[Federal Register Volume 69, Number 148 (Tuesday, August 3, 2004)]
[Rules and Regulations]
[Pages 46401-46426]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-17448]



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 Rules and Regulations
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  Federal Register / Vol. 69, No. 148 / Tuesday, August 3, 2004 / Rules 
and Regulations  

[[Page 46401]]



DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 14a

[TD 9144]
RIN 1545-BA75


Statutory Options

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

-----------------------------------------------------------------------

SUMMARY: This document contains final regulations relating to statutory 
options. These final 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 regulations 
provide guidance to assist these taxpayers in complying with the law in 
addition to clarifying rules regarding statutory options.

DATES: Effective Date: These regulations are effective on August 3, 
2004. For rules concerning reliance and transition period, see 
Sec. Sec.  1.421-1(j)(2), 1.421-2(f)(2), 1.422-5(f)(2), and 1.424-
1(g)(2).

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, please 
contact Erinn Madden at (202) 622-6030 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in these final regulations 
(see Sec.  1.6039-1) has been reviewed and approved by the Office of 
Management and Budget in accordance with the Paperwork Reduction Act 
(44 U.S.C. 3507) under control number 1545-0820. Responses to this 
collection of information are required to assist taxpayers with the 
completion of their income tax returns for the taxable year in which a 
disposition of statutory option stock occurs.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless the collection of 
information displays a valid control number assigned by the Office of 
Management and Budget.
    The estimated annual burden per respondent varies from 15 minutes 
to 25 minutes, depending on individual circumstances, with an estimated 
average of 20 minutes.
    Comments concerning the accuracy of this burden estimate and 
suggestions for reducing this burden should be sent to the Internal 
Revenue Service, Attn: IRS Reports Clearance Officer, 
SE:W:CAR:MP:T:T:SP Washington, DC 20224, and 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.
    Books or records relating to this 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 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 1990 (OBRA 90), 
Pub. L. 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), Pub. L. 100-647 (102 Stat. 
3342), sections 11801 and 11821 of OMBRA 90, 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, Pub. L. 104-88 (110 
Stat. 1755). Changes concerning section 422 were made by section 251 of 
the Economic Recovery Tax Act of 1981, Pub. L. 97-34 (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, 
Pub. L. 97-448 (96 Stat. 2365), section 321(a) of Tax Reform Act of 
1986, Pub. L. 99-514 (100 Stat. 2085), section 1003(d) of TAMRA, and 
sections 11801 and 11821 of OBRA 90, 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 19, 1961 (TD 6527), January 20, 1961 (TD 6540), 
December 12, 1963 (TD 6696), June 24, 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, the 1984 proposed regulations provided a 
comprehensive set of rules under section 422 of the Code. The 1984 
proposed regulations and the temporary regulations have been withdrawn. 
See 68 FR 34344.
    On June 9, 2003, a notice of proposed rulemaking (REG-122917-02) 
was published in the Federal Register at 68 FR 34344 (the 2003 proposed 
regulations). No hearing concerning the 2003 proposed regulations was 
held; however, the IRS received written and electronic comments 
responding to this notice. After consideration of these comments, the 
2003 proposed regulations are adopted as amended by this Treasury 
decision. The significant revisions are discussed below.

[[Page 46402]]

Explanation of Provisions

Overview

    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 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 per 
year 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.
    These final regulations provide comprehensive rules governing 
incentive stock options that, as did the 2003 proposed regulations, 
incorporate many of the rules contained in the 1984 proposed 
regulations. However, the 2003 proposed regulations are re-numbered, 
and these final regulations adopt that reorganization. These final 
regulations 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

    Sections 422 and 423 provide that a statutory option may be granted 
to an individual who is an employee of the corporation granting the 
option, 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 1.421-1(h) of the 2003 proposed regulations further 
describes the requisite employment relationship for purposes of a 
statutory option. The 2003 proposed regulations provide that 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. In the case of an assumption 
or substitution under Sec.  1.424-1(a), the optionee must, at the time 
of the assumption or substitution, be an employee of the corporation 
assuming or substituting the option or a related corporation of such 
corporation. In response to comments, these final regulations provide 
that in the case of an assumption or substitution under Sec.  1.424-
1(a) an option also will be treated as granted to an employee of the 
granting corporation if the optionee is an individual who is in the 3-
month period following termination of the employment relationship.
    Section Sec.  1.421-1(h)(2) of the 2003 proposed regulations also 
provides that the employment relationship is considered to continue 
intact while an individual is on military leave, sick leave, or other 
bona fide leave of absence if the period of leave does not exceed 3 
months, 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 assuming or substituting an option 
under Sec.  1.424-1(a) is guaranteed by statute or contract. Commentors 
requested clarification in the final regulations concerning whether the 
right to employment must be absolute and whether the right to 
reemployment provided by the Family Medical Leave Act or the Uniformed 
Services Employment and Reemployment Rights Act satisfies the 
requirements of this section. These final regulations provide that the 
right to reemployment must be provided by statute or contract. Thus, 
for example, if an optionee is on leave pursuant to the Family Medical 
Leave Act, the Uniformed Services Employment and Reemployment Rights 
Act, or any similar statute providing for continued employment rights 
for an extended period of time, the employment relationship is 
considered intact.

Section 422: Incentive Stock Options

1. Special Rules Regarding Disqualifying Dispositions
    The general rules concerning disqualifying dispositions are 
described in Sec.  1.421-2(b) of the 2003 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. The effects of 
a disqualifying disposition are determined under section 83(a). 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 (determined without regard to any lapse restriction 
and without regard to any reduction for any brokerage fees or other 
costs paid in connection with the disposition) on the date the stock is 
substantially vested less the exercise price. (See section 422(c)(2) 
concerning special rules that are applicable where the amount realized 
in a disposition is less than this difference.) A deduction 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. Section 422(c)(2) and 
Sec.  1.422-1(b) of the 2003 proposed regulations provide special rules 
concerning disqualifying dispositions.

[[Page 46403]]

    The application of the disqualifying disposition rules is described 
in several examples in Sec.  1.422-1(b)(3) of the 2003 proposed 
regulations. In Example 1 of Sec.  1.422-1(b)(3) of the 2003 proposed 
regulations, on exercise of an incentive stock option, the optionee 
receives vested stock and disposes of the stock before meeting the 
applicable holding period. In this example, the amount of compensation 
income is based on the fair market value of the stock on the date of 
exercise less the exercise price, and the section 422(a)(1) holding 
period is based on the date of exercise.
    However, in Example 2 of Sec.  1.422-1(b)(3) of the 2003 proposed 
regulations, the optionee receives nonvested stock on exercise of an 
incentive stock option. This example retains the same holding period 
for the receipt of nonvested stock, but computes the amount of 
compensation income based on the date of vesting of the underlying 
stock (rather than the date of exercise).
    Several commentors suggested that if the option is exercised for 
nonvested stock the compensation income should not be calculated on the 
date of vesting because section 83 does not apply to a transaction to 
which section 421 applies (and section 421(b) applies to a 
disqualifying disposition). Instead, the compensation income should be 
computed on the date of exercise. Alternatively, if the proposed rule 
is retained, commentors suggest that the final regulations and examples 
provide that an optionee may make a protective section 83(b) election 
on exercise of the option.
    These final regulations retain the rules described in the 2003 
proposed regulations, however, the examples in Sec.  1.422-1(b)(3) of 
the final regulations more fully describe the application of the 
disqualifying disposition rules. Specifically, Example 2 indicates that 
pursuant to section 83(e)(1) of the Code, section 83 does not apply to 
a transaction to which section 421 applies. Thus, on exercise of a 
statutory option section 83 does not apply, and an optionee cannot make 
an effective election under section 83(b) for purposes of the income 
tax consequences on the date of exercise. However, an effective 
election under section 83(b) may be made for purposes of the 
alternative minimum tax, which calculates income as if section 83 
applies. Example 2 also illustrates that on a disqualifying 
disposition, the rules of section 83 and the regulations thereunder 
(rather than section 422 and the regulations thereunder) are used to 
determine the amount of compensation includible in income. Applying the 
rules under section 83(a), the amount of compensation includible is the 
difference between the fair market value of the stock on the date the 
substantial risk of forfeiture lapses less the fair market value on the 
date of exercise. Additionally, Example 2 demonstrates that there is a 
transfer (as defined in Sec.  1.421-1(g) of the final regulations) of 
the stock on the date of exercise for purposes of the holding period 
requirement of section 422(a)(1). Thus, the holding period for the 
transfer of the stock for purposes of section 422 and the holding 
period requirements begins on the date of exercise (rather than the 
date of vesting). See also, Sec.  1.422-1(b)(3), Example 3. However, 
the amount of capital gain (if any) is computed from the date of 
vesting.
2. Shareholder Approval
    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) and Sec.  1.422-
2(b)(2)(i) of the 2003 proposed regulations.
    These final regulations retain the rules contained in the 2003 
proposed regulations concerning shareholder approval. However, an 
additional example in Sec.  1.422-2(b)(6) illustrates the shareholder 
approval requirements where an incentive stock option plan is assumed 
in connection with a corporate transaction. See Sec.  1.422-2(b)(6), 
Example 3.
    In Example 3 of Sec.  1.422-2(b)(6) of these final regulations, 
Corporation X maintains an incentive stock option plan, but Corporation 
Y does not maintain such a plan. The companies combine to form one 
corporation that will be named Y, the plan will be continued by Y, and 
future grants under the plan will be made by Y (the new combined 
entity). The consolidation agreement describes the plan, including the 
maximum aggregate number of shares available for issuance pursuant to 
incentive stock options under the plan after the consolidation and the 
employees eligible to receive options under the plan. Because there is 
a change in the granting corporation under Sec.  1.422-2(b)(3)(iii), Y 
is considered to have adopted a new plan that must satisfy the 
shareholder approval requirements. In this example, because the 
consolidation agreement describes the plan and indicates that it will 
continue after the consolidation, the shareholder approval requirements 
of Sec.  1.422-2(b)(3) are satisfied, and the plan is considered 
adopted and approved on the date the consolidation agreement is 
approved. See Rev. Rul. 68-233, 1968-1 C.B. 187.
3. Maximum Aggregate Number of Shares
    Section 422(b)(1) provides that an incentive stock option must be 
granted pursuant to a plan that includes the aggregate number of shares 
which may be issued under options. Section 1.422-2(b)(3)(i) of the 2003 
proposed regulations provides that the plan 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 under the plan.
    In response to comments, these final regulations provide that the 
plan must designate the maximum aggregate number of shares that may be 
issued under the plan through incentive stock options. Thus, for 
example, if a corporation maintains an omnibus plan under which 
incentive stock options, nonstatutory options, and other stock-based 
awards may be made, the plan must contain a maximum number of shares 
that may be issued as incentive stock options. These final regulations 
do not require the plan to include the maximum number of shares that 
may be issued pursuant to nonstatutory options or other stock-based 
awards.
    Commentators also asked whether the maximum aggregate number of 
shares that may be issued under an incentive stock option plan is 
affected by the use of outstanding shares used to exercise an option. 
Under these final regulations, only the net number of shares that are 
issued pursuant to the exercise of a statutory option are counted 
against the maximum aggregate number of shares. For example, if the 
exercise price of an option to purchase 100 shares equals the value of 
20 shares, and the corporation permits the employee to use those 20 of 
the 100 shares to pay the exercise price of the option, and the 
corporation only issues 80 shares to the optionee, then 80 shares are 
counted against the maximum aggregate number of shares (rather than 
100).
4. Option Price
    Under section 422(b)(4), the option price of an incentive stock 
option must not be less than the fair market value of the stock at the 
time the option is granted. The 2003 proposed regulations retain this 
rule, but also provide that the option price may be determined in any 
reasonable manner, including the valuation methods permitted under 
Sec.  20.2031-2 (Estate Tax Regulations), so long as the minimum price 
possible under the terms of the option is not less

[[Page 46404]]

than the fair market value of the stock on the date of grant.
    Section 1.422-2(e)(2)(i) of the 2003 proposed regulations provides 
that if a share of stock is transferred to an individual pursuant to 
the exercise of an incentive stock option, which fails to qualify as an 
incentive stock option because the exercise price is less than the fair 
market value of the underlying stock on the date of grant, such 
requirement is still considered to have been met if there was an 
attempt, made in good faith, to meet the option price requirements of 
Sec.  1.422-2(e)(1).
    For nonpublicly traded stock, Sec.  1.422-2(e)(2)(iii) provides 
that if it is demonstrated that the fair market value of the stock on 
the date of grant was based on 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 determination establishes that a good-
faith attempt to meet the option price requirements of Sec.  1.422-2(e) 
was made. Taxpayers are required to retain adequate books and records 
to demonstrate that the option price requirements are satisfied. See 
section 6001.
    Commentors suggested that the final regulations be revised to 
provide that a good-faith attempt to meet the option price requirements 
is demonstrated if the value of the stock is determined by a qualified 
appraiser (as defined in Sec.  1.170A-13(c)(5)), by an individual 
(rather than more than one individual) who is not a qualified 
appraiser, or by the corporation at the date of grant. Because of 
concerns that the value determined under these approaches may not 
reliably reflect the fair market value of the stock on the date of 
grant, these final regulations retain the rules described in the 2003 
proposed regulations.
5. $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 an individual during the calendar year (under all 
of the 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.
    Section 1.422-4(b)(5)(ii) of the 2003 proposed regulations provides 
that if the option is not canceled, modified, or transferred prior to 
the year in which it would first become exercisable, it is treated as 
outstanding until the end of the year in which it first becomes 
exercisable. Commentors suggested that the final regulations permit an 
individual to cancel, modify, or transfer an option at any time prior 
to the date of exercise (rather than the year it first becomes 
exercisable). Because of concerns about the administrability of a rule 
that, for purposes of the $100,000 limitation, would permit an 
individual to determine the status of an option as statutory or 
nonstatutory until the date of exercise, these final regulations retain 
the rule described in the 2003 proposed regulations.
    Section 1.422-4(c) of the 2003 proposed regulations provides that 
the application of the $100,000 limitation may result in an option 
being treated, in part, as an incentive stock option and, in part, as a 
nonstatutory option. In response to comments, these final regulations 
provide additional guidance concerning the treatment of options (and 
the stock purchasable thereunder) that are bifurcated into an incentive 
stock option and nonstatutory option as a result of the application of 
the $100,000 limitation.
    These final regulations provide that a corporation may issue a 
separate certificate for incentive stock option stock or designate such 
stock as incentive stock option stock in the corporation's transfer 
records or the plan records. The issuance of separate certificates or 
designation in plan records is not considered a modification under 
Sec.  1.424-1(e). However, in the absence of such an issuance or 
designation, shares are deemed purchased under an incentive stock 
option first to the extent of the $100,000 limitation, and then the 
excess shares are deemed purchased under a nonstatutory option.

Section 424: Definitions and Special Rules

1. 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.
    The 2003 proposed regulations provide that an eligible corporation 
(as defined in Sec.  1.424-1(a)(2)) may, by reason of a corporate 
transaction (as defined in Sec.  1.424-1(a)(3)), 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). 
These final regulations retain most of the rules contained in the 2003 
proposed regulations, with certain changes.
    Under the 2003 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.
    In response to comments, these final regulations provide that a 
``distribution'' does not include a stock dividend or stock split 
(including a reverse stock split) that merely changes the number of 
outstanding shares of a corporation. Thus, an outstanding option is not 
treated as substituted or assumed under section 424(a) and Sec.  1.424-
1(a) in connection with a stock dividend or stock split that merely 
changes the number of outstanding shares. Instead, the exercise price 
of an outstanding option may be proportionally adjusted to reflect a 
stock dividend or stock split that merely changes the number of 
outstanding shares of a corporation under Sec.  1.424-1(e). This 
adjustment is not a modification of the option, and because the stock 
dividend or stock split is not a corporate transaction, the 
requirements of Sec.  1.424-1(a), including the spread and ratio tests, 
do not have to be satisfied.
    The 2003 proposed regulations also provide that a new or assumed 
option must otherwise qualify as a statutory option. See Sec.  1.424-
1(a)(5)(vi) of the 2003 proposed regulations. The 2003 proposed 
regulations provide that, except as necessary to comply with the 
specific requirements regarding substitution or assumption, such as the 
rules concerning ratio and spread, the option must comply with the 
requirements of Sec.  1.422-2 of the 2003

[[Page 46405]]

proposed regulations or 1.423-2, as applicable. Thus, under the 2003 
proposed regulations, for example, the new option must be substituted, 
or the old option must be assumed, under a plan approved by the 
stockholders of the corporation substituting or assuming the option.
    In Rev. Rul. 71-474 (1971-2 C.B. 215) involving qualified stock 
options, 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 originally was approved was sufficient to satisfy the 
stockholder approval requirements.
    In response to comments, these final regulations refrain from 
imposing an additional stockholder approval requirement for statutory 
options that have been granted and are outstanding at the time of a 
corporate transaction. Thus, the requirement in Sec.  1.424-1(a)(5)(vi) 
of the 2003 proposed regulations is removed. Further, the examples in 
Sec.  1.424-1(a)(10) of these final regulations demonstrate that if the 
shareholder approval requirements are met on the date of grant, a 
subsequent substitution or assumption of an outstanding option (old 
option) by an acquiring corporation does not require additional 
stockholder approval for the substituted or assumed option (new option) 
to continue to qualify as a statutory option. See, Sec.  1.424-
1(a)(10), Example 9. For example, assume Corporation X maintains an 
incentive stock option plan that meets the requirements of Sec.  1.422-
2 on the date of grant. E, an employee of X, holds outstanding 
incentive stock options to acquire X stock on exercise of the options. 
If Corporation Y acquires X and substitutes new options to acquire Y 
stock for the old options to acquire X stock held by E, the 
substitution of the new Y options does not require new stockholder 
approval. The result is the same if the options are assumed by Y. 
However, for future options granted under the plan to qualify as 
incentive stock options, the plan must be approved by the Y 
shareholders. (See, Sec.  1.422-2(b)(6) Example 3, for guidance 
concerning future grants under an option plan that is assumed in a 
corporate transaction.)
    Finally, commentors requested guidance concerning the treatment of 
earn-out payments received by option holders in connection with a 
corporate transaction. Because of the factual nature of these 
transactions, these final regulations do not address the issues raised 
by these transactions. However, this area is currently under study and 
may be the subject of future guidance of general applicability under 
Sec.  601.601(d)(2).
2. Modification, Extension, or Renewal of Option
    Section 424(h)(3) provides that a modification is any change in the 
terms of an option which gives the optionee additional benefits under 
the option, with certain specified exceptions.
    Under Sec.  1.424-1(e)(4)(iii) of the 2003 proposed regulations, a 
change to an option providing that the optionee may receive an 
additional benefit under the option at the future discretion of the 
granting corporation is a modification of the option at the time the 
option is changed to provide the discretion. Additionally, the exercise 
of such discretion is a modification of the option. Although several 
commentors suggested that the final regulations provide that the later 
exercise of the discretion is not a modification of the option, these 
final regulations retain the rule contained in the 2003 proposed 
regulations.
    However, as under the 2003 proposed regulations, it is not a 
modification for the granting corporation to exercise discretion 
specifically reserved under an option 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, is a modification.
    Commentors suggested broadening this rule to include the exercise 
of any reserved discretion under the option. These final regulations, 
however, only expand this rule to provide that it is not a modification 
to exercise discretion specifically reserved under an option with 
respect to the payment of employment taxes and/or withholding taxes 
resulting from the exercise of a statutory option.
    The 2003 proposed regulations also provide that an option is not 
modified merely because an optionee is offered a change in the terms of 
the option if the change is not made. These final regulations retain 
this rule, but also provide that if an offer to change the terms of the 
option remains outstanding for less than 30 days, the option is not 
modified. However, if the offer to change the terms of the option 
remains outstanding for 30 days or more, the option is treated as 
modified as of the date the offer to change the terms of the option is 
made.
    Finally, commentors suggested that these final regulations provide 
an exception to the modification rule for an inadvertent change to a 
statutory option where the change is promptly reversed. In response, 
these final regulations provide that any inadvertent modification of an 
option is not treated as a modification to the extent the modification 
is reversed by the earlier of the date the option is exercised or the 
last day of the calendar year during which such change occurred.

Section 6039

    Under section 1.6039-1(f) of the 2003 proposed regulations, the 
issue of furnishing electronic statements was reserved. These final 
regulations provide that the furnishing of statements in electronic 
form is permitted, provided the recipient consents to that means of 
delivery.

Effective Date and Reliance

    These final regulations are effective on August 3, 2004. However, 
these final regulations provide special transitional and reliance 
rules.
    For statutory options granted on or before June 9, 2003, taxpayers 
may rely on the 1984 proposed regulations LR-279-81 (49 FR 4504), the 
2003 proposed regulations REG-122917-02 (68 FR 34344), or these final 
regulations until the earlier of January 1, 2006, or the first 
regularly scheduled stockholders meeting of the granting corporation 
occurring 6 months after August 3, 2004. For statutory options granted 
after June 9, 2003, and before the earlier of January 1, 2006, or the 
first regularly scheduled stockholders meeting of the granting 
corporation occurring 6 months after August 3, 2004, taxpayers may rely 
on either the REG-122917-02 or the final regulations. Taxpayers may not 
rely on LR-279-81 or REG-122917-02 after December 31, 2005. Reliance on 
LR-279-81, REG-122917-02, or the final regulations must be in its 
entirety, and all statutory options granted during the reliance period 
must be treated consistently.

Special Analyses

    It has been determined that these regulations are not a significant 
regulatory action as defined in Executive Order 12866. Therefore, a 
regulatory assessment is not required. 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

[[Page 46406]]

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, the notice of proposed rulemaking preceding these final 
regulations is being submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on its impact on small 
business.

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.

Proposed Amendments to the Regulations

0
Accordingly, 26 CFR parts 1 and 14a are amended as follows:

PART 1--INCOME TAXES

0
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]

0
Par. 2. Sections 1.421-1 through 1.421-6 are removed.

0
Par. 3. Section 1.421-7 is re-designated as Sec.  1.421-1 and is 
amended as follows:
0
1. In paragraph (a)(1), 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.
0
2. In paragraph (a)(1), first sentence, the language ``includes'' is 
removed, and ``means'' is added in its place.
0
3. In paragraph (a)(1), removing the second sentence.
0
4. Removing the last sentence of paragraph (a)(1) and adding two 
sentences in its place.
0
5. Revising paragraph (a)(3).
0
6. Revising paragraphs (b)(1) and (b)(2).
0
7. In paragraph (b)(3)(i), third sentence, removing the language 
``1.425-1'' and inserting ``1.424-1'' in its place.
0
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   S-1.................  X.
 first, second, third and
 fourth sentences.
1.421-1(b)(3)(ii) Example 1   1964................  2004.
 second sentence.
1.421-1(b)(3)(ii) Example 1   1965................  2005.
 third and fourth sentences.
1.421-1(b)(3)(ii) Example 2   1964................  2004.
 first and second sentences.
1.421-1(b)(3)(ii) Example 2   S-1.................  X.
 first, third, and fourth
 sentences.
1.421-1(b)(3)(ii) Example 2   1965................  2005.
 third and fourth sentences.
------------------------------------------------------------------------

0
9. Revising the last sentence of paragraph (b)(3)(ii) Example 1.
0
10. Removing the last sentence of paragraph (b)(3)(ii) Example 2, and 
adding two sentences in its place.
0
11. Removing the first sentence of paragraph (c)(1) and adding two new 
sentences in its place.
0
12. In paragraph (c)(2), second sentence, the language ``425'' is 
removed and ``424'' is added in its place.
0
13. In paragraph (c)(3), second and last sentences, the language 
``1964'' is removed and ``2004'' is added in its place.
0
14. In paragraph (c)(3), second sentence, the language ``1965'' is 
removed wherever it appears and ``2005'' is added in its place.
0
15. Revising paragraphs (d) and (e).
0
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.
0
17. Revising the last sentence of paragraph (f).
0
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.
0
19. Adding a new third, fourth, and fifth sentences to paragraph (g).
0
20. Revising the first, second, and third sentences of paragraph 
(h)(1).
0
21. Revising paragraph (h)(2).
0
22. In paragraph (h)(3), first sentence, the language ``425'' is 
removed and ``424'' is added in its place.
0
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.
0
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.

[[Page 46407]]

 
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.
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 last  its parent and        related
 sentence.                     subsidiary            corporations.
                               corporation.
1.421-1(h)(4) Example 7,      terminated..........  deemed terminated.
 last sentence.
------------------------------------------------------------------------

0
25. Revising paragraph (i).
0
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 domestic relations order, 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 S or P on the 
date of the grant of the option, the option is not a statutory 
option even though X 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 Sec. Sec.  1.422-2(f) and 1.423-2(d) have 
been met, stock which does not have voting

[[Page 46408]]

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).
    (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. * * * For purposes of section 422, a transfer may 
occur even if a share of stock is subject to a substantial risk of 
forfeiture or is not otherwise transferable immediately after the date 
of exercise. See Sec.  1.422-1(b)(3) Example 3. 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 or a right to 
reacquire the share 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 
(or a former employee within the 3-month period following termination 
of the employment relationship) 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 3 months, 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 provided 
either by statute or by contract. If the period of leave exceeds 3 
months and the individual's right to reemployment is not provided 
either by statute or by contract, the employment relationship is deemed 
to terminate on the first day immediately following such three-month 
period. 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--(1) In general. These regulations are effective 
on August 3, 2004.
    (2) Reliance and transition period. For statutory options granted 
on or before June 9, 2003, taxpayers may rely on the 1984 proposed 
regulations LR-279-81 (49 FR 4504), the 2003 proposed regulations REG-
122917-02 (68 FR 34344), or this section until the earlier of January 
1, 2006, or the first regularly scheduled stockholders meeting of the 
granting corporation occurring 6 months after August 3, 2004. For 
statutory options granted after June 9, 2003, and before the earlier of 
January 1, 2006, or the first regularly scheduled stockholders meeting 
of the granting corporation occurring 6 months after August 3, 2004, 
taxpayers may rely on either the REG-122917-02 or this section. 
Taxpayers may not rely on LR-279-81 or REG-122917-02 after December 31, 
2005. Reliance on LR-279-81, REG-122917-02, or this section must be in 
its entirety, and all statutory options granted during the reliance 
period must be treated consistently.

0
Par. 4. Section 1.421-8 is re-designated as 1.421-2 and is amended by:
0
1. Revising paragraphs (a)(1), (b), and (c)(1).
0
2. In paragraph (c)(2), first sentence, add the phrase ``for purposes 
of section 423(c)'' at the end of the first sentence.
0
3. 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:

[[Page 46409]]



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

0
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.
0
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.
0
6. Removing Example (1) in newly designated paragraph (c)(4)(iii) and 
redesignating Examples (2) through (5) as Examples (1) through (4), 
respectively.
0
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 sentence...  422(c)(1), 423(c), or          423(c).
                                        424(c)(1).
1.421-2(c)(4)(i)(b), first, second,    422(c)(1), 423(c), or          423(c).
 and last sentences.                    424(c)(1).
1.421-2(c)(4)(i)(c), first sentence..  422(c)(1), 423(c), or          423(c).
                                        424(c)(1).
1.421-2(c)(4)(iii) Example 1, first    1964.........................  2005.
 sentence.
1.421-2(c)(4)(iii), Example 1, eighth  subdivision (ii)(b) of this    paragraph (c)(4)(i)(b) of this section.
 sentence.                              subparagraph.
1.421-2(c)(4)(iii), Example 1, third   1966.........................  2006.
 and fifth sentences.
1.421-2(c)(4)(iii) Example 1, ninth    subdivision (ii)(c) of this    paragraph (c)(4)(i)(c) of this section.
 sentence.                              subparagraph..
1.421-2(c)(4)(iii) Example 2, second   subdivision (ii)(a) of this    paragraph (c)(4)(i)(a) of this section.
 and fifth sentences.                   subparagraph.
1.421-2(c)(4)(iii) Example 2, fifth    subdivision (ii)(b) of this    paragraph (c)(4)(i)(b) of this section.
 sentence.                              subparagraph.
1.421-2(c)(4)(iii) Example 2, first    example (2)..................  Example 1.
 sentence.
1.421-2(c)(4)(iii) Example 3, first    example (2)..................  Example 1.
 sentence.
1.421-2(c)(4)(iii), Example 3, second  subdivision (ii)(a) of this    paragraph (c)(4)(i)(a) of this section.
 and fourth sentences.                  subparagraph.
1.421-2(c)(4)(iii) Example 3, fourth   subdivision (ii)(c) of this    paragraph (c)(4)(i)(c) of this section.
 sentence.                              subparagraph.
1.421-2(c)(4)(iii) Example 4, first    example (2)..................  Example 1.
 sentence.
1.421-2(c)(4)(iii) Example 4, first    1966.........................  2006.
 sentence.
1.421-2(c)(4)(iii) Example 4, first    1967.........................  2007.
 and second sentences.
1.421-2(c)(iii) Example 4, third,      subdivision (ii)(a) of this    paragraph (c)(4)(i)(a) of this section.
 fifth, and sixth sentences.            subparagraph.
1.421-2(c)(4)(iii) Example 4, fifth    subdivision (ii)(b) of this    paragraph (c)(4)(i)(b) of this section.
 and sixth sentences.                   subparagraph.
1.421-2(c)(4)(iii) Example 4, sixth    subdivision (ii)(c) of this    paragraph (c)(4)(i)(c) of this section.
 sentence.                              subparagraph.
----------------------------------------------------------------------------------------------------------------

0
8. Revising paragraph (d).
0
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 under section 83 at the time of the transfer 
of such share to the individual upon the exercise of the option with 
respect to such share;
    (ii) No deduction under sections 83(h) or 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 section 83(a) to 
determine the amount includible on a disqualifying disposition. 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. A deduction attributable to such transfer is allowable, to the 
extent otherwise allowable under section 162, 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, the amount

[[Page 46410]]

allowed as a deduction must be determined as if the requirements of 
section 83(h) and Sec.  1.83-6(a) apply. 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 for $20 per share. 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 therefore 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 in the year of the disqualifying disposition. The 
amount of compensation income A must include in income is $1,000 
($2,000, the fair market value of X stock on transfer less $1,000, 
the exercise price per share). If the requirements of Sec.  83(h) 
and Sec.  1.83-6(a) are satisfied and otherwise allowable under 
section162, 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 are met, 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 to the 
transfer of the shares, and E must include the compensation income 
attributable to the transfer of the shares in gross income in the 
year of the disqualifying disposition. The amount of compensation 
income that E must include in income 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 the requirements of Sec.  83(h) and Sec.  
1.83-6(a) are satisfied and otherwise allowable under section 162, 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--(1) In general. These regulations are effective 
on August 3, 2004.
    (2) Reliance and transition period. For statutory options granted 
on or before June 9, 2003, taxpayers may rely on the 1984 proposed 
regulations LR-279-81 (49 FR 4504), the 2003 proposed regulations REG-
122917-02 (68 FR 34344), or this section until the earlier of January 
1, 2006, or the first regularly

[[Page 46411]]

scheduled stockholders meeting of the granting corporation occurring 6 
months after August 3, 2004. For statutory options granted after June 
9, 2003, and before the earlier of January 1, 2006, or the first 
regularly scheduled stockholders meeting of the granting corporation 
occurring 6 months after August 3, 2004, taxpayers may rely on either 
the REG-122917-02 or this section. Taxpayers may not rely on LR-279-81 
or REG-122917-02 after December 31, 2005. Reliance on LR-279-81, REG-
122917-02, or this section must be in its entirety, and all statutory 
options granted during the reliance period must be treated 
consistently.

0
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 transfer 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 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 
(determined without reduction for brokerage fees or other costs paid in 
connection with the disposition) 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 section 83(a); 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 by 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. Disqualifying disposition of vested stock. 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. 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)). If the requirements of section 83(h) and 
Sec.  1.83-6(a) are satisfied

[[Page 46412]]

and the deduction is otherwise allowable under section 162, for its 
taxable year in which the disqualifying disposition occurs, X 
Corporation is allowed a deduction of $100 for compensation 
attributable to A's exercise of the incentive stock option.

    Example 2. Disqualifying disposition of unvested stock. Assume 
the same facts as in Example 1, except that the share of X 
Corporation stock received by A is subject to a substantial risk of 
forfeiture and not transferable for a period of six months after 
such exercise. Assume further that the fair market value of X 
Corporation stock is $225 on February 1, 2007, the date on which the 
six-month restriction lapses. Because section 83 does not apply for 
ordinary income tax purposes on the date of exercise, A cannot make 
an effective section 83(b) election at that time (although such an 
election is permissible for alternative minimum tax purposes). 
Additionally, at the time of the disposition, section 422 and Sec.  
1.422-1(a) no longer apply, and thus, section 83(a) is used to 
measure the consequences of the disposition. 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). 
Because the amount realized ($225) 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 
$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)). If 
the requirements of section 83(h) and Sec.  1.83-6(a) are satisfied 
and the deduction is otherwise allowable under section 162, for its 
taxable year in which the disqualifying disposition occurs, X 
Corporation is allowed a deduction of $125 for the compensation 
attributable to A's exercise of the option.

    Example 3. (i) Disqualifying disposition and application of 
special rule. 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. If the requirements of section 
83(h) and Sec.  1.83-6(a) are satisfied and the deduction is 
otherwise allowable under section 162, for its taxable year in which 
the disqualifying disposition occurs, X Corporation is allowed a 
deduction of $50 for the compensation attributable to A's exercise 
of the option and disqualifying disposition of the share.
    (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. 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. If the requirements of section 83(h) and 
Sec.  1.83-6(a) are satisfied and the deduction is otherwise 
allowable under section 162, for its taxable year in which the 
disqualifying disposition occurs X Corporation is allowed a $100 
deduction for compensation attributable to A's exercise of the 
option and disqualifying disposition of the share.
    (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).

0
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 as defined in Sec.  1.421-
1(i)(2)), 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

[[Page 46413]]

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, if changed, must be re-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. If nonstatutory options or other stock-based awards may be 
granted, the plan may separately designate terms for each type of 
option or other stock-based awards and designate the maximum number of 
shares that may be issued under such option or other stock-based 
awards. 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 as incentive stock options 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 as incentive stock options 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; shares purchased under the 
plan and forfeited back to the plan; shares surrendered in payment of 
the exercise price of an option; shares withheld for payment of 
applicable employment taxes and/or withholding obligations resulting 
from the exercise of an option.
    (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 available for issuance 
pursuant to incentive stock options 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 employees (or the class or 
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

[[Page 46414]]

case, P) within 12 months before or after January 1, 2006.
    (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 of P 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. Stockholder approval. (i) Corporation X maintains a 
plan under which incentive stock options may be granted to all 
eligible employees. Corporation Y does not maintain an incentive 
stock option plan. On May 15, 2006, Corporation X and Corporation Y 
consolidate under state law to form one corporation. The new 
corporation will be named Corporation Y. The consolidation agreement 
describes the Corporation X plan, including the maximum aggregate 
number of shares available for issuance pursuant to incentive stock 
options after the consolidation and the employees eligible to 
receive options under the plan. Additionally, the consolidation 
agreement states that the plan will be continued by Corporation Y 
after the consolidation and incentive stock options will be issued 
by Corporation Y. The consolidation agreement is unanimously 
approved by the shareholders of Corporations X and Y on May 1, 2006. 
Corporation Y assumes the plan formerly maintained by Corporation X 
and continues to grant options under the plan to all eligible 
employees.
    (ii) Because there is a change in the granting corporation (from 
Corporation X to Corporation Y), under paragraph (b)(2)(iii) of this 
section, Corporation Y is considered to have adopted a new plan. 
Because the plan is fully described in the consolidation agreement, 
including the maximum aggregate number of shares available for 
issuance pursuant to incentive stock options and employees eligible 
to receive options under the plan, the approval of the consolidation 
agreement by the shareholders constitutes approval of the plan. 
Thus, the shareholder approval of the consolidation agreement 
satisfies the shareholder approval requirements of paragraph (b)(2) 
of this section, and the plan is considered to be adopted by 
Corporation Y and approved by its shareholders on May 1, 2006.

    Example 4. 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 incentive stock 
options is designated in the plan, the requirements of paragraph 
(b)(3) of this section are satisfied.

    Example 5. 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 that may be issued 
under the plan is designated in the plan, the requirements of 
paragraph (b)(3) of this section are met.

    Example 6. 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 for 
issuance 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 
6, 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 that may be issued 
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, 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, 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 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). 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

[[Page 46415]]

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 owns 7,500 shares of M 
Corporation stock, and E owns 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 
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 does 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 is granted, F owns 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 are 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]

0
Par. 7. Section 1.422-4 is removed.


Sec.  1.422-5  [Redesignated as Sec.  1.422-3]

0
Par. 8. Section 1.422-5 is re-designated as Sec.  1.422-3.

0
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

[[Page 46416]]

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 an 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--(1) 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. See Sec.  1.83-7 for the treatment of nonstatutory 
options.
    (2) Stock. A corporation may issue a separate certificate for 
incentive option stock or designate such stock as incentive stock 
option stock in the corporation's transfer records or plan records. In 
such a case, the issuance of separate certificates or designation in 
the corporation's transfer records or plan records is not a 
modification under Sec.  1.424-1(e). In the absence of such an issuance 
or designation, shares are treated as first purchased under an 
incentive stock option to the extent of the $100,000 limitation, and 
the excess shares are treated as purchased under a nonstatutory option. 
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 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
                                Date of grant     value of      First
                                                   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
------------------------------------------------------------------------


[[Page 46417]]

    (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
                                Date of grant     value of      First
                                                   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
                                Date of grant     value of      First
                                                   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 limitation 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 $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 
(or a designation in the corporation's transfer records or the plan 
records) shares with a fair market value of $100,000 are deemed 
purchased first under an incentive stock option, and shares with a 
fair market value of $50,000 are deemed purchased under a 
nonstatutory option.

0
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

[[Page 46418]]

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 economic and 
tax consequences no more favorable than 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 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, which consists of $375 ($450, the 
amount realized from the sale of 15 shares, less A's basis of $75) 
plus $300 ($1,800, the amount realized from the sale of 60 shares, 
less A's basis of $1,500 resulting from the inclusion of that amount 
in income as compensation). 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) 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

[[Page 46419]]

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. If the requirements of Sec.  83(h) and Sec.  1.83-6(a) 
are satisfied and the deduction is otherwise allowable under section 
162, for its taxable year in which the disqualifying disposition 
occurs, 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 the requirements of section 
83(h) and Sec.  1.83-6(a) are satisfied and the deduction is 
otherwise allowable under section 162.

    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 the requirements of section 
83(h) and Sec.  1.83-6(a) are satisfied and the deduction is 
otherwise allowable under section 162.

    (f) Effective date--(1) In general. These regulations are effective 
on August 3, 2004.
    (2) Reliance and transition period. For statutory options granted 
on or before June 9, 2003, taxpayers may rely on the 1984 proposed 
regulations LR-279-81 (49 FR 4504), the 2003 proposed regulations REG-
122917-02 (68 FR 34344), or this section until the earlier of January 
1, 2006, or the first regularly scheduled stockholders meeting of the 
granting corporation occurring 6 months after August 3, 2004. For 
statutory options granted after June 9, 2003, and before the earlier of 
January 1, 2006, or the first regularly scheduled stockholders meeting 
of the granting corporation occurring 6 months after August 3, 2004, 
taxpayers may rely on either the REG-122917-02 or this section. 
Taxpayers may not rely on LR-279-81 or REG-122917-02 after December 31, 
2005. Reliance on LR-279-81, REG-122917-02, or this section must be in 
its entirety, and all statutory options granted during the reliance 
period must be treated consistently.


Sec.  1.423-1  [Amended]

0
Par. 11. Section 1.423-1 is amended as follows:
0
1. In paragraph (a)(2), the language ``425(a)'' is removed and 
``424(a)'' is added in its place.
0
2. In paragraph (b), first sentence, the language ``Sec.  1.421-7'' is 
removed and ``Sec.  1.421-1'' is added in its place.
0
3. In paragraph (b), second sentence, the language ``Sec.  1.421-8'' is 
removed and Sec.  1.421-2'' is added in its place.
0
4. In paragraph (b), last sentence, the language ``425(c)'' is removed 
and ``424(c)'' is added in its place.
0
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]

0
Par. 12. Section 1.423-2 is amended by:
0
1. In paragraph (b), last sentence, the language ``Sec.  1.421-7'' is 
removed and ``Sec.  1.421-1'' is added in its place.
0
2. In paragraph (d)(1), second sentence, the language ``425(d)'' is 
removed and ``424(d)'' is added in its place.
0
3. In paragraph (d)(3), Example 1, fourth sentence, the language 
``425(d)'' is removed and ``424(d)'' is added in its place.
0
4. In paragraph (e)(2), the language ``Sec.  1.421-7'' is removed and 
``Sec.  1.421-1'' is added in its place.
0
5. In paragraph (g)(1), the first sentence of the concluding text, the 
language ``Sec.  1.421-7'' is removed and ``Sec.  1.421-1'' is added in 
its place.
0
6. In paragraph (g)(1), the second sentence of the concluding text, the 
language ``Sec.  1.421-7'' is removed and ``Sec.  1.421-1'' is added in 
its place.
0
7. In paragraph (j), second sentence, the language ``Sec.  1.421-7'' is 
removed and ``Sec.  1.421-1'' is added in its place.
0
8. In paragraph (j), last sentence, the language ``425'' is removed and 
``424'' is added in its place.
0
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 as Sec.  1.424-1]

0
Par. 13. Section 1.425-1 is redesignated as Sec.  1.424-1 and is 
amended by:
0
1. Revising paragraphs (a)(1) through (a)(6).
0
2. Redesignating paragraph (a)(7) as paragraph (a)(9).
0
3. Adding a new paragraph (a)(7).
0
4. Revising paragraph (a)(8).

[[Page 46]]

0
5. Adding paragraph (a)(10).
0
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.
0
7. In paragraph (c)(1), first sentence, the language ``425'' is removed 
and ``424'' is added in its place.
0
8. In paragraph (c)(1), first sentence, the language ``disposition'' is 
removed and ``disposition of stock'' is added in its place.
0
9. Adding paragraph (c)(1)(iv).
0
10. Redesignating paragraph (c)(3) as (c)(4).
0
11. Adding new paragraph (c)(3).
0
12. Adding newly designated paragraph (c)(4) Examples 7 through 9.
0
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.
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).
------------------------------------------------------------------------

0
14. Revising paragraph (d).
0
15. Revising paragraphs (e)(1) and (e)(2).
0
16. In paragraph (e)(3), first sentence, remove the phrase ``Except as 
otherwise provided in subparagraph (4) of this paragraph'' and add ``If 
section 423(c) applies to an option then,''.
0
17. In paragraph (e)(3), first sentence, remove the language ``, and 
424(b)(1).''
0
18. Removing paragraph (e)(4).
0
19. Redesignating paragraph (e)(5) as paragraph (e)(4).
0
20. Revising newly designated paragraph (e)(4).
0
21. Redesignating paragraph (e)(6) as paragraph (e)(5) and removing the 
second and third sentences.
0
22. Adding and reserving a new paragraph (e)(6).
0
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:

------------------------------------------------------------------------
           Section                   Remove                  Add
------------------------------------------------------------------------
1.424-1(e)(7) Example 1,      1964................  2004
 first and sixth sentences.
1.424-1(e)(7) Example 1,      1966................  2006
 first sentence.
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.
------------------------------------------------------------------------


0
24. In paragraph (e)(7), remove Example 4.
0
25. Adding paragraphs (f) and (g).
    The additions and revisions are as follows:

[[Page 46421]]

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. See Sec.  1.421-
1(h) for rules concerning the employment relationship.
    (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 an ordinary dividend or a stock 
split or stock dividend described in Sec.  1.424-1(e)(v)) or change in 
the terms or number of outstanding shares of such corporation; and
    (iii) 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).
    (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 
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.
    (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).

[[Page 46422]]

    (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 common stock. At the time of grant, the fair market 
value of Z common stock is $200 per share. E's option price is $200 
per share. On July 1, 2005, when the fair market value of Z common 
stock is $400, Z declares a stock dividend of preferred stock 
distributed on common stock that causes the fair market value of Z 
common stock to decrease to $200 per share. On the same day, Z 
grants to E a new option to acquire 200 shares of Z common stock in 
exchange for E's old option. The new option has an exercise price of 
$100 per share.
    (ii) A stock dividend other than that described in Sec.  1.424-
1(e)(4)(v) 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. Corporate transaction. (i) E, an employee of 
Corporation A, holds an option to acquire 100 shares of Corporation 
A stock. On September 1, 2006, Corporation A has one class of stock 
outstanding and declares a stock dividend of one share of common 
stock for each outstanding share of common stock. The rights 
associated with the common stock issued as a dividend are the same 
as the rights under existing shares of stock. In connection with the 
stock dividend, E's option is exchanged for an option to acquire 200 
shares of Corporation A stock. The per-share exercise price is equal 
to one half of the per-share exercise price of the original option. 
The stock dividend merely changes the number of shares of 
Corporation A outstanding and effects no other change to the stock 
of Corporation A. The option is proportionally adjusted and the 
aggregate exercise price remains the same and therefore satisfies 
the requirements described in Sec.  1.424-1(e)(4)(v).
    (ii) The stock dividend is not a corporate transaction under 
paragraph (a)(3) of this section, and the declaration of the stock 
dividend is not a modification of the old option under paragraph (a) 
of this section. Pursuant to Sec.  1.424-1(e)(4)(v), the exercise 
price of the old option may be adjusted proportionally with the 
change in the number of outstanding shares of Corporation A such 
that the ratio of the aggregate exercise price of the option to the 
number of shares covered by the option is the same both before and 
after the stock dividend. The adjustment of E's option is not 
treated as a modification of the option.
    Example 5. 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 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 6. 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 7. Ratio test and partial substitution. Assume the same 
facts as in Example 6, 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)

[[Page 46423]]

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 8. 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 9. 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. After the acquisition, X employees remain employees 
of X. In connection with the acquisition, Y Corporation substitutes 
new options to acquire Y stock for the old options to acquire X 
stock 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 the requirements of Sec.  1.422-2 were met on the 
date of grant, the substitution of the new Y options for the old X 
options does not require new stockholder approval. 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 paragraphs (i) and (ii) of 
this Example 9. Assume further that 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 a new 
plan under Sec.  1.422-2(b)(2)(iii), 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 10. 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.
    Example 11. Eligible corporation. (i) D Corporation grants an 
option to acquire 100 shares of D Corporation stock to E, an 
employee of D Corporation. S Corporation is a subsidiary of D 
Corporation. On March 1, 2005, D Corporation spins off S 
Corporation. E remains an employee of D Corporation. In connection 
with the spin off, D Corporation substitutes a new option to acquire 
D Corporation stock and a new option to acquire S Corporation stock 
for the old option in a manner that meets the requirements of 
paragraph (a) of this section.
    (ii) The substitution of the new option to acquire S and D stock 
for the old option to acquire D stock is not a modification of the 
old option. However, because S is no longer a related corporation 
with respect to D Corporation, E must exercise the option for S 
stock within three months from March 1, 2005, for the option to be 
treated as a statutory option. See Sec.  1.421-1(h).
    (iii) Assume the same facts as in paragraph (i) of this Example 
11 except that E's employment with D Corporation is terminated on 
February 20, 2005. The substitution of the new option to acquire S 
and D stock for the old option to acquire D stock is not a 
modification of the old option. However, because the employment 
relationship between E and D Corporation terminated on February 20, 
2005, E must exercise the option for the D and S stock within three 
months from February 20, 2005, for the option to be treated as a 
statutory option. See Sec.  1.421-1(h).
* * * * *
    (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 Sec.  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 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 Y Corporation stock, Y Corporation will purchase 
the fractional share for cash equal to its fair market value.

[[Page 46424]]

After applying the conversion formula to the shares held by E, E has 
10 \1/2\ Y Corporation shares. Y Corporation purchases E's one-half 
share for $25, the fair market value of one-half of a Y 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 Y 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 specifically 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, the right to tender 
previously acquired stock for the stock purchasable under the option, 
or the payment of employment taxes and/or required withholding taxes 
resulting from the exercise of a statutory 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. An offer to change 
the terms of an option that remains open less than 30 days is not a 
modification of the option. However, if an offer to change the terms of 
an option remains outstanding for 30 days or more, there is a 
modification of the option as of the date the offer to change the 
option is made.
    (iv) A change in the terms of the stock purchasable under the 
option that increases 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. Notwithstanding the previous sentence, if the 
exercise price and number of shares subject to an option are 
proportionally adjusted to reflect a stock split (including a reverse 
stock split) or stock dividend, and the only effect of the stock split 
or stock dividend is to increase (or decrease) on a pro rata basis the 
number of shares owned by each shareholder of the class of stock 
subject to the option, then the option is not modified if it is 
proportionally adjusted to reflect the stock split or stock dividend 
and the aggregate exercise price of the option is not less than the 
aggregate exercise price before the stock split or stock dividend.
    (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. However, if the terms 
of an option are changed to provide that the optionee cannot transfer 
the option except by will or by the laws of descent and distribution in 
order to meet the requirements of section 422(b)(5) or 423(b)(9) such 
change is not a modification.
    (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.
    (viii) Any inadvertent change to the terms of an option (or change 
in the

[[Page 46425]]

terms of the plan pursuant to which the option was granted or in the 
terms of any other agreement governing the arrangement) that is treated 
as a modification under this paragraph (e) is not considered a 
modification of the option to the extent the change in the terms of the 
option is removed by the earlier of the date the option is exercised or 
the last day of the calendar year during which such change occurred. 
Thus, for example, if the terms of an option are inadvertently changed 
on March 1 to extend the exercise period and the change is removed on 
November, then if the option is not exercised prior to November 1, the 
option is not considered modified under this paragraph (e).
* * * * *
    (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--(1) In general. These regulations are effective 
on August 3, 2004.
    (2) Reliance and transition period. For statutory options granted 
on or before June 9, 2003, taxpayers may rely on the 1984 proposed 
regulations LR-279-81 (49 FR 4504), the 2003 proposed regulations REG-
122917-02 (68 FR 34344), or this section until the earlier of January 
1, 2006, or the first regularly scheduled stockholders meeting of the 
granting corporation occurring 6 months after August 3, 2004. For 
statutory options granted after June 9, 2003, and before the earlier of 
January 1, 2006, or the first regularly scheduled stockholders meeting 
of the granting corporation occurring 6 months after August 3, 2004, 
taxpayers may rely on either the REG-122917-02 or this section. 
Taxpayers may not rely on LR-279-81 or REG-122917-02 after December 31, 
2005. Reliance on LR-279-81, REG-122917-02, or this section must be in 
its entirety, and all statutory options granted during the reliance 
period must be treated consistently.


Sec.  1.6039-1 and 1.6039-2  [Removed]

0
Par. 14. Section 1.6039-1 and 1.6039-2 are removed.

0
Par. 15. A new Sec.  1.6039-1 is added 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

[[Page 46426]]

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: Extension of Time 
Coordinator). Such a request in the form of a letter to the Martinsburg 
Computing Center, 250 Murall Drive, Kearneysville, West Virginia 25430, 
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. The statements required to 
be furnished pursuant to this section may be provided in an electronic 
format in lieu of a paper format, with the consent of the recipient. 
See Sec.  31.6051-1(j) of the Regulations on Employment Taxes and 
Collection of Income Tax at the Source for further guidance regarding 
the manner in which such electronic statements must be furnished.
    (g) Effective date-- (1) In general. These regulations are 
effective on August 3, 2004.
    (2) Reliance and transition period. For statutory options 
transferred on or before June 9, 2003, taxpayers may rely on the 1984 
proposed regulations LR-279-81 (49 FR 4504), the 2003 proposed 
regulations REG-122917-02 (68 FR 34344), or this section until the 
earlier of January 1, 2006, or the first regularly scheduled 
stockholders meeting of the granting corporation occurring 6 months 
after August 3, 2004. For statutory options transferred after June 9, 
2003, and before the earlier of January 1, 2006, or the first regularly 
scheduled stockholders meeting of the granting corporation occurring 6 
months after August 3, 2004, taxpayers may rely on either the REG-
122917-02 or this section. Taxpayers may not rely on LR-279-81 or REG-
122917-02 after December 31, 2005. Reliance on LR-279-81, REG-122917-
02, or this section must be in its entirety, and all statutory options 
granted during the reliance period must be treated consistently.

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

PART 14A [REMOVED]

0
Par. 16. Part 14a is removed.

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
    Approved: July 20, 2004.
Gregory Jenner,
Acting Assistant Secretary of Treasury.
[FR Doc. 04-17448 Filed 8-2-04; 8:45 am]
BILLING CODE 4830-01-P