating Examples (2) through (5) as Examples (1) through (4), 
respectively.
    7. In the list below, for each section indicated in the left 
column, remove the language in the middle column and add the language 
in the right column:

------------------------------------------------------------------------
  Newly designated section           Remove                  Add
------------------------------------------------------------------------
1.421-2(c)(4)(i)(a), last     422(c)(1), 423(c),    423(c).
 sentence.                     or 424(c)(1).
1.421-2(c)(4)(i)(b), first,   422(c)(1), 423(c),    423(c).
 second, and last sentences.   or 424(c)(1).
1.421-2(c)(4)(i)(c), first    422(c)(1), 423(c),    423(c).
 sentence.                     or 424(c)(1).
1.421-2(c)(4)(iii), Example   1964................  2005.
 1, first sentence.
1.421-2(c)(4)(iii), Example   subdivision (ii)(b)   paragraph
 1, eighth sentence.           of this               (c)(4)(i)(b) of
                               subparagraph.         this section.
1.421-2(c)(4)(iii), Example   1966................  2006.
 1, third and fifth
 sentences.
1.421-2(c)(4)(iii), Example   subdivision (ii)(c)   paragraph
 1, ninth sentence.            of this               (c)(4)(i)(c) of
                               subparagraph.         this section.

[[Page 34354]]

 
1.421-2(c)(4)(iii), Example   subdivision (ii)(a)   paragraph
 2, second and fifth           of this               (c)(4)(i)(a) of
 sentences.                    subparagraph.         this section.
1.421-2(c)(4)(iii), Example   subdivision (ii)(b)   paragraph
 2, fifth sentence.            of this               (c)(4)(i)(b) of
                               subparagraph.         this section.
1.421-2(c)(4)(iii), Example   example (2).........  Example 1.
 2, first sentence.
1.421-2(c)(4)(iii), Example   example (2).........  Example 1.
 3, first sentence.
1.421-2(c)(4)(iii), Example   subdivision (ii)(a)   paragraph
 3, second and fourth          of this               (c)(4)(i)(a) of
 sentences.                    subparagraph.         this section.
1.421-2(c)(4)(iii), Example   subdivision (ii)(c)   paragraph
 3, fourth sentence.           of this               (c)(4)(i)(c) of
                               subparagraph.         this section
1.421-2(c)(4)(iii), Example   example (2).........  Example 1.
 4, first sentence.
1.421-2(c)(4)(iii), Example   1966................  2006.
 4, first sentence.
1.421-2(c)(4)(iii), Example   1967................  2007.
 4, first and second
 sentences.
1.421-2(c)(4)(iii), Example   subdivision (ii)(a)   paragraph
 4, third and fifth            of this               (c)(4)(i)(a) of
 sentences.                    subparagraph.         this section.
1.421-2(c)(4)(iii), Example   subdivision (ii)(a)   paragraph
 4, sixth sentence.            of this               (c)(4)(i)(a) of
                               subparagraph.         this section.
1.421-2(c)(4)(iii), Example   subdivision (ii)(b)   paragraph
 4, fifth and sixth            of this               (c)(4)(i)(b) of
 sentences.                    subparagraph.         this section.
1.421-2(c)(4)(iii), Example   subdivision (ii)(c)   paragraph
 4, sixth sentence.            of this               (c)(4)(i)(c) of
                               subparagraph.         this section.
------------------------------------------------------------------------

    8. Revising paragraph (d).
    9. Adding paragraph (f).
    The revisions read as follows:


Sec.  1.421-2  General rules.

    (a) Effect of qualifying transfer. (1) If a share of stock is 
transferred to an individual pursuant to the individual's exercise of a 
statutory option, and if the requirements of Sec.  1.422-1(a) (relating 
to incentive stock options) or Sec.  1.423-1(a) (relating to employee 
stock purchase plans) whichever is applicable, are met, then--
    (i) No income results at the time of the transfer of such share to 
the individual upon the exercise of the option with respect to such 
share (in addition, no income results upon grant of the option, see 
Sec.  1.83-7);
    (ii) No deduction under section 162 or the regulations thereunder 
(relating to trade or business expenses) is allowable at any time with 
respect to the share so transferred; and
    (iii) No amount other than the price paid under the option is 
considered as received by the employer corporation, a related 
corporation of such corporation, or a corporation substituting or 
assuming a stock option in a transaction to which Sec.  1.424-1(a) 
(relating to corporate reorganizations, liquidations, etc.) applies, 
for the share so transferred.
* * * * *
    (b) Effect of disqualifying disposition. (1)(i) The disposition (as 
defined in Sec.  1.424-1(c)) of a share of stock acquired by the 
exercise of a statutory option before the expiration of the applicable 
holding periods as determined under Sec.  1.422-1(a) or 1.423-1(a) is a 
disqualifying disposition and makes paragraph (a) of this section 
inapplicable to the transfer of such share. See Sec.  1.83-7 for the 
treatment of nonstatutory options. The income attributable to such 
transfer (determined without reduction for any brokerage fees or other 
costs paid in connection with the disposition) is treated by the 
individual as compensation income received in the taxable year in which 
such disqualifying disposition occurs. Similarly, if otherwise 
allowable under sections 83(h) and 162, a deduction attributable to 
such transfer is allowable for the taxable year in which such 
disqualifying disposition occurs to the employer corporation, or a 
related corporation of such corporation, or a corporation substituting 
or assuming an option in a transaction to which Sec.  1.424-1(a) 
applies. Additionally, an amount is allowed as a deduction only if the 
requirements of Sec.  1.83-6(a) are satisfied. No amount is treated as 
income, and no amount is allowed as a deduction, for any taxable year 
other than the taxable year in which the disqualifying disposition 
occurs. If the amount realized on the disposition exceeds (or is less 
than) the sum of the amount paid for the share and the amount of 
compensation income recognized as a result of such disposition, the 
extent to which the difference is treated as gain (or loss) is 
determined under the rules of section 302 or 1001, as applicable.
    (ii) The following examples illustrate the principles of this 
paragraph (b):

    Example 1. On June 1, 2006, X Corporation grants an incentive 
stock option to A, an employee of X, entitling A to purchase 100 
shares of X stock at $10 per share. On August 1, 2006, A exercises 
the option when the fair market value of X stock is $20 per share, 
and 100 shares of X stock are transferred to A on that date. On 
December 15, 2007, A sells the stock. Because A disposed of the 
stock before June 2, 2008, A did not satisfy the holding period 
requirements of Sec.  1.422-1(a). Under paragraph (b)(1)(i) of this 
section, A made a disqualifying disposition of the stock. Thus, 
paragraph (a) of this section is inapplicable to the transfer of the 
shares, and A must include the compensation income attributable to 
the transfer of the shares in gross income. The amount of 
compensation income A must include in income under Sec.  1.83-7 in 
the year of the disqualifying disposition is $1,000 (($20, the fair 
market value of X stock on transfer less $10, the exercise price per 
share) times 100 shares)). If otherwise allowable under sections 
83(h) and 162 and if the requirements of Sec.  1.83-6(a) are met, X 
is allowed a deduction of $1,000 for its taxable year in which the 
disqualifying disposition occurs.
    Example 2. Y Corporation grants an incentive stock option for 
100 shares of its stock to E, an employee of Y. The option has an 
exercise price of $10 per share. E exercises the option and is 
transferred the shares when the fair market value of a share of Y 
stock is $30. Before the applicable holding periods expire, Y 
redeems the shares for $70 per share. Because the holding period 
requirements of Sec.  1.422-1(a) are not met, the redemption of the 
shares is a disqualifying disposition of the shares. Under paragraph 
(b)(1)(i) of this section, A made a disqualifying disposition of the 
stock. Thus, paragraph (a) of this section is inapplicable

[[Page 34355]]

to the transfer of the shares, and E must include the compensation 
income attributable to the transfer of the shares in gross income. 
Under Sec.  1.83-7, the amount of compensation income attributable 
to E's purchase of the share that E must include in gross income in 
the year of the disqualifying disposition is $2,000 ($3,000, the 
fair market value of Y stock on transfer, less $1,000, the exercise 
price paid by E). The character of the additional gain that is 
includible in E's income as a result of the redemption is determined 
under the rules of section 302. If otherwise allowable under 
sections 83(h) and 162 and if the requirements of Sec.  1.83-6(a) 
are met, Y is allowed a deduction for the taxable year in which the 
disqualifying disposition occurs for the compensation income of 
$2,000. Y is not allowed a deduction for the additional gain 
includible in E's income as a result of the redemption.

    (2) If an optionee transfers stock acquired through the optionee's 
exercise of a statutory option prior to the expiration of the 
applicable holding periods, paragraph (a) of this section continues to 
apply to the transfer of the stock pursuant to the exercise of the 
option if such transfer is not a disposition of the stock as defined in 
Sec.  1.424-1(c) (for example, a transfer from a decedent to the 
decedent's estate or a transfer by bequest or inheritance). Similarly, 
a subsequent transfer by the executor, administrator, heir, or legatee 
is not a disqualifying disposition by the decedent. If a statutory 
option is exercised by the estate of the optionee or by a person who 
acquired the option by bequest or inheritance or by reason of the death 
of such optionee, see paragraph (c) of this section. If a statutory 
option is exercised by the individual to whom the option was granted 
and the individual dies before the expiration of the holding periods, 
see paragraph (d) of this section.
    (3) For special rules relating to the disqualifying disposition of 
a share of stock acquired by exercise of an incentive stock option, see 
Sec. Sec.  1.422-5(b)(2) and 1.424-1(c)(3).
    (c) Exercise by estate. (1) If a statutory option is exercised by 
the estate of the individual to whom the option was granted (or by any 
person who acquired such option by bequest or inheritance or by reason 
of the death of such individual), paragraph (a) of this section applies 
to the transfer of stock pursuant to such exercise in the same manner 
as if the option had been exercised by the deceased optionee. 
Consequently, neither the estate nor such person is required to include 
any amount in gross income as a result of a transfer of stock pursuant 
to the exercise of the option. Paragraph (a) of this section applies 
even if the executor, administrator, or such person disposes of the 
stock so acquired before the expiration of the applicable holding 
periods as determined under Sec.  1.422-1(a) or 1.423-1(a). This 
special rule does not affect the applicability of section 423(c), 
relating to the estate's or other qualifying person's recognition of 
compensation income, or section 1222, relating to what constitutes a 
short-term and long-term capital gain or loss. Paragraph (a) of this 
section also applies even if the executor, administrator, or such 
person does not exercise the option within three months after the death 
of the individual or is not employed as described in Sec.  1.421-1(h), 
either when the option is exercised or at any time. However, paragraph 
(a) of this section does not apply to a transfer of shares pursuant to 
an exercise of the option by the estate or by such person unless the 
individual met the employment requirements described in Sec.  1.421-
1(h) either at the time of the individual's death or within three 
months before such time (or, if applicable, within the period described 
in Sec.  1.422-1(a)(3)). Additionally, paragraph (a) of this section 
does not apply if the option is exercised by a person other than the 
executor or administrator, or other than a person who acquired the 
option by bequest or inheritance or by reason of the death of such 
deceased individual. For example, if the option is sold by the estate, 
paragraph (a) of this section does not apply to the transfer of stock 
pursuant to an exercise of the option by the buyer, but if the option 
is distributed by the administrator to an heir as part of the estate, 
paragraph (a) of this section applies to the transfer of stock pursuant 
to an exercise of the option by such heir.
* * * * *
    (d) Option exercised by the individual to whom the option was 
granted if the individual dies before expiration of the applicable 
holding periods. If a statutory option is exercised by the individual 
to whom the option was granted and such individual dies before the 
expiration of the applicable holding periods as determined under Sec.  
1.422-1(a) or 1.423-1(a), paragraph (a) of this section does not become 
inapplicable if the executor or administrator of the estate of such 
individual, or any person who acquired such stock by bequest or 
inheritance or by reason of the death of such individual, disposes of 
such stock before the expiration of such applicable holding periods. 
This rule does not affect the applicability of section 423(c), relating 
to the individual's recognition of compensation income, or section 
1222, relating to what constitutes a short-term and long-term capital 
gain or loss.
* * * * *
    (f) Effective date. This section is applies to any statutory option 
granted on or after the date that is 180 days after publication of 
final regulations in the Federal Register. Taxpayers can rely on these 
regulations for the treatment of any statutory option granted on or 
after June 9, 2003.
    Par. 5. Section 1.422-1 is added to read as follows:


Sec.  1.422-1  Incentive stock options; general rules.

    (a) Applicability of section 421(a). (1)(i) Section 1.421-2(a) 
applies to the transfer of a share of stock to an individual pursuant 
to the individual's exercise of an incentive stock option if the 
following conditions are satisfied--
    (A) The individual makes no disposition of such share before the 
later of the expiration of the 2-year period from the date of grant of 
the option pursuant to which such share was transferred, or the 
expiration of the 1-year period from the date of transfer of such share 
to the individual; and
    (B) At all times during the period beginning on the date of grant 
of the option and ending on the day 3 months before the date of 
exercise, the individual was an employee of either the corporation 
granting the option, a related corporation of such corporation, or a 
corporation (or a related corporation of such corporation) substituting 
or assuming a stock option in a transaction to which Sec.  1.424-1(a) 
applies.
    (ii) For rules relating to the disposition of shares of stock 
acquired pursuant to the exercise of a statutory option, see Sec.  
1.424-1(c). For rules relating to the requisite employment 
relationship, see Sec.  1.421-1(h).
    (2)(i) The holding period requirement of section 422(a)(1), 
described in paragraph (a)(1)(i)(A) of this section, does not apply to 
the transfers of shares by an insolvent individual described in this 
paragraph (a)(2). If an insolvent individual holds a share of stock 
acquired pursuant to the individual's exercise of an incentive stock 
option, and if such share is transferred to a trustee, receiver, or 
other similar fiduciary in any proceeding under the Bankruptcy Act or 
any other similar insolvency proceeding, neither such transfer, nor any 
other transfer of such share for the benefit of the individual's 
creditors in such proceeding is a disposition of such share for 
purposes of this paragraph (a). For purposes of this paragraph (a)(2), 
an individual is insolvent only if the individual's

[[Page 34356]]

liabilities exceed the individual's assets or the individual is unable 
to satisfy the individual's liabilities as they become due. See section 
422(c)(3).
    (ii) A transfer by the trustee or other fiduciary that is not 
treated as a disposition for purposes of this paragraph (a) may be a 
sale or exchange for purposes of recognizing capital gain or loss with 
respect to the share transferred. For example, if the trustee transfers 
the share to a creditor in an insolvency proceeding, capital gain or 
loss must be recognized by the insolvent individual to the extent of 
the difference between the amount realized from such transfer and the 
adjusted basis of such share.
    (iii) If any transfer by the trustee or other fiduciary (other than 
a transfer back to the insolvent individual) is not for the exclusive 
benefit of the creditors in an insolvency proceeding, then whether such 
transfer is a disposition of the share by the individual for purposes 
of this paragraph (a) is determined under Sec.  1.424-1(c). Similarly, 
if the trustee or other fiduciary transfers the share back to the 
insolvent individual, any subsequent transfer of the share by such 
individual which is not made in respect of the insolvency proceeding 
may be a disposition of the share for purposes of this paragraph (a).
    (3) If the employee exercising an option ceased employment because 
of permanent and total disability, within the meaning of section 
22(e)(3), 1 year is used instead of 3 months in the employment period 
requirement of paragraph (a)(1)(i)(B) of this section.
    (b) Failure to satisfy holding period requirements--(1) General 
rule. For general rules concerning a disqualifying disposition of a 
share of stock acquired pursuant to the exercise of an incentive stock 
option, see Sec.  1.421-2(b)(1).
    (2)(i) Special rule. If an individual makes a disqualifying 
disposition of a share of stock acquired by the exercise of an 
incentive stock option, and if such disposition is a sale or exchange 
with respect to which a loss (if sustained) would be recognized to the 
individual, then, under this paragraph (b)(2)(i), the amount includible 
in the gross income of such individual, and deductible from the income 
of the employer corporation (or a related corporation of such 
corporation, or of a corporation substituting or assuming the option in 
a transaction to which Sec.  1.424-1(a) applies) as compensation 
attributable to the exercise of such option, shall not exceed the 
excess (if any) of the amount realized on such sale or exchange over 
the adjusted basis of such share. Subject to the special rule provided 
by this paragraph (b)(2)(i), the amount of compensation attributable to 
the exercise of the option is determined under Sec.  1.83-7; see Sec.  
1.421-2(b)(1)(i).
    (ii) Limitation to special rule. The special rule described in 
paragraph (b)(2)(i) of this section does not apply if the disposition 
is a sale or exchange with respect to which a loss (if sustained) would 
not be recognized to the individual. Thus, for example, if a 
disqualifying disposition is a sale described in section 1091 (relating 
to loss from wash sales of stock or securities), a gift (or any other 
transaction which is not at arm's length), or a sale described in 
section 267(a)(1) (relating to sales between related persons), the 
special rule described in paragraph (b)(2)(i) of this section does not 
apply because a loss sustained in any such transaction would not be 
recognized.
    (3) Examples. The following examples illustrate the principles of 
this paragraph (b):

    Example 1. On June 1, 2006, X Corporation grants an incentive 
stock option to A, an employee of X Corporation, entitling A to 
purchase one share of X Corporation stock. On August 1, 2006, A 
exercises the option and the share of X Corporation stock is 
transferred to A on that date. The option price is $100 (the fair 
market value of a share of X Corporation stock on June 1, 2006) and 
the fair market value of a share of X Corporation stock on August 1, 
2006 (the date of transfer) is $200. The share transferred to A is 
transferable and not subject to a substantial risk of forfeiture. A 
makes a disqualifying disposition by selling the share on June 1, 
2007, for $250. Under Sec.  1.83-7(a) (relating to options to which 
section 421 does not apply), the amount of compensation attributable 
to A's exercise is $100 (the difference between the fair market 
value of the share at the date of transfer, $200, and the amount 
paid for the share, $100). Because the amount realized ($250) is 
greater than the value of the share at transfer ($200), paragraph 
(b)(2)(i) of this section does not apply and thus does not affect 
the amount includible as compensation in A's gross income and 
deductible by X. A must include in gross income for the taxable year 
in which the sale occurred $100 as compensation and $50 as capital 
gain ($250, the amount realized from the sale, less A's basis of 
$200 (the $100 paid for the share plus the $100 increase in basis 
resulting from the inclusion of that amount in A's gross income as 
compensation attributable to the exercise of the option)). For its 
taxable year in which the disqualifying disposition occurs, if 
otherwise allowable under sections 83(h) and 162 and if the 
requirements of Sec.  1.83-6(a) are met, X Corporation is allowed a 
deduction of $100 for compensation attributable to A's exercise of 
the incentive stock option.
    Example 2. Assume the same facts as in Example 1, except that 
the share of X Corporation stock transferred to A is subject to a 
substantial risk of forfeiture and not transferable for a period of 
six months after such transfer. Assume further that the fair market 
value of X Corporation stock is $225 on February 1, 2005, the date 
on which the six-month restriction lapses. Under section 83(a) and 
Sec.  1.83-7(a), the amount of compensation attributable to A's 
exercise of the option and disqualifying disposition of the share is 
$125 (the difference between the fair market value of the share on 
the date that the restriction lapsed, $225, and the amount paid for 
the share, $100). A must include $125 of compensation income and $25 
of capital gain in gross income for the taxable year in which the 
disposition occurs ($250, the amount realized from the sale, less 
A's basis of $225 (the $100 paid for the share plus the $125 
increase in basis resulting from the inclusion of that amount of 
compensation in A's gross income)). For its taxable year in which 
the disqualifying disposition occurs, if otherwise allowable under 
sections 83(h) and 162 and if the requirements of Sec.  1.83-6(a) 
are met, X Corporation is allowed a deduction of $125 for the 
compensation attributable to A's exercise of the option.
    Example 3. (i) Assume the same facts as in Example 1, except 
that A sells the share for $150 to M.
    (ii) If the sale to M is a disposition that meets the 
requirements of paragraph (b)(2)(i) of this section, instead of $100 
which otherwise would have been includible as compensation under 
Sec.  1.83-7, under paragraph (b)(2)(i) of this section, A must 
include only $50 (the excess of the amount realized on such sale, 
$150, over the adjusted basis of the share, $100) in gross income as 
compensation attributable to the exercise of the incentive stock 
option. Because A's basis for the share is $150 (the $100 which A 
paid for the share, plus the $50 increase in basis resulting from 
the inclusion of that amount in A's gross income as compensation 
attributable to the exercise of the option), A realizes no capital 
gain or loss as a result of the sale. For its taxable year in which 
the disqualifying disposition occurs, if otherwise allowable under 
sections 83(h) and 162 and if the requirements of Sec.  1.83-6(a) 
are met, X Corporation is allowed a deduction of $50 for the 
compensation attributable to A's exercise of the option.
    (iii) Assume the same facts as in paragraph (i) of this Example 
3, except that 10 days after the sale to M, A purchases 
substantially identical stock. Because under section 1091(a) a loss 
(if it were sustained on the sale) would not be recognized on the 
sale, under paragraph (b)(2)(ii) of this section, the special rule 
described in paragraph (b)(2)(i) of this section does not apply. 
Under Sec.  1.83-7, A must include $100 (the difference between the 
fair market value of the share on the date of transfer, $200, and 
the amount paid for the share, $100) in gross income as compensation 
attributable to the exercise of the option for the taxable year in 
which the disqualifying disposition occurred. A recognizes no 
capital gain or loss on the transaction. For its taxable year in 
which the disqualifying disposition occurs, if otherwise allowable 
under sections 83(h) and 162 and if the requirements of Sec.  1.83-
6(a) are met, X Corporation is allowed a $100 deduction for 
compensation attributable to A's exercise of the option.

[[Page 34357]]

    (iv) Assume the same facts as in paragraph (ii) of this Example 
3, except that A sells the share for $50. Under paragraph (b)(2)(i) 
of this section, A is not required to include any amount in gross 
income as compensation attributable to the exercise of the option. A 
is allowed a capital loss of $50 (the difference between the amount 
realized on the sale, $50, and the adjusted basis of the share, 
$100). X Corporation is not allowed any deduction attributable to 
A's exercise of the option and disqualifying disposition of the 
share.

    (c) Failure to satisfy employment requirement. Section 1.421-2(a) 
does not apply to the transfer of a share of stock pursuant to the 
exercise of an incentive stock option if the employment requirement, as 
determined under paragraph (a)(1)(i)(B) of this section, is not met at 
the time of the exercise of such option. Consequently, the effects of 
such a transfer are determined under the rules of Sec.  1.83-7. For 
rules relating to the employment relationship, see Sec.  1.421-1(h).
    Par. 6. Section 1.422-2 is added to read as follows:


Sec.  1.422-2  Incentive stock options defined.

    (a) Incentive stock option defined--(1) In general. The term 
incentive stock option means an option that meets the requirements of 
paragraph (a)(2) of this section on the date of grant. An incentive 
stock option is also subject to the $100,000 limitation described in 
Sec.  1.422-4. An incentive stock option may contain a number of 
permissible provisions that do not affect the status of the option as 
an incentive stock option. See Sec.  1.422-5 for rules relating to 
permissible provisions of an incentive stock option.
    (2) Option requirements. To qualify as an incentive stock option 
under this section, an option must be granted to an individual in 
connection with the individual's employment by the corporation granting 
such option (or by a related corporation), and granted only for stock 
of any of such corporations. In addition, the option must meet all of 
the following requirements--
    (i) It must be granted pursuant to a plan that meets the 
requirements described in paragraph (b) of this section;
    (ii) It must be granted within 10 years from the date of the 
adoption of the plan or the date such plan is approved by the 
stockholders, whichever is earlier (see paragraph (c) of this section);
    (iii) It must not be exercisable after the expiration of 10 years 
from the date of grant (see paragraph (d) of this section);
    (iv) It must provide that the option price per share is not less 
than the fair market value of the share on the date of grant (see 
paragraph (e) of this section);
    (v) By its terms, it must not be transferrable by the individual to 
whom the option is granted other than by will or the laws of descent 
and distribution, and must be exercisable, during such individual's 
lifetime, only by such individual (see Sec. Sec.  1.421-1(b)(2) and 
1.421-2(c)); and
    (vi) Except as provided in paragraph (f) of this section, it must 
be granted to an individual who, at the time the option is granted, 
does not own stock possessing more than 10 percent of the total 
combined voting power of all classes of stock of the corporation 
employing such individual or of any related corporation of such 
corporation.
    (3) Amendment of option terms. Except as otherwise provided in 
Sec.  1.424-1, the amendment of the terms of an incentive stock option 
may cause it to cease to be an option described in this section. If the 
terms of an option that has lost its status as an incentive stock 
option are subsequently changed with the intent to re-qualify the 
option as an incentive stock option, such change results in the grant 
of a new option on the date of the change. See Sec.  1.424-1(e).
    (4) Terms provide option not an incentive stock option. If the 
terms of an option, when granted, provide that it will not be treated 
as an incentive stock option, such option is not treated as an 
incentive stock option.
    (b) Option plan--(1) In general. An incentive stock option must be 
granted pursuant to a plan that meets the requirements of this 
paragraph (b). The authority to grant other stock options or other 
stock-based awards pursuant to the plan, where the exercise of such 
other options or awards does not affect the exercise of incentive stock 
options granted pursuant to the plan, does not disqualify such 
incentive stock options. The plan must be in writing or electronic 
form, provided that such writing or electronic form is adequate to 
establish the terms of the plan. See Sec.  1.422-5 for rules relating 
to permissible provisions of an incentive stock option.
    (2) Stockholder approval. (i) The plan required by this paragraph 
(b) must be approved by the stockholders of the corporation granting 
the incentive stock option within 12 months before or after the date 
such plan is adopted. Ordinarily, a plan is adopted when it is approved 
by the granting corporation's board of directors, and the date of the 
board's action is the reference point for determining whether 
stockholder approval occurs within the applicable 24-month period. 
However, if the board's action is subject to a condition (such as 
stockholder approval) or the happening of a particular event, the plan 
is adopted on the date the condition is met or the event occurs, unless 
the board's resolution fixes the date of approval as the date of the 
board's action.
    (ii) For purposes of paragraph (b)(2)(i) of this section, the 
stockholder approval must comply with the rules described in Sec.  
1.422-3.
    (iii) The provisions relating to the maximum aggregate number of 
shares to be issued under the plan (described in paragraph (b)(3) of 
this section) and the employees (or class or classes of employees) 
eligible to receive options under the plan (described in paragraph 
(b)(4) of this section) are the only provisions of a stock option plan 
that must be approved by stockholders for purposes of section 
422(b)(1). Any increase in the maximum aggregate number of shares that 
may be issued under the plan (other than an increase merely reflecting 
a change in the number of outstanding shares, such as a stock dividend 
or stock split), or change in the designation of the employees (or 
class or classes of employees) eligible to receive options under the 
plan is considered the adoption of a new plan requiring stockholder 
approval within the prescribed 24-month period. In addition, a change 
in the granting corporation or the stock available for purchase or 
award under the plan is considered the adoption of a new plan requiring 
new stockholder approval within the prescribed 24-month period. Any 
other changes in the terms of an incentive stock option plan are not 
considered the adoption of a new plan and, thus, do not require 
stockholder approval.
    (3) Maximum aggregate number of shares. (i) The plan required by 
this paragraph (b) must designate the maximum aggregate number of 
shares that may be issued under the plan through incentive stock 
options, nonstatutory options, and all other stock-based awards to be 
granted thereunder. If nonstatutory options or other stock-based awards 
may be granted, the plan may separately designate terms for each type 
of option and other stock-based award and designate the maximum number 
of shares that may be issued under such option or other stock-based 
award. Unless otherwise specified, all terms of the plan apply to all 
options and other stock-based awards that may be granted under the 
plan.
    (ii) A plan that merely provides that the number of shares that may 
be issued under options and other stock-based

[[Page 34358]]

awards granted under such plan may not exceed a stated percentage of 
the shares outstanding at the time of each offering or grant under such 
plan does not satisfy the requirement that the plan state the maximum 
aggregate number of shares that may be issued under the plan. However, 
the maximum aggregate number of shares that may be issued under the 
plan may be stated in terms of a percentage of the authorized, issued 
or outstanding shares at the date of the adoption of the plan. The plan 
may specify that the maximum aggregate number of shares available for 
grants under the plan may increase annually by a specified percentage 
of the authorized, issued or outstanding shares at the date of the 
adoption of the plan. A plan which provides that the maximum aggregate 
number of shares that may be issued under the plan may change based on 
any other specified circumstances satisfies the requirements of this 
paragraph (b)(3) only if the stockholders approve an immediately 
determinable maximum aggregate number of shares that may be issued 
under the plan in any event.
    (iii) It is permissible for the plan to provide that shares 
purchasable under the plan may be supplied to the plan through 
acquisitions of stock on the open market, that shares purchased under 
the plan and forfeited back to the plan are available for re-issuance 
under the plan, or that shares surrendered in payment of the exercise 
price of an option are available for re-issuance under the plan.
    (iv) If there is more than one plan under which incentive stock 
options may be granted and stockholders of the granting corporation 
merely approve a maximum aggregate number of shares that are available 
for issuance under such plans, the stockholder approval requirements 
described in paragraph (b)(2) of this section are not satisfied. A 
separate maximum aggregate number of shares must be approved for each 
plan.
    (4) Designation of employees. The plan described in this paragraph 
(b), as adopted and approved, must indicate the employees (or class or 
classes of employees) eligible to receive the options or other stock-
based awards to be granted under the plan. This requirement is 
satisfied by a general designation of the classes of employees eligible 
to receive options or other stock-based awards under the plan. 
Designations such as ``key employees of the grantor corporation''; 
``all salaried employees of the grantor corporation and its 
subsidiaries, including subsidiaries which become such after adoption 
of the plan;'' or ``all employees of the corporation'' meet this 
requirement. This requirement is considered satisfied even though the 
board of directors, another group, or an individual is given the 
authority to select the particular employees who are to receive options 
or other stock-based awards from a described class and to determine the 
number of shares to be optioned or granted to each such employee. If 
individuals other than employees may be granted options or other stock-
based awards under the plan, the plan must separately designate the 
employees or classes of employees eligible to receive incentive stock 
options.
    (5) Conflicting option terms. An option on stock available for 
purchase or grant under the plan is treated as having been granted 
pursuant to a plan even if the terms of the option conflict with the 
terms of the plan, unless such option is granted to an employee who is 
ineligible to receive options under the plan, options have been granted 
on stock in excess of the aggregate number of shares which may be 
issued under the plan, or the option provides otherwise.
    (6) The following examples illustrate the principles of this 
paragraph (b):

    Example 1. Stockholder approval. (i) S Corporation is a 
subsidiary of P Corporation, a publicly traded corporation. On 
January 1, 2006, S adopts a plan under which incentive stock options 
for S stock are granted to S employees.
    (ii) To meet the requirements of paragraph (b)(2) of this 
section, the plan must be approved by the stockholders of S (in this 
case, P) within 12 months before or after January 1, 2004.
    (iii) Assume the same facts as in paragraph (i) of this Example 
1. Assume further that the plan was approved by the stockholders of 
S (in this case, P) on March 1, 2006. On January 1, 2008, S changes 
the plan to provide that incentive stock options for P stock will be 
granted to S employees under the plan. Because there is a change in 
the stock available for grant under the plan, the change is 
considered the adoption of a new plan that must be approved by the 
stockholders within 12 months before or after January 1, 2008.
    Example 2. Stockholder approval. (i) Assume the same facts as in 
paragraph (i) of Example 1, except that on March 15, 2007, P 
completely disposes of its interest in S. Thereafter, S continues to 
grant options for S stock to S employees under the plan.
    (ii) The new S options are granted under a plan that meets the 
stockholder approval requirements of paragraph (b)(2) of this 
section without regard to whether S seeks approval of the plan from 
the stockholders of S after P disposes of its interest in S.
    (iii) Assume the same facts as in paragraph (i) of this Example 
2, except that under the plan as adopted on January 1, 2006, only 
options for P stock are granted to S employees. Assume further that 
after P disposes of its interest in S, S changes the plan to provide 
for the grant of options for S stock to S employees. Because there 
is a change in the stock available for purchase or grant under the 
plan, under paragraph (b)(2)(iii) of this section, the stockholders 
of S must approve the plan within 12 months before or after the 
change to the plan to meet the stockholder approval requirements of 
paragraph (b) of this section.
    Example 3. Maximum aggregate number of shares. X Corporation 
maintains a plan under which statutory options and nonstatutory 
options may be granted. The plan designates the number of shares 
that may be used for incentive stock options. 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 
of paragraph (b)(3) of this section are not satisfied.
    Example 4. Maximum aggregate number of shares. Y Corporation 
adopts an incentive stock option plan on November 1, 2006. On that 
date there are two million outstanding shares of Y Corporation 
stock. The plan provides that the maximum aggregate number of shares 
that may be issued under the plan may not exceed 15% of the 
outstanding number of shares of Y Corporation on November 1, 2006. 
Because the maximum aggregate number of shares under the plan is 
designated in the plan, the requirements of paragraph (b)(3) of this 
section are met.
    Example 5. Maximum aggregate number of shares. (i) B Corporation 
adopts an incentive stock option plan on March 15, 2005. The plan 
provides that the maximum aggregate number of shares available under 
the plan is 50,000, increased on each anniversary date of the 
adoption of the plan by 5 percent of the then-outstanding shares.
    (ii) Because the maximum aggregate number of shares is not 
designated under the plan, the requirements of paragraph (b)(3) of 
this section are not met.
    (iii) Assume the same facts as in paragraph (i) of this Example 
5, except that the plan provides that the maximum aggregate number 
of shares available under the plan is the lesser of (a) 50,000 
shares increased each anniversary date of the adoption of the plan 
by 5 percent of the then-outstanding shares or (b) 200,000 shares. 
Because the maximum aggregate number of shares under the plan is 
designated as the lesser of one of two numbers, one of which 
provides an immediately determinable maximum aggregate number of 
shares that may be issued under the plan in any event, the 
requirements of paragraph (b)(3) of this section are met.

    (c) Duration of option grants under the plan. An incentive stock 
option must be granted within 10 years from the date that the plan 
under which it is granted is adopted or the date such plan is approved 
by the stockholders, whichever is earlier. To grant incentive stock 
options after the expiration of the 10-year period, a new plan must be 
adopted and approved.
    (d) Period for exercising options. An incentive stock option, by 
its terms,

[[Page 34359]]

must not be exercisable after the expiration of 10 years from the date 
such option is granted, or 5 years from the date such option is granted 
to an employee described in paragraph (f) of this section. An option 
that does not contain such a provision when granted is not an incentive 
stock option.
    (e) Option price. (1) Except as provided by paragraph (e)(2) of 
this section, the option price of an incentive stock option must not be 
less than the fair market value of the stock subject to the option at 
the time the option is granted. The option price may be determined in 
any reasonable manner, including the valuation methods permitted under 
Sec.  20.2031-2 of this chapter (Estate Tax Regulations), so long as 
the minimum price possible under the terms of the option is not less 
than the fair market value of the stock on the date of grant. For 
general rules relating to the option price, see Sec.  1.421-1(e). For 
rules relating to the determination of when an option is granted, see 
Sec.  1.421-1(c).
    (2)(i) If a share of stock is transferred to an individual pursuant 
to the exercise of an option which fails to qualify as an incentive 
stock option merely because there was a failure of an attempt, made in 
good faith, to meet the option price requirements of paragraph (e)(1) 
of this section, the requirements of such paragraph are considered to 
have been met. Whether there was a good-faith attempt to set the option 
price at not less than the fair market value of the stock subject to 
the option at the time the option was granted depends on the relevant 
facts and circumstances.
    (ii) For publicly held stock that is actively traded on an 
established market at the time the option is granted, determining the 
fair market value of such stock by the appropriate method described in 
Sec.  20.2031-2 of this chapter (Estate Tax Regulations) establishes 
that a good-faith attempt to meet the option price requirements of this 
paragraph (e) was made.
    (iii) For non-publicly traded stock, if it is demonstrated, for 
example, that the fair market value of the stock at the date of grant 
was based upon an average of the fair market values as of such date set 
forth in the opinions of completely independent and well-qualified 
experts, such a demonstration generally establishes that there was a 
good-faith attempt to meet the option price requirements of this 
paragraph (e). If the stock is non-publicly traded, the optionee's 
status as a majority or minority stockholder may be taken into 
consideration.
    (iv) Regardless of whether the stock offered under an option is 
publicly traded, a good-faith attempt to meet the option price 
requirements of this paragraph (e) is not demonstrated unless the fair 
market value of the stock on the date of grant is determined with 
regard to nonlapse restrictions (as defined in Sec.  1.83-3(h)) and 
without regard to lapse restrictions (as defined in Sec.  1.83-3(i)).
    (v) Amounts treated as interest and amounts paid as interest under 
a deferred payment arrangement are not includible as part of the option 
price. See Sec.  1.421-1(e)(1). An attempt to set the option price at 
not less than fair market value is not regarded as made in good faith 
where an adjustment of the option price to reflect amounts treated as 
interest results in the option price being lower than the fair market 
value on which the option price was based.
    (3) Notwithstanding that the option price requirements of 
paragraphs (e)(1) and (2) of this section are satisfied by an option 
granted to an employee whose stock ownership exceeds the limitation 
provided by paragraph (f) of this section, such option is not an 
incentive stock option when granted unless it also complies with 
paragraph (f) of this section. If the option, when granted, does not 
comply with the requirements described in paragraph (f) of this 
section, such option can never become an incentive stock option, even 
if the employee's stock ownership does not exceed the limitation of 
paragraph (f) of this section when such option is exercised.
    (f) Options granted to certain stockholders. (1) If, immediately 
before an option is granted, an individual owns (or is treated as 
owning) stock possessing more than 10 percent of the total combined 
voting power of all classes of stock of the corporation employing the 
optionee or of any related corporation of such corporation, then an 
option granted to such individual cannot qualify as an incentive stock 
option unless the option price is at least 110 percent of the stock's 
fair market value on the date of grant and such option by its terms is 
not exercisable after the expiration of 5 years from the date of grant. 
For purposes of determining the minimum option price for purposes of 
this paragraph (f), the rules described in paragraph (e)(2) of this 
section, relating to the good-faith determination of the option price, 
do not apply.
    (2) For purposes of determining the stock ownership of the 
optionee, the stock attribution rules of Sec.  1.424-1(d) apply. Stock 
that the optionee may purchase under outstanding options is not treated 
as stock owned by the individual. The determination of the percentage 
of the total combined voting power of all classes of stock of the 
employer corporation (or of its related corporations) that is owned by 
the optionee is made with respect to each such corporation in the 
related group by comparing the voting power of the shares owned (or 
treated as owned) by the optionee to the aggregate voting power of all 
shares of each such corporation actually issued and outstanding 
immediately before the grant of the option to the optionee. The 
aggregate voting power of all shares actually issued and outstanding 
immediately before the grant of the option does not include the voting 
power of treasury shares or shares authorized for issue under 
outstanding options held by the individual or any other person.
    (3) Examples. The rules of this paragraph (f) are illustrated by 
the following examples:
    Example 1. (i) E, an employee of M Corporation, owns 15,000 
shares of M Corporation common stock, which is the only class of 
stock outstanding. M has 100,000 shares of its common stock 
outstanding. On January 1, 2005, when the fair market value of M 
stock is $100, E is granted an option with an option price of $100 
and an exercise period of 10 years from the date of grant.
    (ii) Because E owns stock possessing more than 10 percent of the 
total combined voting power of all classes of M Corporation stock, M 
cannot grant an incentive stock option to E unless the option is 
granted at an option price of at least 110 percent of the fair 
market value of the stock subject to the option and the option, by 
its terms, expires no later than 5 years from its date of grant. The 
option granted to E fails to meet the option-price and term 
requirements described in paragraph (f)(1) of this section and, 
thus, the option is not an incentive stock option.
    (iii) Assume the same facts as in paragraph (i) of this Example 
1, except that E's father and brother each owned 7,500 shares of M 
Corporation stock, and E owned no M stock in E's own name. Because 
under the attribution rules of Sec.  1.424-1(d), E is treated as 
owning stock held by E's parents and siblings, M cannot grant an 
incentive stock option to E unless the option price is at least 110 
percent of the fair market value of the stock subject to the option, 
and the option, by its terms, expires no later than 5 years from the 
date of grant.
    Example 2. Assume the same facts as in paragraph (i) of this 
Example 1. Assume further that M is a subsidiary of P Corporation. 
Regardless of whether E owns any P stock and the number of P shares 
outstanding, if P Corporation grants an option to E which purports 
to be an incentive stock option, but which fails to meet the 110-
percent-option-price and 5-year-term requirements, the option is not 
an incentive stock option because E owns more than 10 percent of the 
total combined voting power of all classes of stock of a related 
corporation of P Corporation (i.e., M Corporation). An individual 
who owns (or is treated as owning) stock in excess of the ownership

[[Page 34360]]

specified in paragraph (f)(1) of this section, in any corporation in 
a group of corporations consisting of the employer corporation and 
its related corporations, cannot be granted an incentive stock 
option by any corporation in the group unless such option meets the 
110-percent-option-price and 5-year-term requirements of paragraph 
(f)(1) of this section.
    Example 3. (i) F is an employee of R Corporation. R has only one 
class of stock, of which 100,000 shares are issued and outstanding. 
F owns no stock in R Corporation or any related corporation of R 
Corporation. On January 1, 2005, R grants a 10-year incentive stock 
option to F to purchase 50,000 shares of R stock at $3 per share, 
the fair market value of R stock on the date of grant of the option. 
On April 1, 2005, F exercises half of the January option and 
receives 25,000 shares of R stock that previously were not 
outstanding. On July 1, 2005, R grants a second 50,000 share option 
to F which purports to be an incentive stock option. The terms of 
the July option are identical to the terms of the January option, 
except that the option price is $3.25 per share, which is the fair 
market value of R stock on the date of grant of the July option.
    (ii) Because F did not own more than 10% of the total combined 
voting power of all classes of stock of R Corporation or any related 
corporation on the date of the grant of the January option and the 
pricing requirements of paragraph (e) of this section are satisfied 
on the date of grant of such option, the unexercised portion of the 
January option remains an incentive stock option regardless of the 
changes in F's percentage of stock ownership in R after the date of 
grant. However, the July option is not an incentive stock option 
because, on the date that it was granted, F owned 20 percent (25,000 
shares owned by F divided by 125,000 shares of R stock issued and 
outstanding) of the total combined voting power of all classes of R 
Corporation stock and, thus the pricing requirements of paragraph 
(f)(1) of this section were not met.
    (iii) Assume the same facts as in paragraph (i) of this Example 
3 except that the partial exercise of the January incentive stock 
option on April 1, 2003, is for only 10,000 shares. Under these 
circumstances, the July option is an incentive stock option, 
because, on the date of grant of the July option, F does not own 
more than 10 percent of the total combined voting power (10,000 
shares owned by F divided by 110,000 shares of R issued and 
outstanding) of all classes of R Corporation stock.


Sec.  1.422-4  [Removed]

    Par. 7. Section 1.422-4 is removed.


Sec.  1.422-5  [Redesignated]

    Par. 8. Section 1.422-5 is re-designated as Sec.  1.422-3.
    Par. 9. New Sec.  1.422-4 is added to read as follows:


Sec.  1.422-4  $100,000 limitation for incentive stock options.

    (a) $100,000 per year limitation--(1) General rule. An option that 
otherwise qualifies as an incentive stock option nevertheless fails to 
be an incentive stock option to the extent that the $100,000 limitation 
described in paragraph (a)(2) of this section is exceeded.
    (2) $100,000 per year limitation. To the extent that the aggregate 
fair market value of stock with respect to which an incentive stock 
option (determined without regard to this section) is exercisable for 
the first time by any individual during any calendar year (under all 
plans of the employer corporation and related corporations) exceeds 
$100,000, such option is treated as a nonstatutory option. See Sec.  
1.83-7 for rules applicable to nonstatutory options.
    (b) Application. To determine whether the limitation described in 
paragraph (a)(2) of this section has been exceeded, the following rules 
apply.
    (1) An option that does not meet the requirements of Sec.  1.422-2 
when granted (including an option which, when granted, contains terms 
providing that it will not be treated as incentive stock option) is 
disregarded. See Sec.  1.422-2(a)(4).
    (2) The fair market value of stock is determined as of the date of 
grant of the option for such stock.
    (3) Except as otherwise provided in paragraph (b)(4) of this 
section, options are taken into account in the order in which they are 
granted.
    (4) For purposes of this section, an option is considered to be 
first exercisable during a calendar year if the option will become 
exercisable at any time during the year assuming that any condition on 
the optionee's ability to exercise the option related to the 
performance of services is satisfied. If the optionee's ability to 
exercise the option in the year is subject to an acceleration 
provision, then the option is considered first exercisable in the 
calendar year in which the acceleration provision is triggered. After 
an acceleration provision is triggered, the options subject to such 
provision are then taken into account in accordance with paragraph 
(b)(3) of this section for purposes of applying the limitation 
described in paragraph (a)(2) of this section to all options first 
exercisable during a calendar year. However, because an acceleration 
provision is not taken into account prior to its triggering, an 
incentive stock option that becomes exercisable for the first time 
during a calendar year by operation of such a provision does not affect 
the application of the $100,000 limitation with respect to any option 
(or portion thereof) exercised prior to such acceleration. For purposes 
of this paragraph (b)(4), an acceleration provision includes, for 
example, a provision that accelerates the exercisability of an option 
on a change in ownership or control or a provision that conditions 
exercisability on the attainment of a performance goal. See paragraph 
(d), Example 4 of this section.
    (5)(i) An option (or portion thereof) is disregarded if, prior to 
the calendar year during which it would otherwise have become 
exercisable for the first time, the option (or portion thereof) is 
modified and thereafter ceases to be an incentive stock option 
described in Sec.  1.422-2, is canceled, or is transferred in violation 
of Sec.  1.421-1(b)(2).
    (ii) If an option (or portion thereof) is modified, canceled, or 
transferred at any other time, such option (or portion thereof) is 
treated as outstanding according to its original terms until the end of 
the calendar year during which it would otherwise have become 
exercisable for the first time.
    (6) A disqualifying disposition has no effect on the determination 
of whether an option exceeds the $100,000 limitation.
    (c) Bifurcation of options. The application of the rules described 
in paragraph (b) of this section may result in an option being treated, 
in part, as an incentive stock option and, in part, as a nonstatutory 
option. In such a case, a corporation can issue a separate certificate 
for incentive option stock and designate such stock as incentive stock 
option stock in the corporation's transfer records. In the absence of 
such a designation, a pro rata portion of each share of stock purchased 
under the option is treated as incentive stock option stock and 
nonstatutory option stock. See Sec.  1.83-7 for the treatment of 
nonstatutory options.
    (d) Examples. The following examples illustrate the principles of 
this section. In each of the following examples E is an employee of X 
Corporation. The examples are as follows:

    Example 1. General rule. Effective January 1, 2004, X 
Corporation adopts a plan under which incentive stock options may be 
granted to its employees. On January 1, 2004, and each succeeding 
January 1 through January 1, 2013, E is granted immediately 
exercisable options for X Corporation stock with a fair market value 
of $100,000 determined on the date of grant. The options qualify as 
incentive stock options (determined without regard to this section). 
On January 1, 2014, E exercises all of the options. Because the 
$100,000 limitation has not been exceeded during any calendar year, 
all of the options are treated as incentive stock options.
    Example 2. Order of grant. X Corporation is a parent corporation 
of Y Corporation, which is a parent corporation of Z Corporation. 
Each corporation has adopted

[[Page 34361]]

its own separate plan, under which an employee of any member of the 
corporate group may be granted options for stock of any member of 
the group. On January 1, 2004, X Corporation grants E an incentive 
stock option (determined without regard to this section) for stock 
of Y Corporation with a fair market value of $100,000 on the date of 
grant. On December 31, 2004, Y Corporation grants E an incentive 
stock option (determined without regard to this section) for stock 
of Z Corporation with a fair market value of $75,000 as of the date 
of grant. Both of the options are immediately exercisable. For 
purposes of this section, options are taken into account in the 
order in which granted using the fair market value of stock as of 
the date on the option is granted. During calendar year 2004, the 
aggregate fair market value of stock with respect to which E's 
options are exercisable for the first time exceeds $100,000. 
Therefore, the option for Y Corporation stock is treated as an 
incentive stock option, and the option for Z Corporation stock is 
treated as a nonstatutory option.
    Example 3. Acceleration provision. (i) In 2004, X Corporation 
grants E three incentive stock options (determined without regard to 
this section) to acquire stock with an aggregate fair market value 
of $150,000 on the date of grant. The dates of grant, the fair 
market value of the stock (as of the applicable date of grant) with 
respect to which the options are exercisable, and the years in which 
the options are first exercisable (without regard to acceleration 
provisions) are as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                    Fair market        First
                                                          Date of grant           value of stock    exercisable
----------------------------------------------------------------------------------------------------------------
Option 1......................................  April 1, 2004...................         $60,000            2004
Option 2......................................  May 1, 2004.....................          50,000            2006
Option 3......................................  June 1, 2004....................          40,000            2004
----------------------------------------------------------------------------------------------------------------

    (ii) In July of 2004, a change in control of X Corporation 
occurs, and, under the terms of its option plan, all outstanding 
options become immediately exercisable. Under the rules of this 
section, Option 1 is treated as an incentive stock option in its 
entirety; Option 2 exceeds the $100,000 aggregate fair market value 
limitation for calendar year 2004 by $10,000 (Option 1's $60,000 + 
Option 2's $50,000 = $110,000) and is, therefore, bifurcated into an 
incentive stock option for stock with a fair market value of $40,000 
as of the date of grant and a nonstatutory option for stock with a 
fair market value of $10,000 as of the date of grant. Option 3 is 
treated as a nonstatutory option in its entirety.
    Example 4. Exercise of option and acceleration provision. (i) In 
2004, X Corporation grants E three incentive stock options 
(determined without regard to this section) to acquire stock with an 
aggregate fair market value of $120,000 on the date of grant. The 
dates of grant, the fair market value of the stock (as of the 
applicable date of grant) with respect to which the options are 
exercisable, and the years in which the options are first 
exercisable (without regard to acceleration provisions) are as 
follows:

----------------------------------------------------------------------------------------------------------------
                                                                                    Fair market        First
                                                          Date of grant           value of stock    exercisable
----------------------------------------------------------------------------------------------------------------
Option 1......................................  April 1, 2004...................         $60,000            2005
Option 2......................................  May 1, 2004.....................          40,000            2006
Option 3......................................  June 1, 2004....................          20,000            2005
----------------------------------------------------------------------------------------------------------------

    (ii) On June 1, 2005, E exercises Option 3. At the time of 
exercise of Option 3, the fair market value of X stock (at the time 
of grant) with respect to which options held by E are first 
exercisable in 2005 does not exceed $100,000. On September 1, 2005, 
a change of control of X Corporation occurs, and, under the terms of 
its option plan, Option 2 becomes immediately exercisable. Under the 
rules of this section, because E's exercise of Option 3 occurs 
before the change of control and the effects of an acceleration 
provision are not taken into account until it is triggered, Option 3 
is treated as an incentive stock option in its entirety. Option 1 is 
treated as an incentive stock option in its entirety. Option 2 is 
bifurcated into an incentive stock option for stock with a fair 
market value of $20,000 on the date of grant and a nonstatutory 
option for stock with a fair market value of $20,000 on the date of 
grant because it exceeds the $100,000 limitation for 2003 by $20,000 
(Option 1 for $60,000 + Option 3 for $20,000 + Option 2 for $40,000 
= $120,000).
    (iii) Assume the same facts as in paragraph (ii) of this Example 
4, except that the change of control occurs on May 1, 2005. Because 
options are taken into account in the order in which they are 
granted, Option 1 and Option 2 are treated as incentive stock 
options in their entirety. Because the exercise of Option 3 (on June 
1, 2005) takes place after the acceleration provision is triggered, 
Option 3 is treated as a nonstatutory option in its entirety.
    Example 5. Cancellation of option. (i) In 2004, X Corporation 
grants E three incentive stock options (determined without regard to 
this section) to acquire stock with an aggregate fair market value 
of $140,000 as of the date of grant. The dates of grant, the fair 
market value of the stock (as of the applicable date of grant) with 
respect to which the options are exercisable, and the years in which 
the options are first exercisable (without regard to acceleration 
provisions) are as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                    Fair market        First
                                                          Date of grant           value of stock    exercisable
----------------------------------------------------------------------------------------------------------------
Option 1......................................  April 1, 2004...................         $60,000            2005
Option 2......................................  May 1, 2004.....................          40,000            2005
Option 3......................................  June 1, 2004....................          40,000            2005
----------------------------------------------------------------------------------------------------------------

    (ii) On December 31, 2004, Option 2 is canceled. Because Option 
2 is canceled before the calendar year during which it would have 
become exercisable for the first time, it is disregarded. As a 
result, Option 1 and Option 3 are treated as incentive stock options 
in their entirety.
    (iii) Assume the same facts as in paragraph (ii) of this Example 
5, except that Option 2 is canceled on January 1, 2005. Because 
Option 2 is not canceled prior to the calendar year during which it 
would have become exercisable for the first time (2005), it is 
treated as an outstanding option for purposes of determining whether 
the $100,000 requirement for 2005 has been exceeded. Because options 
are taken into account in the order in which granted, Option 1 is 
treated as an incentive stock option in its entirety. Because Option 
3 exceeds the $100,000 limitation by $40,000 (Option 1 for $60,000 + 
Option 2 for $40,000 + Option 3 for

[[Page 34362]]

$40,000 = $140,000), it is treated as a nonstatutory options in its 
entirety.
    (iv) Assume the same facts as in paragraph (i) of this Example 
5, except that on January 1, 2005, E exercises Option 2 and 
immediately sells the stock in a disqualifying disposition. A 
disqualifying disposition has no effect on the determination of 
whether the underlying option is considered outstanding during the 
calendar year during which it is first exercisable. Because options 
are taken into account in the order in which granted, Option 1 is 
treated as an incentive stock option in its entirety. Because Option 
3 exceeds the $100,000 limitation by $40,000 (Option 1 for $60,000 + 
Option 2 for $40,000 + Option 3 for $40,000 = $140,000), it is 
treated as a nonstatutory option in its entirety.
    Example 6. Designation of stock. On January 1, 2004, X grants E 
an immediately exercisable incentive stock option (determined 
without regard to this section) to acquire X stock with a fair 
market value of $150,000 on that date. Under the rules of this 
section, the option is bifurcated and treated as an incentive stock 
option for X stock with a fair market value of $100,000 and a 
nonstatutory option for X stock with a fair market value of $50,000. 
In these circumstances, X may designate the stock that is treated as 
stock acquired pursuant to the exercise of an incentive stock option 
by issuing a separate certificate (or certificates) for $100,000 of 
stock and identifying such certificates as Incentive Stock Option 
Stock in its transfer records. In the absence of such a designation, 
two-thirds ($100,000 / $150,000) of each share of stock is treated 
as acquired pursuant to the exercise of an incentive stock option 
and one-third ($50,000 / $150,000) as stock acquired pursuant to the 
exercise of a nonstatutory option.

    Par. 10. Section 1.422-5 is added to read as follows:


Sec.  1.422-5  Permissible provisions.

    (a) General rule. An option that otherwise qualifies as an 
incentive stock option does not fail to be an incentive stock option 
merely because such option contains one or more of the provisions 
described in paragraphs (b), (c), and (d) of this section.
    (b) Cashless exercise. (1) An option does not fail to be an 
incentive stock option merely because the optionee may exercise the 
option with previously acquired stock of the corporation that granted 
the option or stock of the corporation whose stock is being offered for 
purchase under the option. For special rules relating to the use of 
statutory option stock to pay the option price of an incentive stock 
option, see Sec.  1.424-1(c)(3).
    (2) All shares acquired through the exercise of an incentive stock 
option are individually subject to the holding period requirements 
described in Sec.  1.422-1(a) and the disqualifying disposition rules 
of Sec.  1.422-1(b), regardless of whether the option is exercised with 
previously acquired stock of the corporation that granted the option or 
stock of the corporation whose stock is being offered for purchase 
under the option. If an incentive stock option is exercised with such 
shares, and the exercise results in the basis allocation described in 
paragraph (b)(3) of this section, the optionee's disqualifying 
disposition of any of the stock acquired through such exercise is 
treated as a disqualifying disposition of the shares with the lowest 
basis.
    (3) If the exercise of an incentive stock option with previously 
acquired shares is comprised in part of an exchange to which section 
1036 (and so much of section 1031 as relates to section 1036) applies, 
then:
    (i) The optionee's basis in the incentive stock option shares 
received in the section 1036 exchange is the same as the optionee's 
basis in the shares surrendered in the exchange, increased, if 
applicable, by any amount included in gross income as compensation 
pursuant to sections 421 through 424 or section 83. Except for purposes 
of Sec.  1.422-1(a), the holding period of the shares is determined 
under section 1223. For purposes of Sec.  1.422-1 and sections 421(b) 
and 83 and the regulations thereunder, the amount paid for the shares 
purchased under the option is the fair market value of the shares 
surrendered on the date of the exchange.
    (ii) The optionee's basis in the incentive stock option shares not 
received pursuant to the section 1036 exchange is zero. For all 
purposes, the holding period of such shares begins as of the date that 
such shares are transferred to the optionee. For purposes of Sec.  
1.422-1(b) and sections 421(b) and 83 and the regulations thereunder, 
the amount paid for the shares is considered to be zero.
    (c) Additional compensation. An option does not fail to be an 
incentive stock option merely because the optionee has the right to 
receive additional compensation, in cash or property, when the option 
is exercised, provided such additional compensation is includible in 
income under section 61 or section 83. The amount of such additional 
compensation may be determined in any manner, including by reference to 
the fair market value of the stock at the time of exercise or to the 
option price.
    (d) Option subject to a condition. (1) An option does not fail to 
be an incentive stock option merely because the option is subject to a 
condition, or grants a right, that is not inconsistent with the 
requirements of Sec. Sec.  1.422-2 and 1.422-4.
    (2) An option that includes an alternative right is not an 
incentive stock option if the requirements of Sec.  1.422-2 are 
effectively avoided by the exercise of the alternative right. For 
example, an alternative right extending the option term beyond ten 
years, setting an option price below fair market value, or permitting 
transferability prevents an option from qualifying as an incentive 
stock option. If either of two options can be exercised, but not both, 
each such option is a disqualifying alternative right with respect to 
the other, even though one or both options would individually satisfy 
the requirements of Sec. Sec.  1.422-2, 1.422-4, and this section.
    (3) An alternative right to receive a taxable payment of cash and/
or property in exchange for the cancellation or surrender of the option 
does not disqualify the option as an incentive stock option if the 
right is exercisable only when the then fair market value of the stock 
exceeds the exercise price of the option and the option is otherwise 
exercisable, the right is transferable only when the option is 
otherwise transferable, and the exercise of the right has the same 
economic and tax consequences as the exercise of the option followed by 
an immediate sale of the stock. For this purpose, the exercise of the 
alternative right does not have the same economic and tax consequences 
if the payment exceeds the difference between the then fair market 
value of the stock and the exercise price of the option.
    (e) Examples. The principles of this section are illustrated by the 
following examples:
    Example 1. On June 1, 2004, X Corporation grants an incentive 
stock option to A, an employee of X Corporation, entitling A to 
purchase 100 shares of X Corporation common stock at $10 per share. 
The option provides that A may exercise the option with previously 
acquired shares of X Corporation common stock. X Corporation has 
only one class of common stock outstanding. Under the rules of 
section 83, the shares transferable to A through the exercise of the 
option are transferable and not subject to a substantial risk of 
forfeiture. On June 1, 2005, when the fair market value of an X 
Corporation share is $25, A uses 40 shares of X Corporation common 
stock, which A had purchased on the open market on June 1, 2002, for 
$5 per share, to pay the full option price. After exercising the 
option, A owns 100 shares of incentive stock option stock. Under 
section 1036 (and so much of section 1031 as relates to section 
1036), 40 of the shares have a $200 aggregate carryover basis (the 
$5 purchase price x 40 shares) and a three-year holding period for 
purposes of determining capital gain, and 60 of the shares have a 
zero basis and a holding period beginning on June 1, 2005, for 
purposes of determining capital

[[Page 34363]]

gain. All 100 shares have a holding period beginning on June 1, 
2005, for purposes of determining whether the holding period 
requirements of Sec.  1.422-1(a) are met.
    Example 2. Assume the same facts as in Example 1. Assume further 
that, on September 1, 2005, A sells 75 of the shares that A acquired 
through exercise of the incentive stock option for $30 per share. 
Because the holding period requirements were not satisfied, A made a 
disqualifying disposition of the 75 shares on September 1, 2005. 
Under the rules of paragraph (b)(3) of this section, A has sold all 
60 of the non-section-1036 shares and 15 of the 40 section-1036 
shares. Therefore, under paragraph (b)(3) of this section and 
section 83(a), the amount of compensation attributable to A's 
exercise of the option and subsequent disqualifying disposition of 
75 shares is $1,500 (the difference between the fair market value of 
the stock on the date of transfer, $1,875 (75 shares at $25 per 
share), and the amount paid for the stock, $375 (60 shares at $0 per 
share plus 15 shares at $25 per share)). In addition, A must 
recognize a capital gain of $675. Accordingly, A must include in 
gross income for the taxable year in which the sale occurs $1,500 as 
compensation and $675 as capital gain. For its taxable year in which 
the disqualifying disposition occurs, if otherwise allowable under 
section 162 and if the requirements of Sec.  1.83-6(a) are met, X 
Corporation is allowed a deduction of $1,500 for the compensation 
paid to A.
    Example 3. Assume the same facts as in Example 2, except that, 
instead of selling the 75 shares of incentive stock option stock on 
September 1, 2005, A uses those shares to exercise a second 
incentive stock option. The second option was granted to A by X 
Corporation on January 1, 2005, entitling A to purchase 100 shares 
of X Corporation common stock at $22.50 per share. As in Example 2, 
A has made a disqualifying disposition of the 75 shares of stock 
pursuant to Sec.  1.424-1(c). Under paragraph (b)(1) of this 
section, A has disposed of all 60 of the non-section-1036 shares and 
15 of the 40 section-1036 shares. Therefore, pursuant to paragraph 
(b)(3) of this section and section 83(a), the amount of compensation 
attributable to A's exercise of the first option and subsequent 
disqualifying disposition of 75 shares is $1,500 (the difference 
between the fair market value of the stock on the date of transfer, 
$1,875 (75 shares at $25 per share), and the amount paid for the 
stock, $375 (60 shares at $0 per share plus 15 shares at $25 per 
share)). Unlike Example 2, A does not recognize any capital gain as 
a result of exercising the second option because, for all purposes 
other than the determination of whether the exercise is a 
disposition pursuant to section 424(c), the exercise is considered 
an exchange to which section 1036 applies. Accordingly, A must 
include in gross income for the taxable year in which the 
disqualifying disposition occurs $1,500 as compensation. For its 
taxable year in which the disqualifying disposition occurs, if 
otherwise alllowable under sections 83(h) and 162 and if the 
requirements of Sec.  1.83-6(a) are met, X Corporation is allowed a 
deduction of $1,500 for the compensation paid to A. After exercising 
the second option, A owns a total of 125 shares of incentive stock 
option stock. Under section 1036 (and so much of section 1031 as 
relates to section 1036), the 100 ``new'' shares of incentive stock 
option stock have the following bases and holding periods: 15 shares 
have a $75 carryover basis and a three-year-and-three-month holding 
period for purposes of determining capital gain, 60 shares have a 
$1,500 basis resulting from the inclusion of that amount in income 
as compensation and a three-month holding period for purposes of 
determining capital gain, and 25 shares have a zero basis and a 
holding period beginning on September 1, 2005, for purposes of 
determining capital gain. All 100 shares have a holding period 
beginning on September 1, 2005, for purposes of determining whether 
the holding period requirements of Sec.  1.422-1(a) are met.
    Example 4. Assume the same facts as in Example 2, except that, 
instead of selling the 75 shares of incentive stock option stock on 
September 1, 2005, A uses those shares to exercise a nonstatutory 
option. The nonstatutory option was granted to A by X Corporation on 
January 1, 2005, entitling A to purchase 100 shares of X Corporation 
common stock at $22.50 per share. Unlike Example 3, A has not made a 
disqualifying disposition of the 75 shares of stock. After 
exercising the nonstatutory option, A owns a total of 100 shares of 
incentive stock option stock and 25 shares of nonstatutory stock 
option stock. Under section 1036 (and so much of section 1031 as 
relates to section 1036), the 75 new shares of incentive stock 
option stock have the same basis and holding period as the 75 old 
shares used to exercise the nonstatutory option. The additional 25 
shares of stock received upon exercise of the nonstatutory option 
are taxed under the rules of section 83(a). Accordingly, A must 
include in gross income for the taxable year in which the transfer 
of such shares occurs $750 (25 shares at $30 per share) as 
compensation. A's basis in such shares is the same as the amount 
included in gross income. For its taxable year in which the transfer 
occurs, X Corporation is allowed a deduction of $750 for the 
compensation paid to A to the extent allowable under sections 83(h) 
and 162 and if the requirements of Sec.  1.83-6(a) are satisfied.
    Example 5. Assume the same facts in Example 1, except that the 
shares transferred pursuant to the exercise of the incentive stock 
option are subject to a substantial risk of forfeiture and not 
transferable (substantially nonvested) for a period of six months 
after such transfer. Assume further that the shares that A uses to 
exercise the incentive stock option are similarly restricted. Such 
shares were transferred to A on January 1, 2005, through A's 
exercise of a nonstatutory stock option which was granted to A on 
January 1, 2004. A paid $5 per share for the stock when its fair 
market value was $22.50 per share. A did not file a section 83(b) 
election to include the $700 spread (the difference between the 
option price and the fair market value of the stock on date of 
exercise of the nonstatutory option) in gross income as 
compensation. After exercising the incentive stock option with the 
40 substantially-nonvested shares, A owns 100 shares of 
substantially-nonvested incentive stock option stock. Section 1036 
(and so much of section 1031 as relates to section 1036) applies to 
the 40 shares exchanged in exercise of the incentive stock option. 
However, pursuant to section 83(g), the stock received in such 
exchange, because it is incentive stock option stock, is not subject 
to restrictions and conditions substantially similar to those to 
which the stock given in such exchange was subject. For purposes of 
section 83(a) and Sec.  1.83-1(b)(1), therefore, A has disposed of 
the 40 shares of substantially-nonvested stock on June 1, 2005, and 
must include in gross income as compensation $800 (the difference 
between the amount realized upon such disposition, $1,000, and the 
amount paid for the stock, $200). Accordingly, 40 shares of the 
incentive stock option stock have a $1,000 basis (the $200 original 
basis plus the $800 included in income as compensation) and 60 
shares of the incentive stock option stock have a zero basis. For 
its taxable year in which the disposition of the substantially-
nonvested stock occurs, X Corporation is allowed a deduction of $800 
for the compensation paid to A, provided that the requirements of 
Sec.  1.83-6 are satisfied.

    (f) Effective date. This section applies to any statutory option 
granted on or after the date that is 180 days after publication of 
final regulations in the Federal Register. Taxpayers can rely on these 
regulations for the treatment of any statutory option granted on or 
after June 9, 2003.


Sec.  1.423-1  [Amended]

    Par. 11. Section 1.423-1 is amended as follows:
    1. In paragraph (a)(2), the language ``425(a)'' is removed and 
``424(a)'' is added in its place.
    2. In paragraph (b), first sentence, the language ``Sec.  1.421-7'' 
is removed and ``Sec.  1.421-1'' is added in its place.
    3. In paragraph (b), second sentence, the language ``Sec.  1.421-
8'' is removed and ``Sec.  1.421-2'' is added in its place.
    4. In paragraph (b), last sentence, the language ``425(c)'' is 
removed and ``424(c)'' is added in its place.
    5. In paragraph (b), last sentence, the language ``Sec.  1.425-1'' 
is removed and ``Sec.  1.424-1'' is added in its place.


Sec.  1.423-2  [Amended]

    Par. 12. Section 1.423-2 is amended by:
    1. In paragraph (b), last sentence, the language ``Sec.  1.421-7'' 
is removed and ``Sec.  1.421-1'' is added in its place.
    2. In paragraph (d)(1), second sentence, the language ``425(d)'' is 
removed and ``424(d)'' is added in its place.
    3. In paragraph (d)(3), Example 1, fourth sentence, the language 
``425(d)'' is removed and ``424(d)'' is added in its place.

[[Page 34364]]

    4. In paragraph (e)(2), the language ``Sec.  1.421-7'' is removed 
and ``Sec.  1.421-1'' is added in its place.
    5. In paragraph (g)(1) concluding text, first sentence, the 
language ``Sec.  1.421-7'' is removed and ``Sec.  1.421-1'' is added in 
its place.
    6. In paragraph (g)(1) concluding text, second sentence, the 
language ``Sec.  1.421-7'' is removed and ``Sec.  1.421-1'' is added in 
its place.
    7. In paragraph (j), second sentence, the language ``Sec.  1.421-
7'' is removed and ``Sec.  1.421-1'' is added in its place.
    8. In paragraph (j), last sentence, the language ``425'' is removed 
and ``424'' is added in its place.
    9. In paragraph (k)(2), second sentence, the language ``Sec.  
1.421-8'' is removed and ``Sec.  1.421-2'' is added in its place.


Sec.  1.425-1  [Redesignated]

    Par. 13. Section 1.425-1 is redesignated as Sec.  1.424-1 and is 
amended by:
    1. Revising paragraphs (a)(1) through (a)(6).
    2. Redesignating paragraph (a)(7) as paragraph (a)(9).
    3. Adding paragraph (a)(7).
    4. Revising paragraph (a)(8).
    5. Adding paragraph (a)(10).
    6. In paragraph (b)(1), first, second, and last sentences, the 
language ``425'' is removed wherever it appears and ``424'' is added in 
their places.
    7. In paragraph (c)(1), first sentence, the language ``425'' is 
removed and ``424'' is added in its place.
    8. In paragraph (c)(1), first sentence, the language 
``disposition'' is removed and ``disposition of stock'' is added in its 
place.
    9. Adding paragraph (c)(1)(iv).
    10. Redesignating paragraph (c)(3) as (c)(4).
    11. Adding new paragraph (c)(3).
    12. Adding newly designated paragraph (c)(4), Examples 7 through 9.
    13. In the list below, for each section indicated in the left 
column, remove the language in the middle column and add the language 
in the right column:

------------------------------------------------------------------------
  Newly designated section           Remove                  Add
------------------------------------------------------------------------
1.424-1(c)(4), Example 1,     1964................  2004.
 first sentence.
1.424-1(c)(4), Example 1,     qualified stock       statutory option.
 first sentence.               option.
1.424-1(c)(4), Example 1,     1965................  2005.
 second and fourth sentences.
1.424-1(c)(4), Example 1,     1968................  2006.
 third sentence.
1.424-1(c)(4), Example 2,     1968................  2006.
 first sentence.
1.424-1(c)(4), Example 2,     long-term             ....................
 last sentence.
1.424-1(c)(4), Example 3,     1968................  2006.
 first sentence.
1.424-1(c)(4), Example 4,     1968, two years and   2006.
 first sentence.               11 months after the
                               transfer of shares
                               to him.
1.424-1(c)(4), Example 4,     three years from the  two years from the
 last sentence.                date.                 date the options
                                                     were granted and
                                                     within one year of
                                                     the date that.
1.424-1(c)(4), Example 5,     1965................  2005.
 first sentence.
1.424-1(c)(4), Example 5,     qualified stock       statutory option.
 first sentence.               option.
1.424-1(c)(4), Example 6,     1965................  2005.
 first sentence, wherever it
 appears.
1.424-1(c)(4), Example 6,     three years.........  2 years.
 third sentence.
1.424-1(c)(4), Example 6,     income..............  compensation income.
 third sentence.
1.424-1(c)(4), Example 6,     a qualified stock     the option.
 third sentence.               option.
1.424-1(c)(4), Example 6,     paragraph (b)(2) of   Sec.   1.421-
 last sentence.                Sec.   1.421-8.       2(b)(2).
------------------------------------------------------------------------

    14. Revising paragraph (d).
    15. Revising paragraphs (e)(1) and (e)(2).
    16. In paragraph (e)(3), first sentence, remove the phrase ``Except 
as otherwise provided in subparagraph (4)'' and add ``If section 423(c) 
applies to an option then,''.
    17. In paragraph (e)(3), first sentence, remove the language ``, 
and 424(b)(1).''
    18. Removing paragraph (e)(4).
    19. Redesignating paragraph (e)(5) as paragraph (e)(4).
    20. Revising newly designated paragraph (e)(4).
    21. Redesignating paragraph (e)(6) as paragraph (e)(5) and removing 
the second and third sentences.
    22. Adding and reserving a new paragraph (e)(6).
    23. In list below, for each section indicated in the left column, 
remove the language in the middle column and add the language in the 
right column:

------------------------------------------------------------------------
  Newly designated section           Remove                  Add
------------------------------------------------------------------------
1.424-1(e)(7) Example 1,      1964................  2004.
 first sentence.
1.424-1(e)(7) Example 1,      1966................  2006.
 first sentence.

[[Page 34365]]

 
1.424-1(e)(7) Example 1,      1965................  2005.
 third, fourth, fifth, sixth
 and last sentences.
1.424-1(e)(7) Example 1,      425(h)..............  424(h).
 fifth sentence.
1.424-1(e)(7) Example 1,      The exercise of such  Because the
 last sentence.                                      requirements of
                                                     Sec.   1.424-
                                                     1(e)(3) and Sec.
                                                     1.423-2(g) have not
                                                     been met, the
                                                     exercise of such.
1.424-1(e)(7) Example 2,      1964................  2004.
 first, second, and fifth
 sentences.
1.424-1(e)(7) Example 2,      1965................  2005.
 first, third, fourth, and
 fifth sentences, wherever
 it appears.
1.424-1(e)(7) Example 2,      1966................  2006.
 first and third sentences.
1.424-1(e)(7) Example 2,      425(h)..............  424(h).
 fifth sentence.
1.424-1(e)(7) Example 2,      The exercise of such  Because the
 last sentence.                                      requirements of
                                                     Sec.   1.424-
                                                     1(e)(3) and Sec.
                                                     1.423-2(g) have not
                                                     been met, the
                                                     exercise of such.
1.424-1(e)(7) Example 3,      1965................  2005.
 first, second, and last
 sentences.
------------------------------------------------------------------------

    24. In paragraph (e)(7), remove Example 4.
    25. Adding paragraphs (f) and (g).
    The additions and revisions are as follows:


Sec.  1.424-1  Definitions and special rules applicable to statutory 
options.

    (a) Substitutions and assumptions of options--(1) In general. (i) 
This paragraph (a) provides rules under which an eligible corporation 
(as defined in paragraph (a)(2) of this section) may, by reason of a 
corporate transaction (as defined in paragraph (a)(3) of this section), 
substitute a new statutory option (new option) for an outstanding 
statutory option (old option) or assume an old option without such 
substitution or assumption being considered a modification of the old 
option. For the definition of modification, see paragraph (e) of this 
section.
    (ii) For purposes of Sec. Sec.  1.421-1 through 1.424-1, the phrase 
``substituting or assuming a stock option in a transaction to which 
section 424 applies,'' ``substituting or assuming a stock option in a 
transaction to which Sec.  1.424-1(a) applies,'' and similar phrases 
means a substitution of a new option for an old option or an assumption 
of an old option that meets the requirements of this paragraph (a). For 
a substitution or assumption to qualify under this paragraph (a), the 
substitution or assumption must meet all of the requirements described 
in paragraphs (a)(4) and (a)(5) of this section.
    (2) Eligible corporation. For purposes of this paragraph (a), the 
term eligible corporation means a corporation that is the employer of 
the optionee or a related corporation of such corporation. For purposes 
of this paragraph (a), the determination of whether a corporation is 
the employer of the optionee or a related corporation of such 
corporation is based upon all of the relevant facts and circumstances 
existing immediately after the corporate transaction.
    (3) Corporate transaction. For purposes of this paragraph (a), the 
term corporate transaction includes--
    (i) A corporate merger, consolidation, acquisition of property or 
stock, separation, reorganization, or liquidation;
    (ii) A distribution (excluding ordinary dividends) or change in the 
terms or number of outstanding shares of such corporation (e.g., a 
stock split or stock dividend);
    (iii) A change in the name of the corporation whose stock is 
purchasable under the old option; and
    (iv) Such other corporate events prescribed by the Commissioner in 
published guidance.
    (4) By reason of. (i) For a change in an option or issuance of a 
new option to qualify as a substitution or assumption under this 
paragraph (a), the change must be made by an eligible corporation (as 
defined in paragraph (a)(2) of this section) and occur by reason of a 
corporate transaction (as defined in paragraph (a)(3) of this section).
    (ii) Generally, a change in an option or issuance of a new option 
is considered to be by reason of a corporate transaction, unless the 
relevant facts and circumstances demonstrate that such change or 
issuance is made for reasons unrelated to such corporate transaction. 
For example, a change in an option or issuance of a new option will be 
considered to be made for reasons unrelated to a corporate transaction 
if there is an unreasonable delay between the corporate transaction and 
such change in the option or issuance of a new option, or if the 
corporate transaction serves no substantial corporate business purpose 
independent of the change in options. Similarly, a change in the number 
or price of shares purchasable under an option merely to reflect market 
fluctuations in the price of the stock purchasable under an option is 
not by reason of a corporate transaction.
    (iii) A change in an option or issuance of a new option is by 
reason of a distribution or change in the terms or number of the 
outstanding shares of a corporation (as described in paragraph 
(a)(3)(ii) of this section) only if the option as changed or the new 
option issued is an option on the same stock as under the old option 
(or if such class of stock is eliminated in the change in capital 
structure, on other stock of the same corporation).
    (iv) A change in an option or issuance of a new option is by reason 
of a change in the name of a corporation (as defined in paragraph 
(a)(3)(iii) of this section) only if the option as changed or the new 
option issued is an option on stock of the successor corporation.
    (5) Other requirements. For a change in an option or issuance of a 
new option to qualify as a substitution or assumption under this 
paragraph (a), all of the requirements described in this paragraph 
(a)(5) must be met.
    (i) In the case of an issuance of a new option (or a portion 
thereof) in exchange for an old option (or portion thereof), the 
optionee's rights under the old option (or portion thereof) must be

[[Page 34366]]

canceled, and the optionee must lose all rights under the old option 
(or portion thereof). There cannot be a substitution of a new option 
for an old option within the meaning of this paragraph (a) if the 
optionee may exercise both the old option and the new option. It is not 
necessary to have a complete substitution of a new option for the old 
option. However, any portion of such option which is not substituted or 
assumed in a transaction to which this paragraph (a) applies is an 
outstanding option to purchase stock or, to the extent paragraph (e) of 
this section applies, a modified option.
    (ii) The excess of the aggregate fair market value of the shares 
subject to the new or assumed option immediately after the change in 
the option or issuance of a new option over the aggregate option price 
of such shares must not exceed the excess of the aggregate fair market 
value of all shares subject to the old option (or portion thereof) 
immediately before the change in the option or issuance of a new option 
over the aggregate option price of such shares.
    (iii) On a share by share comparison, the ratio of the option price 
to the fair market value of the shares subject to the option 
immediately after the change in the option or issuance of a new option 
must not be more favorable to the optionee than the ratio of the option 
price to the fair market value of the stock subject to the old option 
(or portion thereof) immediately before the change in the option or 
issuance of a new option. The number of shares subject to the new or 
assumed option may be adjusted to compensate for any change in the 
aggregate spread between the aggregate option price and the aggregate 
fair market value of the shares subject to the option immediately after 
the change in the option or issuance of the new option as compared to 
the aggregate spread between the option price and the aggregate fair 
market value of the shares subject to the option immediately before the 
change in the option or issuance of the new option.
    (iv) The new or assumed option must contain all terms of the old 
option, except to the extent such terms are rendered inoperative by 
reason of the corporate transaction.
    (v) The new option or assumed option must not give the optionee 
additional benefits that the optionee did not have under the old 
option.
    (vi) The new or assumed option must otherwise comply with the 
requirements of Sec.  1.422-2 or Sec.  1.423-2. Thus, for example, the 
old option must be assumed or the new option must be issued under a 
plan approved by the stockholders of the corporation changing the 
option or issuing the new option as described in Sec.  1.422-2(b)(2) or 
Sec.  1.423-2(c), as applicable.
    (6) Obligation to substitute or assume not necessary. For a change 
in the option or issuance of a new option to meet the requirements of 
this paragraph (a), it is not necessary to show that the corporation 
changing an option or issuing a new option is under any obligation to 
do so. In fact, this paragraph (a) may apply even when the option that 
is being replaced or assumed expressly provides that it will terminate 
upon the occurrence of certain corporate transactions. However, this 
paragraph (a) cannot be applied to revive a statutory option which, for 
reasons not related to the corporate transaction, expires before it can 
properly be replaced or assumed under this paragraph (a).
    (7) Issuance of stock without meeting the requirements of this 
paragraph (a). A change in the terms of an option resulting in a 
modification of such option occurs if an optionee's new employer (or a 
related corporation of the new employer) issues its stock (or stock of 
a related corporation) upon exercise of such option without satisfying 
all of the requirements described in paragraphs (a)(4) and (5) of this 
section.
    (8) Date of grant. For purposes of applying the rules of this 
paragraph (a), a substitution or assumption is considered to occur on 
the date that the optionee would, but for this paragraph (a), be 
considered to have been granted the option that the eligible 
corporation is substituting or assuming. A substitution or an 
assumption that occurs by reason of a corporate transaction may occur 
before or after the corporate transaction.
* * * * *
    (10) Examples. The principles of this paragraph (a) are illustrated 
by the following examples:

    Example 1. Eligible corporation. X Corporation acquires a new 
subsidiary, Y Corporation, and transfers some of its employees to Y. 
Y Corporation wishes to grant to its new employees and to the 
employees of X Corporation new options for Y shares in exchange for 
old options for X shares that were previously granted by X 
Corporation. Because Y Corporation is an employer with respect to 
its own employees and a related corporation of X Corporation, Y 
Corporation is an eligible corporation under paragraph (a)(2) of 
this section with respect to both the employees of X and Y 
Corporations.
    Example 2. Corporate transaction. (i) On January 1, 2004, Z 
Corporation grants E, an employee of Z, an option to acquire 100 
shares of Z stock. At the time of grant, the fair market value of Z 
stock is $200 per share. E's option price is $200 per share. On July 
1, 2005, when the fair market value of Z stock is $400, Z declares a 
stock dividend that causes the fair market value of Z stock to 
decrease to $200 per share. On the same day, Z grants to E a new 
option to acquire 200 shares of Z stock in exchange for E's old 
option. The new option has an exercise price of $100 per share.
    (ii) A stock dividend is a corporate transaction under paragraph 
(a)(3)(ii) of this section. Generally, the issuance of a new option 
is considered to be by reason of a corporate transaction. None of 
the facts in this Example 2 indicate that the new option is not 
issued by reason of the stock dividend. In addition, the new option 
is issued on the same stock as the old option. Thus, the 
substitution occurs by reason of the corporate transaction. Assuming 
the other requirements of this section are met, the issuance of the 
new option is a substitution that meets the requirements of this 
paragraph (a) and is not a modification of the option.
    (iii) Assume the same facts as in paragraph (i) of this Example 
2. Assume further that on December 1, 2005, Z declares an ordinary 
cash dividend. On the same day, Z grants E a new option to acquire Z 
stock in substitution for E's old option. Under paragraph (a)(3)(ii) 
of this section, an ordinary cash dividend is not a corporate 
transaction. Thus, the exchange of the new option for the old option 
does not meet the requirements of this paragraph (a) and is a 
modification of the option.
    Example 3. Corporate transaction. On March 15, 2004, A 
Corporation grants E, an employee of A, an option to acquire 100 
shares of A stock at $50 per share, the fair market value of A stock 
on the date of grant. On May 2, 2005, A Corporation transfers 
several employees, including E, to B Corporation, a related 
corporation. B Corporation arranges to purchase some assets from A 
on the same day as E's transfer to B. Such purchase is without a 
substantial business purpose independent of making the exchange of 
E's old options for the new options appear to be by reason of a 
corporate transaction. The following day, B Corporation grants to E, 
one of its new employees, an option to acquire shares of B stock in 
exchange for the old option held by E to acquire A stock. Under 
paragraph (a)(3)(i) of this section, the purchase of assets is a 
corporate transaction. Generally, the substitution of an option is 
considered to occur by reason of a corporate transaction. However, 
in this case, the relevant facts and circumstances demonstrate that 
the issuance of the new option in exchange for the old option 
occurred by reason of the change in E's employer rather than a 
corporate transaction and that the sale of assets is without a 
substantial corporate business purpose independent of the change in 
the options. Thus, the exchange of the new option for the old option 
is not by reason of a corporate transaction that meets the 
requirements of this paragraph (a) and is a modification of the old 
option.
    Example 4. Additional benefit. On June 1, 2004, P Corporation 
acquires 100 percent of the shares of S Corporation and issues a new 
option to purchase P shares in exchange for

[[Page 34367]]

an old option to purchase S shares that is held by E, an employee of 
S. On the date of the exchange, E's old option is exercisable for 3 
more years, and, after the exchange, E's new option is exercisable 
for 5 years. Because the new option is exercisable for an additional 
period of time beyond the time allowed under the old option, the 
effect of the exchange of the new option for the old option is to 
give E an additional benefit that E did not enjoy under the old 
option. Thus, the requirements of paragraph (a)(5) of this section 
are not met, and this paragraph (a) does not apply to the exchange 
of the new option for the old option. Therefore, the exchange is a 
modification of the old options.
    Example 5. Spread and ratio tests. E is an employee of S 
Corporation. E holds an old option that was granted to E by S to 
purchase 60 shares of S at $12 per share. On June 1, 2005, S 
Corporation is merged into P Corporation, and on such date P issues 
a new option to purchase P shares in exchange for E's old option to 
purchase S shares. Immediately before the exchange, the fair market 
value of an S share is $32; immediately after the exchange, the fair 
market value of a P share is $24. The new option entitles E to buy P 
shares at $9 per share. Because, on a share-by-share comparison, the 
ratio of the new option price ($9 per share) to the fair market 
value of a P share immediately after the exchange ($24 per share) is 
not more favorable to E than the ratio of the old option price ($12 
per share) to the fair market value of an S share immediately before 
the exchange ($32 per share) (9/24 = 12/32), the requirements of 
paragraph (a)(5)(iii) of this section are met. The number of shares 
subject to E's option to purchase P stock is set at 80. Because the 
excess of the aggregate fair market value over the aggregate option 
price of the shares subject to E's new option to purchase P stock, 
$1,200 (80 x $24 minus 80 x $9), is not greater than the excess of 
the aggregate fair market value over the aggregate option price of 
the shares subject to E's old option to purchase S stock, $1,200 (60 
x $32 minus 60 x $12), the requirements of paragraph (a)(5)(ii) of 
this section are met.
    Example 6. Ratio test and partial substitution. Assume the same 
facts as in Example 5, except that the fair market value of an S 
share immediately before the exchange of the new option for the old 
option is $8, that the option price is $10 per share, and that the 
fair market value of a P share immediately after the exchange is 
$12. P sets the new option price at $15 per share. Because, on a 
share-by-share comparison, the ratio of the new option price ($15 
per share) to the fair market value of a P share immediately after 
the exchange ($12) is not more favorable to E than the ratio of the 
old option price ($10 per share) to the fair market value of an S 
share immediately before the substitution ($8 per share) (15/12 = 
10/8), the requirements of paragraph (a)(5)(iii) of this section are 
met. Assume further that the number of shares subject to E's P 
option is set at 20, as compared to 60 shares under E's old option 
to buy S stock. Immediately after the exchange, 2 shares of P are 
worth $24, which is what 3 shares of S were worth immediately before 
the exchange (2 x $12 = 3 x $8). Thus, to achieve a complete 
substitution of a new option for E's old option, E would need to 
receive a new option to purchase 40 shares of P (i.e., 2 shares of P 
for each 3 shares of S that E could have purchased under the old 
option (2/3 = 40/60)). Because E's new option is for only 20 shares 
of P, P has replaced only \1/2\ of E's old option, and the other \1/
2\ is still outstanding.
    Example 7. Partial substitution. X Corporation forms a new 
corporation, Y Corporation, by a transfer of certain assets and, in 
a spin-off, distributes the shares of Y Corporation to the 
stockholders of X Corporation. E, an employee of X Corporation, is 
thereafter an employee of Y. Y wishes to substitute a new option to 
purchase some of its stock for E's old option to purchase 100 shares 
of X. E's old option to purchase shares of X, at $50 a share, was 
granted when the fair market value of an X share was $50, and an X 
share was worth $100 just before the distribution of the Y shares to 
X's stockholders. Immediately after the spin-off, which is also the 
time of the substitution, each share of X and each share of Y is 
worth $50. Based on these facts, a new option to purchase 200 shares 
of Y at an option price of $25 per share could be granted to E in 
complete substitution of E's old option. It would also be 
permissible to grant E a new option to purchase 100 shares of Y, at 
an option price of $25 per share, in substitution for E's right to 
purchase 50 of the shares under the old option.
    Example 8. Stockholder approval requirements. (i) X Corporation, 
a publicly traded corporation, adopts an incentive stock option plan 
that meets the requirements of Sec.  1.422-2. Under the plan, 
options to acquire X stock are granted to X employees. X Corporation 
is acquired by Y Corporation and becomes a subsidiary corporation of 
Y Corporation. Y Corporation maintains an incentive stock option 
plan that meets the requirements of Sec.  1.422-2. Under the plan, 
options for Y stock may be granted to employees of Y or its related 
corporations. After the acquisition, X employees remain employees of 
X. In connection with the acquisition, Y Corporation substitutes new 
options for Y stock for old options for X stock that were previously 
granted to the employees of X. As a result of this substitution, on 
exercise of the new options, X employees receive Y Corporation 
stock.
    (ii) Because Y Corporation has a plan that meets the 
requirements of Sec.  1.422-2 in existence on the date it acquires 
X, the new options for Y stock are granted under a plan approved by 
the stockholders of Y. The stockholders of Y do not need to approve 
the X plan. If the other requirements of paragraphs (a)(4) and (5) 
of this section are met, the issuance of new options for Y stock in 
exchange for the old options for X stock meets the requirements of 
this paragraph (a) and is not a modification of the old options.
    (iii) Assume the same facts as in paragraph (i) of this Example 
8, except that Y Corporation does not maintain an incentive stock 
option plan on the date of the acquisition of X. The Y options will 
only be incentive stock options if they are granted under a plan 
that meets the requirements of Sec.  1.422-2(b). Therefore, Y must 
adopt a plan that provides for the grant of incentive stock options, 
and the plan must be approved by the stockholders of Y in accordance 
with Sec.  1.422-2(b). If the stockholders of Y approve the 
incentive stock option plan within 12 months before or after the 
date of the adoption of a plan by Y and the other requirements of 
Sec.  1.422-2 and the requirements of this paragraph (a) are met, 
the issuance of the new options for Y stock in exchange for the old 
options for X stock meets the requirements of this paragraph (a) and 
is not treated as a modification of the old options for X stock. The 
result is the same if Y Corporation assumes the old options instead 
of issuing new options.
    (iv) Assume the same facts as in paragraph (i) of this Example 
8, except that there is no exchange of options. Instead, as part of 
the acquisition, X amends its plan to allow future grants under the 
plan to be grants to acquire Y stock. Because the amendment of the 
plan to allow options on a different stock is considered the 
adoption of the new plan, the stockholders of X must approve the 
plan within 12 months before or after the date of the amendment of 
the plan. If the stockholders of X timely approve the plan, the 
future grants to acquire Y stock will be incentive stock options 
(assuming the other requirements of Sec.  1.422-2 have been met).
    Example 9. Modification. X Corporation merges into Y 
Corporation. Y Corporation retains employees of X who hold old 
options to acquire X Corporation stock. When the former employees of 
X exercise the old options, Y Corporation issues Y stock to the 
former employees of X. Under paragraph (a)(7) of this section, 
because Y issues its stock on exercise of the old options for X 
stock, there is a change in the terms of the old options for X 
stock. Thus, the issuance of Y stock on exercise of the old options 
is a modification of the old options.

* * * * *
    (c) * * * (1) * * *
    (iv) A transfer between spouses or incident to divorce (described 
in section 1041(a)). The special tax treatment of Sec.  1.421-2(a) with 
respect to the transferred stock applies to the transferee. However, 
see Sec.  1.421-1(b)(2) for the treatment of the transfer of a 
statutory option incident to divorce.
* * * * *
    (3) If an optionee exercises an incentive stock option with 
statutory option stock and the applicable holding period requirements 
(under Sec.  1.422-1(a) or 1.423-1(a)) with respect to such statutory 
option stock are not met before such transfer, then sections 354, 355, 
356, or 1036 (or so much of 1031 as relates to 1036) do not apply to 
determine whether there is a disposition of those shares. Therefore, 
there is a disposition of the statutory option stock, and the special 
tax treatment of Sec.  1.421-2(a) does not apply to such stock.
    (4) * * *

    Example 7. On January 1, 2004, X Corporation grants to E, an 
employee of X

[[Page 34368]]

Corporation, an incentive stock option to purchase 100 shares of X 
Corporation stock at $100 per share (the fair market value of an X 
Corporation share on that date). On January 1, 2005, when the fair 
market value of a share of X Corporation stock is $200, E exercises 
half of the option, pays X Corporation $5,000 in cash, and is 
transferred 50 shares of X Corporation stock with an aggregate fair 
market value of $10,000. E makes no disposition of the shares before 
January 2, 2006. Under Sec.  1.421-2(a), no income is recognized by 
E on the transfer of shares pursuant to the exercise of the 
incentive stock option, and X Corporation is not entitled to any 
deduction at any time with respect to its transfer of the shares to 
E. E's basis in the shares is $5,000.
    Example 8. Assume the same facts as in Example 7, except that on 
December 1, 2005, one year and 11 months after the grant of the 
option and 11 months after the transfer of the 50 shares to E, E 
uses 25 of those shares, with a fair market value of $5,000, to pay 
for the remaining 50 shares purchasable under the option. On that 
day, X Corporation transfers 50 of its shares, with an aggregate 
fair market value of $10,000, to E. Because E disposed of the 25 
shares before the expiration of the applicable holding periods, 
Sec.  1.421-2(a) does not apply to the January 1, 2005, transfer of 
the 25 shares used by E to exercise the remainder of the option. As 
a result of the disqualifying disposition of the 25 shares, E 
recognizes compensation income under the rules of Sec.  1.421-2(b).
    Example 9. On January 1, 2005, X Corporation grants an incentive 
stock option to E, an employee of X Corporation. The exercise price 
of the option is $10 per share. On June 1, 2005, when the fair 
market value of an X Corporation share is $20, E exercises the 
option and purchases 5 shares with an aggregate fair market value of 
$100. On January 1, 2006, when the fair market value of an X 
Corporation share is $50, X Corporation is acquired by Y Corporation 
in a section 368(a)(1)(A) reorganization. As part of the 
acquisition, all X Corporation shares are converted into Y 
Corporation shares. After the conversion, if an optionee holds a 
fractional share of X Corporation stock, Y Corporation will purchase 
the fractional share for cash equal to its fair market value. After 
applying the conversion formula to the shares held by E, E has 10 Y 
Corporation shares and one-half of a share of X Corporation stock. Y 
Corporation purchases E's one-half share for $25, the fair market 
value of one-half of an X Corporation share on the conversion date. 
Because E sells the one-half share prior to expiration of the 
holding periods described in Sec.  1.422-1(a), the sale is a 
disqualifying disposition of the one-half share. Thus, in 2006, E 
must recognize compensation income of $5 (one-half of the fair 
market value of an X Corporation share on the date of exercise of 
the option, or $10, less one-half of the exercise price per share, 
or $5). For purposes of computing any additional gain, E's basis in 
the one-half share increases to $10 (reflecting the $5 included in 
income as compensation). E recognizes an additional gain of $15 
($25, the fair market value of the one-half share, less $10, the 
basis in such share). The extent to which the additional $15 of gain 
is treated as a redemption of X Corporation stock is determined 
under section 302.
    (d) Attribution of stock ownership. To determine the amount of 
stock owned by an individual for purposes of applying the percentage 
limitations relating to certain stockholders described in Sec. Sec.  
1.422-2(f) and 1.423-2(d), shares of the employer corporation or of a 
related corporation that are owned (directly or indirectly) by or for 
the individual's brothers and sisters (whether by the whole or half 
blood), spouse, ancestors, and lineal descendants, are considered to be 
owned by the individual. Also, for such purposes, if a domestic or 
foreign corporation, partnership, estate, or trust owns (directly or 
indirectly) shares of the employer corporation or of a related 
corporation, the shares are considered to be owned proportionately by 
or for the stockholders, partners, or beneficiaries of the corporation, 
partnership, estate, or trust. The extent to which stock held by the 
optionee as a trustee of a voting trust is considered owned by the 
optionee is determined under all of the facts and circumstances.
    (e) Modification, extension, or renewal of option. (1) This 
paragraph (e) provides rules for determining whether a share of stock 
transferred to an individual upon the individual's exercise of an 
option after the terms of the option have been changed is transferred 
pursuant to the exercise of a statutory option.
    (2) Any modification, extension, or renewal of the terms of an 
option to purchase shares is considered the granting of a new option. 
The new option may or may not be a statutory option. To determine the 
date of grant of the new option for purposes of section 422 or 423, see 
Sec.  1.421-1(c).
* * * * *
    (4)(i) For purposes of Sec. Sec.  1.421-1 through 1.424-1 the term 
modification means any change in the terms of the option (or change in 
the terms of the plan pursuant to which the option was granted or in 
the terms of any other agreement governing the arrangement) that gives 
the optionee additional benefits under the option regardless of whether 
the optionee in fact benefits from the change in terms. In contrast, 
for example, a change in the terms of the option shortening the period 
during which the option is exercisable is not a modification. However, 
a change providing an extension of the period during which an option 
may be exercised (such as after termination of employment) or a change 
providing an alternative to the exercise of the option (such as a stock 
appreciation right) is a modification regardless of whether the 
optionee in fact benefits from such extension or alternative right. 
Similarly, a change providing an additional benefit upon exercise of 
the option (such as the payment of a cash bonus) or a change providing 
more favorable terms for payment for the stock purchased under the 
option (such as the right to tender previously acquired stock) is a 
modification.
    (ii) If an option is not immediately exercisable in full, a change 
in the terms of the option to accelerate the time at which the option 
(or any portion thereof) may be exercised is not a modification for 
purposes of this section. Additionally, no modification occurs if a 
provision accelerating the time when an option may first be exercised 
is removed prior to the year in which it would otherwise be triggered. 
For example, if an acceleration provision is timely removed to avoid 
exceeding the $100,000 limitation described in Sec.  1.422-4, a 
modification of the option does not occur.
    (iii) A change to an option which provides, either by its terms or 
in substance, that the optionee may receive an additional benefit under 
the option at the future discretion of the grantor, is a modification 
at the time that the option is changed to provide such discretion. In 
addition, the exercise of discretion to provide an additional benefit 
is a modification of the option. However, it is not a modification for 
the grantor to exercise discretion reserved under an option with 
respect to the payment of a cash bonus at the time of exercise, the 
availability of a loan at exercise, or the right to tender previously 
acquired stock for the stock purchasable under the option. An option is 
not modified merely because an optionee is offered a change in the 
terms of an option if the change to the option is not made.
    (iv) A change in the terms of the stock purchasable under the 
option that affects the value of the stock is a modification of such 
option, except to the extent that a new option is substituted for such 
option by reason of the change in the terms of the stock in accordance 
with paragraph (a) of this section.
    (v) If an option is amended solely to increase the number of shares 
subject to the option, the increase is not considered a modification of 
the option but is treated as the grant of a new option for the 
additional shares.
    (vi) Any change in the terms of an option made in an attempt to 
qualify the option as a statutory option grants additional benefits to 
the optionee and is, therefore, a modification.

[[Page 34369]]

    (vii) An extension of an option refers to the granting by the 
corporation to the optionee of an additional period of time within 
which to exercise the option beyond the time originally prescribed. A 
renewal of an option is the granting by the corporation of the same 
rights or privileges contained in the original option on the same terms 
and conditions. The rules of this paragraph apply as well to successive 
modifications, extensions, and renewals.
* * * * *
    (6) [Reserved.]
* * * * *
    (f) Definitions. The following definitions apply for purposes of 
Sec. Sec.  1.421-1 through 1.424-1:
    (1) Parent corporation. The term parent corporation, or parent, 
means any corporation (other than the employer corporation) in an 
unbroken chain of corporations ending with the employer corporation if, 
at the time of the granting of the option, each of the corporations 
other than the employer corporation owns stock possessing 50 percent or 
more of the total combined voting power of all classes of stock in one 
of the other corporations in such chain.
    (2) Subsidiary corporation. The term subsidiary corporation, or 
subsidiary, means any corporation (other than the employer corporation) 
in an unbroken chain of corporations beginning with the employer 
corporation if, at the time of the granting of the option, each of the 
corporations other than the last corporation in an unbroken chain owns 
stock possessing 50 percent or more of the total combined voting power 
of all classes of stock in one of the other corporations in such chain.
    (g) Effective date. This section applies to any statutory option 
granted on or after the date that is 180 days after publication of 
final regulations in the Federal Register. Taxpayers can rely on these 
regulations for the treatment of any statutory option granted on or 
after June 9, 2003.


Sec.  1.6039-1  [Removed]

    Par. 14. Section 1.6039-1 is removed.


Sec.  1.6039-2  [Redesignated]

    Par. 15. Section 1.6039-2 is redesignated as 1.6039-1 and revised 
to read as follows:


Sec.  1.6039-1  Statements to persons with respect to whom information 
is furnished.

    (a) Requirement of statement with respect to incentive stock 
options under section 6039(a)(1). Every corporation which transfers 
stock to any person pursuant to such person's exercise of an incentive 
stock option described in section 422(b) must furnish to such 
transferee, for each calendar year in which such a transfer occurs, a 
written statement with respect to the transfer or transfers made during 
such year. This statement must include the following information--
    (1) The name, address, and employer identification number of the 
corporation transferring the stock;
    (2) The name, address, and identifying number of the person to whom 
the share or shares of stock were transferred;
    (3) The name and address of the corporation the stock of which is 
the subject of the option (if other than the corporation transferring 
the stock);
    (4) The date the option was granted;
    (5) The date the shares were transferred to the person exercising 
the option;
    (6) The fair market value of the stock at the time the option was 
exercised;
    (7) The number of shares of stock transferred pursuant to the 
option;
    (8) The type of option under which the transferred shares were 
acquired; and
    (9) The total cost of all the shares.
    (b) Requirement of statement with respect to stock purchased under 
an employee stock purchase plan under section 6039(a)(2). (1) Every 
corporation which records, or has by its agent recorded, a transfer of 
the title to stock acquired by the transferor pursuant to the 
transferor's exercise on or after January 1, 1964, of an option granted 
under an employee stock purchase plan which meets the requirements of 
section 423(b), and with respect to which the special rule of section 
423(c) applied, must furnish to such transferor, for each calendar year 
in which such a recorded transfer of title to such stock occurs, a 
written statement with respect to the transfer or transfers containing 
the information required by paragraph (b)(2) of this section.
    (2) The statement required by paragraph (b)(1) of this section must 
contain the following information--
    (i) The name and address of the corporation whose stock is being 
transferred;
    (ii) The name, address and identifying number of the transferor;
    (iii) The date such stock was transferred to the transferor;
    (iv) The number of shares to which title is being transferred; and
    (v) The type of option under which the transferred shares were 
acquired.
    (3) If the statement required by this paragraph is made by the 
authorized transfer agent of the corporation, it is deemed to have been 
made by the corporation. The term transfer agent, as used in this 
section means any designee authorized to keep the stock ownership 
records of a corporation and to record a transfer of title of the stock 
of such corporation on behalf of such corporation.
    (4) A statement is required by reason of a transfer described in 
section 6039(a)(2) of a share only with respect to the first transfer 
of such share by the person who exercised the option. Thus, for 
example, if the owner has record title to a share or shares of stock 
transferred to a recognized broker or financial institution and the 
stock is subsequently sold by such broker or institution (on behalf of 
the owner), the corporation is only required to furnish a written 
statement to the owner relating to the transfer of record title to the 
broker or financial institution. Similarly, a written statement is 
required when a share of stock is transferred by the optionee to 
himself and another person (or persons) as joint tenants, tenants by 
the entirety or tenants in common. However, when stock is originally 
issued to the optionee and another person (or persons) as joint 
tenants, or as tenants by the entirety, the written statement required 
by this paragraph shall be furnished (at such time and in such manner 
as is provided by this section) with respect to the first transfer of 
the title to such stock by the optionee.
    (5) Every corporation which transfers any share of stock pursuant 
to the exercise of an option described in this paragraph shall identify 
such stock in a manner sufficient to enable the accurate reporting of 
the transfer of record title to such shares. Such identification may be 
accomplished by assigning to the certificates of stock issued pursuant 
to the exercise of such options a special serial number or color.
    (c) Time for furnishing statements--(1) In general. Each statement 
required by this section to be furnished to any person for a calendar 
year must be furnished to such person on or before January 31 of the 
year following the year for which the statement is required.
    (2) Extension of time. For good cause shown upon written 
application of the corporation required to furnish statements under 
this section, the Director, Martinsburg Computing Center, may grant an 
extension of time not exceeding 30 days in which to furnish such 
statements. The application must contain a full recital of the reasons 
for requesting an extension to aid the Director in determining the 
period of the extension, if any, which will be granted and must be sent 
to the Martinsburg Computing Center (Attn:

[[Page 34370]]

Extension of Time Coordinator). Such a request in the form of a letter 
to the Martinsburg Computing Center signed by the applicant (or its 
agent) will suffice as an application. The application must be filed on 
or before the date prescribed in paragraph (c)(1) of this section for 
furnishing the statements required by this section, and must contain 
the employer identification number of the corporation required to 
furnish statements under this section.
    (3) Last day for furnishing statement. For provisions relating to 
the time for performance of an act when the last day prescribed for 
performance falls on Saturday, Sunday, or a legal holiday, see Sec.  
301.7503-1 of this chapter (Regulations on Procedure and 
Administration).
    (d) Statements furnished by mail. For purposes of this section, a 
statement is considered to be furnished to a person if it is mailed to 
such person's last known address.
    (e) Penalty. For provisions relating to the penalty provided for 
failure to furnish a statement under this section, see section 6722.
    (f) Electronic furnishing of statements. [Reserved]
    (g) Effective date. This section applies as of the date that is 180 
days after publication of final regulations in the Federal Register to 
transfers of stock acquired pursuant to a statutory option on or after 
that date. Taxpayers can rely on these regulations with respect to the 
transfer of stock acquired pursuant to a statutory option on or after 
June 9, 2003.

PART 14a--TEMPORARY INCOME TAX REGULATIONS RELATING TO INCENTIVE 
STOCK OPTIONS

PART 14a--[REMOVED]

    Par. 16. Part 14a is removed.

David A. Mader,
Assistant Deputy Commissioner of Internal Revenue.
[FR Doc. 03-13581 Filed 6-6-03; 8:45 am]
BILLING CODE 4830-01-P