[Federal Register Volume 74, Number 220 (Tuesday, November 17, 2009)]
[Rules and Regulations]
[Pages 59074-59087]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E9-27452]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9471]
RIN 1545-BH68


Employee Stock Purchase Plans Under Internal Revenue Code Section 
423

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains the final regulations relating to 
options granted under an employee stock purchase plan as defined in 
section 423 of the Internal Revenue Code (Code). These final 
regulations affect certain taxpayers who participate in the transfer of 
stock pursuant to the exercise of options granted under an employee 
stock purchase plan. These final regulations provide guidance to assist 
taxpayers in complying with section 423 in addition to clarifying 
certain rules regarding options granted under an employee stock 
purchase plan. This document also contains final regulations under 
sections 421, 422 and 424 of the Code.

DATES: Effective Date: These regulations are effective on November 17, 
2009.
    Applicability Date: These regulations apply as of January 1, 2010.

FOR FURTHER INFORMATION CONTACT: Thomas Scholz or Ilya Enkishev at 
(202) 622-6030 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    This document contains final amendments to the Income Tax 
Regulations (26 CFR part 1) under sections 421, 422, 423 and 424 of the 
Code.
    Section 423 was added to the Code by section 221(a) of the Revenue 
Act of 1964, Public Law 88-272 (78 Stat. 63 (1964)). Changes to the 
applicable law concerning section 423 were made by sections 
1402(b)(1)(C) and 1402(b)(2) of the Tax Reform Act of 1976, Public Law 
94-455 (90 Stat. 1731 and 1732-1733 (1976)); section 1001(b)(5) of the 
Deficit Reduction Act of 1984, Public Law 98-369 (98 Stat. 1011 
(1984)); section 1114 of the Tax Reform Act of 1986, Public Law 99-514 
(100 Stat. 2451 (1986)); and sections 11801(c)(9)(D)(i), (ii) and 
11801(c)(9)(E) of the Omnibus Budget Reconciliation Act of 1990, Public 
Law 101-508 (104 Stat. 1388-525 (1990)).
    Regulations under section 423 were published in the Federal 
Register on June 23, 1966 (TD 6887). These

[[Page 59075]]

regulations were amended on September 27, 1979 (TD 7645), October 31, 
1980 (TD 7728), and December 1, 1988 (TD 8235). In Notice 2004-55 
(2004-34 IRB 319 (August 23, 2004)) (see Sec.  601.601(d)(2)(ii)(b)), 
the IRS and the Treasury Department requested comments concerning 
whether the existing regulations under section 423 should be amended, 
and if so, what issues should be addressed.
    On July 29, 2008, the Treasury Department published a notice of 
proposed rulemaking (REG-106251-08) in the Federal Register (73 FR 
43875) under section 423. A public hearing on the proposed regulations 
was held on January 15, 2009. Written and electronic comments 
responding to the notice of proposed rulemaking were received. After 
consideration of these comments, the Treasury Department adopts the 
proposed regulations as final regulations, with the modifications set 
forth in this Treasury decision. The significant revisions are 
discussed in this preamble.
    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 the option is 
determined under section 83 and the regulations thereunder. However, 
section 421 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 sections 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 the 
transfer and no deduction under section 162 is allowed to the employer 
corporation with respect to the transfer.
    Section 423(a) provides that section 421 applies to the transfer of 
stock to an individual pursuant to the exercise of an option granted 
under an employee stock purchase plan if: (i) No disposition of the 
stock is made within two years from the date of grant of the option or 
within one 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 three 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 423(b) sets 
forth several requirements that must be met for a plan to qualify as an 
employee stock purchase plan. Section 423(c) provides a special rule 
that is applicable where the option exercise price is between 85 and 
100 percent of the fair market value of the stock at the time the 
option was granted.

Explanation of Provisions

    These final regulations provide a comprehensive set of rules 
governing stock options issued under an employee stock purchase plan 
and incorporate substantially all of the rules contained in the 
existing regulations under section 423. These final regulations are 
comprised of two sections: Section 1.423-1, applicability of section 
421(a); and Sec.  1.423-2, employee stock purchase plan defined. The 
modifications to the proposed regulations that are included in these 
final regulations reflect consideration of the comments submitted by 
taxpayers.

1. General Requirements

    The proposed regulations provide that an employee stock purchase 
plan must meet the requirements of paragraphs (i) through (ix) of Sec.  
1.423-2(a)(2) to qualify as an employee stock purchase plan under 
section 423(b). The proposed regulations also provide that the 
requirements of paragraphs (iii) through (ix) of Sec.  1.423-2(a)(2) 
may be satisfied by the terms of the plan or an offering made under the 
plan. The final regulations adopt these requirements of the proposed 
regulations, although the numerical designation of the requirements is 
modified. To emphasize that the requirements of paragraphs (iii) 
through (ix) of Sec.  1.423-2(a)(2) of the proposed regulations may be 
satisfied by the terms of the plan or an offering made under the plan, 
these final regulations separately list these requirements in Sec.  
1.423-2(a)(3).
    Commenters requested clarification of whether options with terms 
that are inconsistent with the terms of the plan will be eligible for 
the special tax treatment of section 421. As provided in Sec.  1.423-
2(a)(3) of the proposed regulations, Sec.  1.423-2(a)(4) of these final 
regulations provides that, if the terms of an option are inconsistent 
with the terms of the employee stock purchase plan or an offering under 
the plan, then the option will not be treated as granted under an 
employee stock purchase plan. However, an option may still qualify for 
the special tax treatment of section 421, even if the terms of the plan 
are inconsistent with any of the requirements in Sec.  1.423-2(a)(3) of 
these final regulations, if the option is granted under an offering 
with terms that comply with the requirements of Sec.  1.423-2(a)(3). 
Example 2 of Sec.  1.423-2(e)(6) of these final regulations illustrates 
this principle.

2. Offerings Under an Employee Stock Purchase Plan

    These final regulations provide further guidance for employee stock 
purchase plans under which more than one offering is made. As set forth 
in Sec.  1.423-2(a)(1) of these final regulations, one or more 
offerings may be made under a plan and the offerings may be consecutive 
or overlapping. Further, pursuant to section 423(b) and its flush 
language, the terms of each offering need not be identical. Although 
the terms of each offering need not be identical, the terms of the plan 
and each offering together must satisfy the requirements of Sec.  
1.423-2(a)(2) and (3) of these final regulations. For example, if 
overlapping offerings are made under an employee stock purchase plan, 
then each offering may contain different terms, provided that the terms 
of each offering (together with the plan) satisfy the requirements of 
Sec.  1.423-2(a)(3) of these final regulations. Furthermore, when a 
parent corporation adopts an employee stock purchase plan, it may 
establish separate offerings with different terms under the plan and 
designate which subsidiary corporations of the parent corporation may 
participate in a particular offering, provided that the terms of each 
offering (together with the plan) satisfy the requirements of Sec.  
1.423-2(a)(3). The terms ``parent corporation'' and ``subsidiary 
corporation'' are defined in Sec.  1.424-1(f) of the regulations.
a. Employees Covered by the Plan
    Paragraphs (i) through (iv) of Sec.  1.423-2(e)(1) of the proposed 
regulations and these final regulations set forth the categories of 
employees that may be excluded from coverage under an employee stock 
purchase plan or an offering under the plan. The proposed regulations 
provide that the exclusions for various categories of employees must be 
applied in an identical manner to all employees of every corporation 
whose employees are granted options under the plan. Commenters noted 
that the requirement of identical exclusions for all offerings under a 
plan constrains the ability to make future and overlapping offerings 
that are more (or less) inclusive than prior offerings under the plan. 
Commenters suggested that the final regulations should permit multiple

[[Page 59076]]

offerings under a plan with different exclusions applicable to the one 
or more corporations whose employees participate in the particular 
offering under the plan.
    These final regulations generally adopt the approach suggested by 
the commenters. Pursuant to these final regulations, whether the terms 
of a plan and offering satisfy the requirements of Sec.  1.423-2(e) is 
made on an offering-by-offering basis. The terms of each offering under 
a plan may be different, provided the plan and offering together 
satisfy the requirements of Sec.  1.423-2(a)(2) and (3) of these final 
regulations. With respect to satisfying the requirements of Sec.  
1.423-2(e), the terms of each offering may provide different exclusions 
of employees, as permitted and within the limitations described in 
Sec.  1.423-2(e)(1), (2) and (3) of these final regulations. The 
exclusions established with respect to a particular offering must be 
applied in an identical manner to all employees of every corporation 
whose employees are granted options under that particular offering. 
Examples 7 and 8 of Sec.  1.423-2(e)(6) of these final regulations 
illustrate these principles.
    Some commenters suggested that the final regulations permit 
employers to exclude from plan participation employees who are 
nonresident aliens and who receive no earned income that constitutes 
income from sources within the United States. Other commenters 
suggested that the final regulations permit employers to exclude from 
plan participation employees under a specified age. The IRS and the 
Treasury Department are aware of the complexities often associated with 
participation in an employee stock purchase plan by nonresident aliens 
and employees under a specified age, such as the age of majority. 
However, section 423 does not provide exclusions for nonresident aliens 
or employees under a specified age. Accordingly, the IRS and the 
Treasury Department are constrained by statutory authority from 
providing a general exclusion from plan participation for employees who 
are nonresident aliens or employees under a specified age.
    One commenter suggested that the final regulations provide 
additional flexibility by permitting employers to exclude from plan 
participation highly compensated employees (HCEs) (within the meaning 
of section 414(q)) on any basis. Section 1.423-2(e)(2)(ii) of the 
proposed regulations provides that the terms of an employee stock 
purchase plan may exclude HCEs: (a) with compensation above a certain 
level, or (b) who are officers or subject to the disclosure 
requirements of section 16(a) of the Securities Exchange Act of 1934, 
provided the exclusion is applied in an identical manner to all HCEs of 
every corporation whose employees are granted options under the plan. 
These final regulations do not adopt the suggestion that HCEs may be 
excluded from participation in an employee stock purchase plan on any 
basis. Instead, these final regulations offer some additional 
flexibility by providing that, with respect to the exclusion of HCEs, 
the terms of each offering made under a plan need not be identical with 
respect to the HCEs, provided the HCEs are excluded as permitted and 
within the limitations described in Sec.  1.423-2(e)(2)(ii) of these 
final regulations.
b. Equal Rights and Privileges
    Commenters further suggested that the final regulations provide 
flexibility by permitting employers to make multiple offerings with 
different rights and privileges applicable to the participants of each 
offering under a plan. These final regulations generally adopt the 
approach suggested by the commenters. Pursuant to these final 
regulations, the determination of whether the terms of an offering 
satisfy the requirements of Sec.  1.423-2(f) is made on an offering-by-
offering basis. The terms of each offering under a plan may be 
different, provided the plan and offering together satisfy the 
requirements of Sec.  1.423-2(a)(2) and (3) of these final regulations. 
However, the rights and privileges established with respect to a 
particular offering must be applied in an identical manner to all 
employees of every corporation whose employees are granted options 
under that particular offering. Examples 4 and 5 of Sec.  1.423-2(f)(7) 
of these final regulations illustrate these principles.
3. Maximum Number of Shares That May Be Purchased By an Employee
    Commenters asked whether the designation of a maximum number of 
shares that may be purchased by an employee during the offering is 
necessary in order for the first day of the offering period to be the 
date of grant. Consistent with the proposed regulations, Sec.  1.423-
2(h)(3) of these final regulations provides that the date of grant will 
be the first day of an offering period if the terms of an employee 
stock purchase plan or offering designate a maximum number of shares 
that may be purchased by each employee during the offering. Similarly, 
the date of grant will be the first day of an offering if the terms of 
the plan or offering require the application of a formula to establish, 
on the first day of the offering, the maximum number of shares that may 
be purchased by each employee during the offering.
    However, Sec.  1.423-2(h)(3) of these final regulations does not 
require that an employee stock purchase plan or offering designate a 
maximum number of shares that may be purchased by each employee during 
the offering or incorporate a formula to establish a maximum number of 
shares that may be purchased by each employee during the offering. If 
the maximum number of shares that can be purchased under an option is 
not fixed or determinable until the date the option is exercised, then 
the date of exercise will be the date of grant of the option. As 
discussed in the preamble to the proposed regulations, the $25,000 
limit under section 423(b)(8) and the limit on the aggregate number of 
shares that may be issued under an employee stock purchase plan are not 
sufficient to establish the maximum number of shares that can be 
purchased by an employee under an option so that the date of grant will 
be the first day of the offering. Examples 1, 2, 3 and 4 in Sec.  
1.423-2(h)(4) of these final regulations illustrate these principles.
    Commenters also asked whether any particular number of shares is 
necessary to satisfy the requirement to designate a maximum number of 
shares that may be purchased during the offering in order for the first 
day of the offering period to be the date of grant. No particular 
number of shares is necessary to satisfy this requirement and establish 
the first day of the offering period as the date of grant for the 
option. These final regulations adopt Sec.  1.423-2(h)(3) of the 
proposed regulations to provide that the designation of any maximum 
number of shares is sufficient to establish the first day of the 
offering period as the date of grant for the option.
4. Annual $25,000 Limitation
    Section 423(b)(8) provides that an employee stock purchase plan 
must, by its terms, provide that no employee may be permitted to accrue 
the right to purchase stock under all the employee stock purchase plans 
of his or her employer corporation and its related corporations at a 
rate which exceeds $25,000 in fair market value of the stock 
(determined on the date of grant) for each calendar year in which an 
option granted to the employee is outstanding. Section 423(b)(8)(A) 
provides that the right to purchase stock under an option accrues when 
the option first becomes exercisable.
    In drafting the proposed regulations, the Treasury Department and 
the IRS were aware that taxpayers were interpreting the $25,000 
limitation

[[Page 59077]]

inconsistently. Certain taxpayers interpreted section 423(b)(8) to mean 
that the limit increases by $25,000 for each calendar year during which 
the option is outstanding and exercisable; other taxpayers interpreted 
the sections to mean that such limit increases for each calendar year 
during which the option is simply outstanding. Consistent with comments 
received by the Treasury Department and the IRS in response to Notice 
2004-55 (2004-34 IRB 319 (August 23, 2004)), (see Sec.  
601.601(d)(2)(ii)(b)), the proposed regulations adopted an approach 
that was generally consistent with the $100,000 limitation for 
incentive stock options and interpreted section 423(b)(8) to mean that 
the limit increases by $25,000 for each calendar year during which the 
option is outstanding and exercisable.
    In response to the proposed regulations, several commenters 
suggested that the Treasury Department and the IRS reconsider the 
calculation of the $25,000 limitation in section 423(b)(8). Commenters 
suggested that the regulations adopt an approach that permits an option 
to accrue at a rate of $25,000 for each calendar year that the option 
is simply outstanding. Specifically, even though section 423(b)(8)(A) 
provides that the right to purchase stock actually accrues when the 
option first becomes exercisable during a calendar year, the first 
sentence of section 423(b)(8) provides that the limit on accruals is 
$25,000 ``for each year in which such option is outstanding.'' Upon 
further consideration and in response to the foregoing comments, these 
final regulations modify Sec.  1.423-2(i) of the proposed regulations 
to provide that the limit increases by $25,000 for each calendar year 
that an option is outstanding. Example 5 in Sec.  1.423-2(i)(5) of 
these final regulations has been modified to illustrate this principle.
5. Stockholder Approval Requirements
    To qualify as an employee stock purchase plan, section 423(b)(2) 
requires that the plan be approved by the stockholders of the granting 
corporation within 12 months before or after the date the plan is 
adopted. These final regulations clarify that new stockholder approval 
is required if there is a change in the shares with respect to which 
options are issued or a change in the granting corporation. In 
particular, these final regulations clarify that the stockholders of a 
subsidiary corporation include the parent corporation and any other 
stockholders of the subsidiary. Accordingly, these final regulations 
adopt Example 1(iii) in Sec.  1.423-2(c)(5) and Example 1(iii) in Sec.  
1.422-2(b)(6) of the proposed regulations.
    One commenter to the proposed regulations suggested that a 
conforming change be made to Example 9(iii) in Sec.  1.424-1(a)(10) 
which addresses the substitution of options in the context of an 
acquisition. Example 9(iii) in Sec.  1.424-1(a)(10), as previously set 
forth in the regulations, requires the stockholders of an acquiring 
company to approve an amendment of the option plan of an acquired 
corporate subsidiary to issue parent stock instead of subsidiary stock. 
The commenter proposed that the example be amended to require the 
acquiring company (instead of its stockholders) to approve the 
amendment of the option plan to issue parent stock instead of 
subsidiary stock. This amendment is consistent with Example 1(iii) in 
Sec.  1.423-2(c)(5) and Example 1(iii) in Sec.  1.422-2(b)(6) of these 
final regulations. Accordingly, Example 9(iii) in Sec.  1.424-1(a)(10) 
of these final regulations has been modified to reflect the adoption of 
the commenter's suggestion.

Effective/Applicability Date

    These regulations apply as of January 1, 2010, and will apply to 
any statutory option granted on or after that date. Taxpayers may rely 
on these final regulations for the treatment of any statutory option 
granted prior to January 1, 2010.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It also has been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations and because the 
regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Code, the notice of proposed 
rulemaking preceding these regulations was submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on its impact on small business.

Drafting Information

    The principal authors of these regulations are Thomas Scholz and 
Ilya Enkishev, Office of the Division Counsel/Associate Chief Counsel 
(Tax Exempt and Government Entities). However, other personnel from the 
IRS and the Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is 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.


0
Par. 2. Section 1.421-1, paragraphs (c)(1) and (j)(1) are revised to 
read as follows:


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

* * * * *
    (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. Except as set forth in Sec.  1.423-2(h)(2), 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.
* * * * *
    (j) Effective/applicability date--(1) In general. Except for 
paragraph (c)(1) of this section, the regulations under this section 
are effective on August 3, 2004. Paragraph (c)(1) of this section is 
effective on November 17, 2009. Paragraph (c)(1) of this section 
applies to statutory options granted on or after January 1, 2010.
* * * * *


0
Par. 3. Section 1.422-2, paragraph (b)(6), Example 1 (iii) is revised 
to read as follows:


Sec.  1.422-2  Incentive stock options defined.

* * * * *
    (b) * * *
    (6) * * *

    Example 1. * * *
    (iii) Assume the same facts as in paragraph (i) of this Example 
1, except that the plan was adopted on January 1, 2010. Assume 
further that the plan was approved by the stockholders of S (in this 
case, P) on March 1, 2010. On January 1, 2012, S changes the plan to 
provide that incentive stock options for P stock will be granted to 
S employees

[[Page 59078]]

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 stockholder of S (in this case, P) 
within 12 months before or after January 1, 2012.
* * * * *


0
Par. 4. Section 1.422-5, paragraph (f)(1) is revised to read as 
follows:


Sec.  1.422-5  Permissible provisions.

* * * * *
    (f) Effective/applicability date--(1) In general. Except for Sec.  
1.422-2(b)(6) Example 1 (iii), the regulations under this section are 
effective on August 3, 2004. Section 1.422-2(b)(6) Example 1 (iii) is 
effective on November 17, 2009. Section 1.422-2(b)(6) Example 1 (iii) 
applies to statutory options granted on or after January 1, 2010.
* * * * *


0
Par. 5. Section 1.423-1 is revised to read as follows:


Sec.  1.423-1  Applicability of section 421(a).

    (a) General rule. Subject to the provisions of section 423(c) and 
Sec.  1.423-2(k), the special rules of income tax treatment provided in 
section 421(a) apply with respect to the transfer of a share of stock 
to an individual pursuant to the individual's exercise of an option 
granted under an employee stock purchase plan, as defined in Sec.  
1.423-2, if the following conditions are satisfied--
    (1) The individual makes no disposition of such share before the 
later of the expiration of the two-year period from the date of the 
grant of the option pursuant to which such share was transferred or the 
expiration of the one-year period from the date of transfer of such 
share to the individual; and
    (2) At all times during the period beginning on the date of the 
grant of the option and ending on the day three months before the date 
of exercise, the individual was an employee of the corporation granting 
the option, a related corporation, or a corporation (or a related 
corporation) substituting or assuming the stock option in a transaction 
to which section 424(a) applies.
    (b) Cross-references. For rules relating to the requisite 
employment relationship, see Sec.  1.421-1(h). For rules relating to 
the effect of a disqualifying disposition, see section 421(b) and Sec.  
1.421-2(b). For the definition of the term ``disposition,'' see section 
424(c) and Sec.  1.424-1(c). For the definition of the term ``related 
corporation,'' see Sec.  1.421-1(i).
    (c) Effective/applicability date. The regulations under this 
section are effective on November 17, 2009. The regulations under this 
section apply to options granted under an employee stock purchase plan 
on or after January 1, 2010.


0
Par. 6. Section 1.423-2 is revised to read as follows:


Sec.  1.423-2  Employee stock purchase plan defined.

    (a) In general--(1) The term ``employee stock purchase'' plan means 
a plan that meets the requirements of paragraphs (a)(2) and (a)(3) of 
this section. If the terms of the plan do not satisfy the requirements 
of paragraph (a)(3) of this section, then such requirements may be 
satisfied by the terms of an offering made under the plan. However, 
where the requirements of paragraph (a)(3) of this section are 
satisfied by the terms of an offering, such requirements will be 
treated as satisfied only with respect to options exercised under that 
offering. One or more offerings may be made under an employee stock 
purchase plan. Offerings may be consecutive or overlapping, and the 
terms of each offering need not be identical provided the terms of the 
plan and the offering together satisfy the requirements of paragraphs 
(a)(2) and (a)(3) of this section. The plan and the terms of an 
offering must be in writing or electronic form, provided that such 
writing or electronic form is adequate to establish the terms of the 
plan or offering, as applicable.
    (2) To satisfy the requirements of this paragraph (a)(2) and Sec.  
1.423-1, the plan must meet both of the following requirements--
    (i) The plan must provide that options can be granted only to 
employees of the employer corporation or of a related corporation (as 
defined in paragraph (i) of Sec.  1.421-1) to purchase stock in any 
such corporation (see paragraph (b) of this section); and
    (ii) The plan must be approved by the stockholders of the granting 
corporation within 12 months before or after the date the plan is 
adopted (see paragraph (c) of this section).
    (3) To satisfy the requirements of this paragraph (a)(3) and Sec.  
1.423-1, the terms of the plan or offering must meet all of the 
following requirements--
    (i) An employee cannot be granted an option if, immediately after 
the option is granted, the employee owns stock possessing 5 percent or 
more of the total combined voting power or value of all classes of 
stock of the employer corporation or of a related corporation (see 
paragraph (d) of this section);
    (ii) Options must be granted to all employees of any corporation 
whose employees are granted any options by reason of their employment 
by the corporation (see paragraph (e) of this section);
    (iii) All employees granted options must have the same rights and 
privileges (see paragraph (f) of this section);
    (iv) The option price cannot be less than the lesser of--
    (A) An amount equal to 85 percent of the fair market value of the 
stock at the time the option is granted, or
    (B) An amount not less than 85 percent of the fair market value of 
the stock at the time the option is exercised (see paragraph (g) of 
this section).
    (v) Options cannot be exercised after the expiration of--
    (A) Five years from the date the option is granted if, under the 
terms of such plan, the option price cannot be less than 85 percent of 
the fair market value of the stock at the time the option is exercised, 
or
    (B) Twenty-seven months from the date the option is granted, if the 
option price is not determined in the manner described in paragraph 
(a)(3)(v)(A) of this section (see paragraph (h) of this section).
    (vi) No employee may be granted an option that permits the 
employee's rights to purchase stock under all employee stock purchase 
plans of the employer corporation and its related corporations to 
accrue at a rate that exceeds $25,000 of fair market value of the stock 
(determined at the time the option is granted) for each calendar year 
in which the option is outstanding at any time (see paragraph (i) of 
this section); and
    (vii) Options are not transferable by the optionee other than by 
will or the laws of descent and distribution, and are exercisable, 
during the lifetime of the optionee, only by the optionee (see 
paragraph (j) of this section).
    (4) The determination of whether a particular option is an option 
granted under an employee stock purchase plan is made at the time the 
option is granted. If the terms of an option are inconsistent with the 
terms of the employee stock purchase plan or the offering under the 
plan pursuant to which the option is granted, the option will not be 
treated as granted under an employee stock purchase plan. If an option 
with terms that are inconsistent with the terms of the plan or an 
offering under the plan is granted to an employee who is entitled to 
the grant of an option under the terms of the plan or offering, and the 
employee is not granted an option under the offering that qualifies as 
an option granted under an employee stock purchase plan, the

[[Page 59079]]

offering will not meet the requirements of paragraph (e) of this 
section. Accordingly, none of the options granted under the offering 
will be eligible for the special tax treatment of section 421. However, 
if an option with terms that are inconsistent with the terms of the 
plan or an offering under the plan is granted to an individual who is 
not entitled to the grant of an option under the terms of the plan or 
offering, the option will not be treated as an option granted under an 
employee stock purchase plan but the grant of the option will not 
disqualify the options granted under the plan or offering. If, at the 
time of grant, an option qualifies as an option granted under an 
employee stock purchase plan, but after the time of grant one or more 
of the requirements of paragraph (a)(3) of this section is not 
satisfied with respect to the option, the option will not be treated as 
granted under an employee stock purchase plan but this failure to 
comply with the terms of the option will not disqualify the other 
options granted under the plan or offering.
    (5) Examples. The following examples illustrate the principles of 
paragraph (a):

    Example 1. Corporation A operates an employee stock purchase 
plan under which options for A stock are granted to employees of A. 
The terms of an offering provide that the option price will be 90 
percent of the fair market value of A stock on the date of exercise. 
A grants an option under the offering to Employee Z, an employee of 
A. The terms of the option provide that the option price will be 85 
percent of the fair market value of A stock on the date of exercise. 
Because the terms of Z's option are inconsistent with the terms of 
the offering, the option granted to Z will not be treated as an 
option granted under the employee stock purchase plan. Further, 
unless Z is granted an option under the offering that qualifies as 
an option granted under the employee stock purchase plan, the 
offering will not meet the requirements of paragraph (e) of this 
section and none of the options granted under the offering will be 
eligible for the special tax treatment of section 421.

    Example 2.  Corporation B operates an employee stock purchase 
plan that provides that options for B stock may only be granted to 
employees of B. Under the terms of the plan, options may not be 
granted to consultants and other non-employees. B grants an option 
to Consultant Y, a consultant of B. Because Y is ineligible to 
receive an option under the plan because Y is not an employee, the 
grant of the option to Y is inconsistent with the terms of the plan 
and the option granted to Y will not be treated as an option granted 
under the employee stock purchase plan. However, the grant of the 
option to Y will not disqualify the options granted under the plan 
or any offering because Y was not entitled to the grant of an option 
under the plan.

    Example 3.  Corporation C operates an employee stock purchase 
plan under which options for C stock are granted to employees of C. 
C grants an option pursuant to an offering under the plan to 
Employee X, an employee of C who is a highly compensated employee. 
The terms of the employee stock purchase plan exclude highly 
compensated employees from participation in the plan. Because X is 
ineligible to receive an option under the plan by reason of X's 
exclusion from participation in the plan, the option granted to X 
will not be treated as an option granted under the employee stock 
purchase plan. However, the grant of the option to X will not 
disqualify the options granted under the plan or offering because X 
was not entitled to the grant of an option under the plan.

    Example 4.  Corporation D operates an employee stock purchase 
plan under which options for D stock are granted to employees of D. 
D grants an option pursuant to an offering under the plan to 
Employee W, an employee of D. The terms of the option provide that 
the option price will be 90 percent of the fair market value of D 
stock on the date of exercise. On the date of exercise, W pays only 
85 percent of the fair market value of D stock. Because the terms of 
W's option are not satisfied, the option granted to W will not be 
treated as an option granted under the employee stock purchase plan. 
However, the failure to comply with the terms of the option granted 
to W will not disqualify the options granted under the plan or 
offering.

    (b) Options restricted to employees. An employee stock purchase 
plan must provide that options can be granted only to employees of the 
employer corporation (or employees of its related corporations) to 
purchase stock in the employer corporation (or one of its related 
corporations). If such a provision is not included in the terms of the 
plan, the plan will not be an employee stock purchase plan and options 
granted under the plan will not qualify for the special tax treatment 
of section 421. For rules relating to the employment requirement, see 
Sec.  1.421-1(h).
    (c) Stockholder approval--(1) An employee stock purchase plan must 
be approved by the stockholders of the granting corporation within 12 
months before or after the date such plan is adopted. The approval of 
the stockholders must comply with all applicable provisions of the 
corporate charter and bylaws and of applicable State law prescribing 
the method and degree of stockholder approval required for the issuance 
of corporate stock or options. If the applicable State law does not 
prescribe a method and degree of stockholder approval, then an employee 
stock purchase plan must be approved--
    (i) By a majority of the votes cast at a duly held stockholder's 
meeting at which a quorum representing a majority of all outstanding 
voting stock is, either in person or by proxy, present and voting on 
the plan; or
    (ii) By a method and in a degree that would be treated as adequate 
under applicable State law in the case of an action requiring 
stockholder approval (such as, an action on which stockholders would be 
entitled to vote if the action were taken at a duly held stockholders' 
meeting).
    (2) For purposes of the stockholder approval required by this 
paragraph (c), 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 adoption as the date of the board's action.
    (3) An employee stock purchase plan, as adopted and approved, must 
designate the maximum aggregate number of shares that may be issued 
under the plan, and the corporations or class of corporations whose 
employees may be offered options under the plan. A plan that merely 
provides that the number of shares that may be issued under the plan 
may not exceed a stated percentage of the shares outstanding at the 
time of each offering or grant under the plan does not satisfy the 
requirements of this paragraph (c)(3). 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 
on 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 on the date of the adoption of the plan. 
A plan that provides that the maximum aggregate number of shares that 
may be issued as options under the plan may change based on any other 
specific circumstances satisfies the requirements of this paragraph 
only if the stockholders approve an immediately determinable maximum 
number of shares that may be issued under the plan in any event. If 
there is more than one employee stock purchase plan under which options 
may be granted and stockholders of the granting corporation merely 
approve a maximum aggregate number of shares that are

[[Page 59080]]

available for issuance under the plans, the stockholder approval 
requirements described in paragraph (c)(1) of this section are not 
satisfied. A separate maximum aggregate number of shares available for 
issuance pursuant to options must be specified and approved for each 
plan.
    (4) Once an employee stock purchase plan is approved by the 
stockholders of the granting corporation, the plan need not be 
reapproved by the stockholders of the granting corporation unless the 
plan is amended or changed in a manner that is considered the adoption 
of a new plan, in which case the plan must be reapproved within the 
prescribed 24-month period. Any increase in the 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) will be considered the adoption of a new 
plan requiring stockholder approval within the prescribed 24-month 
period. Similarly, a change in the designation of corporations whose 
employees may be offered options under the plan will be considered the 
adoption of a new plan requiring stockholder approval within the 
prescribed 24-month period unless the plan provides that designations 
of participating corporations may be made from time to time from among 
a group consisting of the granting corporation and its related 
corporations. The group from among which such changes and designations 
are permitted without additional stockholder approval may include 
corporations having become parents or subsidiaries of the granting 
corporation after the adoption and approval of the plan. In addition, a 
change in the granting corporation or the stock available for purchase 
under the plan will be considered the adoption of a new plan requiring 
stockholder approval within the prescribed 24-month period. Any other 
changes in the terms of an employee stock purchase plan are not 
considered the adoption of a new plan and, thus, do not require 
stockholder approval.
    (5) Examples. The following examples illustrate the principles of 
this paragraph (c):

    Example 1. (i) Corporation E is a subsidiary of Corporation F, a 
publicly traded corporation. On January 1, 2010, E adopts an 
employee stock purchase plan under which options for E stock are 
granted to E employees.
    (ii) To meet the requirements of paragraph (c)(1) of this 
section, the plan must be approved by the stockholders of E (in this 
case, F) within 12 months before or after January 1, 2010.
    (iii) Assume the same facts as in paragraph (i) of this Example 
1, except that the plan was approved by the stockholders of E (in 
this case, F) on March 1, 2010. On January 1, 2012, E changes the 
plan to provide that options for F stock will be granted to E 
employees under the plan. Because there is a change in the stock 
available for grant under the plan, under paragraph (c)(4) of this 
section, the change is considered the adoption of a new plan that 
must be approved by the stockholders of E (in this case, F) within 
12 months before or after January 1, 2012.
    Example 2. (i) Assume the same facts as in paragraph (i) of 
Example 1, except that on March 15, 2011, F completely disposes of 
its interest in E. Thereafter, E continues to grant options for E 
stock to E employees under the plan.
    (ii) The new E options are granted under a plan that meets the 
stockholder approval requirements of paragraph (c)(1) of this 
section without regard to whether E seeks approval of the plan from 
the stockholders of E after F disposes of its interest in E.
    (iii) Assume the same facts as in paragraph (i) of this Example 
2, except that under the plan as adopted on January 1, 2010, only 
options for F stock are granted to E employees. Assume further that, 
after F disposes of its interest in E, E changes the plan to provide 
for the grant of options for E stock to E employees. Because there 
is a change in the stock available for purchase or grant under the 
plan, under paragraph (c)(4) of this section, the stockholders of E 
must approve the plan within 12 months before or after the change to 
the plan to meet the stockholder approval requirements of paragraph 
(c) of this section.
    Example 3. (i) Corporation G maintains an employee stock 
purchase plan providing options for G stock. Corporation H does not 
maintain an employee stock purchase plan. On May 15, 2010, G and H 
consolidate under State law to form one corporation. The new 
corporation is named Corporation H. The consolidation agreement 
describes the G plan, including the maximum aggregate number of 
shares available for issuance under the plan after the 
consolidation. Additionally, the consolidation agreement states that 
the plan will be continued by H after the consolidation. The 
consolidation agreement is approved by the stockholders of G and H 
on May 1, 2010. H assumes the plan formerly maintained by G and 
continues to grant options under the plan to all eligible employees, 
but the options are for H stock.
    (ii) Because there is a change in the granting corporation (from 
G to H) and the stock available for purchase, under paragraph (c)(4) 
of this section, H 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 under the plan, the approval of the consolidation agreement 
by the stockholders constitutes approval of the plan. Thus, the 
stockholder approval of the consolidation agreement satisfies the 
stockholder approval requirements of paragraph (c)(1) of this 
section, and the plan is considered to be adopted by H and approved 
by its stockholders on May 1, 2010.
    Example 4. Corporation I adopts an employee stock purchase plan 
on November 1, 2010. On that date, there are two million shares of I 
stock outstanding. The plan provides that the maximum aggregate 
number of shares that may be issued under the plan may not exceed 15 
percent of the number of shares of I stock outstanding on November 
1, 2010. Because the maximum aggregate number of shares that may be 
issued under the plan is designated in the plan, the requirements of 
paragraph (c)(3) of this section are met.

    Example 5. (i) Corporation J adopts an employee stock purchase 
plan on March 15, 2010. The plan provides that the maximum aggregate 
number of shares of J stock 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. Because the 
maximum aggregate number of shares is not designated under the plan, 
the requirements of paragraph (c)(3) of this section are not met.
    (ii) Assume the same facts as in paragraph (i) of this Example 
5, except that the plan provides that the maximum aggregate number 
of shares available under the plan is the lesser of (a) 50,000 
shares, increased each anniversary date of the adoption of the plan 
by 5 percent of the then-outstanding shares, or (b) 200,000 shares. 
Because the maximum aggregate number of shares that may be issued 
under the plan is designated as the lesser 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 (c)(3) of this section are met.

    (d) Options granted to certain shareholders--(1) An employee stock 
purchase plan or offering must, by its terms, provide that an employee 
cannot be granted an option if the employee, immediately after the 
option is granted, owns stock possessing 5 percent or more of the total 
combined voting power or value of all classes of stock of the employer 
corporation or a related corporation. In determining whether the stock 
ownership of an employee equals or exceeds this 5 percent limit, the 
rules of section 424(d) (relating to attribution of stock ownership) 
shall apply, and stock that the employee may purchase under outstanding 
options (whether or not the options qualify for the special tax 
treatment afforded by section 421(a)) shall be treated as stock owned 
by the employee. An option is outstanding for purposes of this 
paragraph (d) although under its terms it may be exercised only in 
installments or after the expiration of a fixed period of time. If an 
option is granted to an employee whose stock ownership (as determined 
under this paragraph (d)) exceeds the limitation set forth in this 
paragraph (d), no portion of the option will be treated as having been 
granted under an employee stock purchase plan.

[[Page 59081]]

    (2) The determination of the percentage of the total combined 
voting power or value of all classes of stock of the employer 
corporation (or a related corporation) that is owned by the employee is 
made by comparing the voting power or value of the shares owned (or 
treated as owned) by the employee to the aggregate voting power or 
value of all shares actually issued and outstanding immediately after 
the grant of the option to the employee. The aggregate voting power or 
value of all shares actually issued and outstanding immediately after 
the grant of the option does not include the voting power or value of 
treasury shares or shares authorized for issue under outstanding 
options held by the employee or any other person.
    (3) Examples. The following examples illustrate the principles this 
paragraph (d):

    Example 1. Employee V, an employee of Corporation K, owns 6,000 
shares of K common stock, the only class of K stock outstanding. K 
has 100,000 shares of its common stock outstanding. Because V owns 6 
percent of the combined voting power or value of all classes of K 
stock, K cannot grant an option to V under K's employee stock 
purchase plan. If V's father and brother each owned 3,000 shares of 
K stock and V did not own any K stock, then the result would be the 
same because, under section 424(d), an individual is treated as 
owning stock held by the person's father and brother. Similarly, the 
result would be the same if, instead of actually owning 6,000 
shares, V merely held an option on 6,000 shares of K stock, 
irrespective of whether the transfer of stock under the option could 
qualify for the special tax treatment of section 421, because this 
paragraph (d) provides that stock the employee may purchase under 
outstanding options is treated as stock owned by such employee.
    Example 2. Assume the same facts as in Example 1, except that K 
is a 50 percent subsidiary corporation of Corporation L. 
Irrespective of whether V owns any L stock, V cannot receive an 
option from L under L's employee stock purchase plan because he owns 
5 percent of the total combined voting power of all classes of stock 
of a subsidiary of L, in this example, K. An employee who owns (or 
is treated as owning) stock in excess of the limitation of this 
paragraph (d), in any corporation in a group of related 
corporations, consisting of a parent and its subsidiary 
corporations, cannot receive an option under an employee stock 
purchase plan from any corporation in the group.
    Example 3. Employee U is an employee of Corporation M. M has 
only one class of stock, of which 100,000 shares are issued and 
outstanding. Assuming U does not own (and is not treated as owning) 
any stock in M or in any related corporation of M, M may grant an 
option to U under its employee stock purchase plan for 4,999 shares, 
because immediately after the grant of the option, U would not own 5 
percent or more of the combined voting power or value of all classes 
of M stock actually issued and outstanding at such time. The 4,999 
shares that U would be treated as owning under this paragraph (d) 
would not be added to the 100,000 shares actually issued and 
outstanding immediately after the grant for purposes of determining 
whether U's stock ownership exceeds the limitation of this paragraph 
(d).
    Example 4. Assume the same facts as in Example 3 but instead of 
an option for 4,999 shares, M grants U an option, purportedly under 
its employee stock purchase plan, for 5,000 shares. No portion of 
this option will be treated as granted under an employee stock 
purchase plan because U's stock ownership exceeds the limitation of 
this paragraph (d).

    (e) Employees covered by plan--(1) Subject to the provisions of 
this paragraph (e) and the limitations of paragraphs (d), (f) and (i) 
of this section, an employee stock purchase plan or offering must, by 
its terms, provide that options are to be granted to all employees of 
any corporation whose employees are granted any of such options by 
reason of their employment by that corporation, except that one or more 
of the following categories of employees may be excluded from the 
coverage of the plan or offering--
    (i) Employees who have been employed less than two years;
    (ii) Employees whose customary employment is 20 hours or less per 
week;
    (iii) Employees whose customary employment is for not more than 
five months in any calendar year; and
    (iv) Highly compensated employees (within the meaning of section 
414(q)).
    (2) A plan or offering does not fail to satisfy the coverage 
provision of paragraph (e)(1) of this section in the following 
circumstances--
    (i) The plan or offering excludes employees who have completed a 
shorter period of service or whose customary employment is for fewer 
hours per week or fewer months in a calendar year than is specified in 
paragraphs (e)(1)(i), (ii) and (iii) of this section, provided the 
exclusion is applied in an identical manner to all employees of every 
corporation whose employees are granted options under the plan or 
offering.
    (ii) The plan or offering excludes highly compensated employees 
(within the meaning of section 414(q)) with compensation above a 
certain level or who are officers or subject to the disclosure 
requirements of section 16(a) of the Securities Exchange Act of 1934, 
provided the exclusion is applied in an identical manner to all highly 
compensated employees of every corporation whose employees are granted 
options under the plan or offering.
    (3) Notwithstanding paragraph (e)(1) of this section, employees who 
are citizens or residents of a foreign jurisdiction (without regard to 
whether they are also citizens of the United States or resident aliens 
(within the meaning of section 7701(b)(1)(A))) may be excluded from the 
coverage of an employee stock purchase plan or offering under the 
following circumstances--
    (i) The grant of an option under the plan or offering to a citizen 
or resident of the foreign jurisdiction is prohibited under the laws of 
such jurisdiction; or
    (ii) Compliance with the laws of the foreign jurisdiction would 
cause the plan or offering to violate the requirements of section 423.
    (4) No option granted under a plan or offering that excludes from 
participation any employees, other than those who may be excluded under 
this paragraph (e), and those barred from participation by reason of 
paragraphs (d), (f) and (i) of this section, can be regarded as having 
been granted under an employee stock purchase plan. If an option is not 
granted to any employee who is entitled to the grant of an option under 
the terms of the plan or offering, none of the options granted under 
such offering will be treated as having been granted under an employee 
stock purchase plan. However, a plan that, by its terms, permits all 
eligible employees to elect to participate in an offering will not 
violate the requirements of this paragraph solely because eligible 
employees who elect not to participate in the offering are not granted 
options pursuant to such offering.
    (5) For purposes of this paragraph (e), the existence of the 
employment relationship between an individual and the corporation 
participating under the plan will be determined under Sec.  1.421-1(h).
    (6) Examples. The following examples illustrate the principles of 
this paragraph (e):

    Example 1. Corporation N has a stock purchase plan that meets 
all the requirements of paragraphs (a)(2) and (a)(3) of this section 
except that options are not required to be granted to employees 
whose weekly rate of pay is less than $1,000. As a matter of 
corporate practice, however, N grants options under its plan to all 
employees, irrespective of their weekly rate of pay. Even though N's 
plan is operated in compliance with the requirements of this 
paragraph (e), N's plan is not an employee stock purchase plan 
because the terms of the plan exclude a category of employees that 
is not permitted under this paragraph (e).
    Example 2. Assume the same facts as in Example 1, except that 
the first offering under N's plan provides that options will be 
granted to all employees of N. The terms of

[[Page 59082]]

the first offering will be treated as part of the terms of N's plan, 
but only for purposes of the first offering. Because the terms of 
the first offering satisfy the requirements of this paragraph (e), 
stock transferred pursuant to options exercised under the first 
offering will be treated as stock transferred pursuant to the 
exercise of options granted under an employee stock purchase plan 
for purposes of section 421.
    Example 3. Corporation O has a stock purchase plan that excludes 
from participation all employees who have been employed less than 
one year. Assuming all other requirements of paragraphs (a)(2) and 
(a)(3) of this section are satisfied, O's plan qualifies as an 
employee stock purchase plan under section 423.
    Example 4. Corporation P has a stock purchase plan that excludes 
from participation clerical employees who have been employed less 
than two years. However, non-clerical employees with less than two 
years of service are permitted to participate in the plan. P's plan 
is not an employee stock purchase plan because the exclusion of 
employees who have been employed less than two years applies only to 
certain employees of P and is not applied in an identical manner to 
all employees of P. If, instead, P's plan excludes from 
participation all employees (both clerical and non-clerical) who 
have been employed less than two years, then P's plan would qualify 
as an employee stock purchase plan under section 423 assuming all 
other requirements of paragraphs (a)(2) and (a)(3) of this section 
are satisfied.
    Example 5. Corporation Q has a stock purchase plan that excludes 
from participation all officers who are highly compensated employees 
(within the meaning of section 414(q)). Assuming all other 
requirements of paragraphs (a)(2) and (a)(3) of this section are 
satisfied, Q's plan qualifies as an employee stock purchase plan 
under section 423.
    Example 6. Corporation R maintains an employee stock purchase 
plan that excludes from participation all highly compensated 
employees (within the meaning of section 414(q)), except highly 
compensated employees who are officers of R. R's plan is not an 
employee stock purchase plan because the exclusion of all highly 
compensated employees except highly compensated employees who are 
officers of R is not a permissible exclusion under paragraph 
(e)(2)(ii) of this section.
    Example 7. Corporation S is the parent corporation of Subsidiary 
YY and Subsidiary ZZ. S maintains an employee stock purchase plan 
with both YY and ZZ participating in the same offering under the 
plan. Under the terms of the offering under the plan, all employees 
of YY and ZZ are permitted to participate in the plan with the 
exception of ZZ's highly compensated employees with annual 
compensation greater than $300,000. None of the options granted 
under the offering will be considered granted under an employee 
stock purchase plan because the exclusion of highly compensated 
employees with annual compensation greater than $300,000 is not 
applied in an identical manner to all employees of YY and ZZ granted 
options in the same offering.
    Example 8. Assume the same facts as in Example 7, except that 
Corporation S establishes separate offerings under the plan for YY 
and ZZ. Under the terms of the separate offering for YY, all 
employees of YY are permitted to participate in the plan. Under the 
terms of the separate offering established for ZZ, all employees of 
ZZ are permitted to participate in the plan with the exception of 
ZZ's highly compensated employees with annual compensation greater 
than $300,000. The options granted under the separate offering for 
YY will be considered granted under an employee stock purchase plan. 
Further, the options granted under the separate offering for ZZ will 
be considered granted under an employee stock purchase plan because 
the exclusion of highly compensated employees with annual 
compensation greater than $300,000 is applied in an identical manner 
to all employees of ZZ granted options in the same offering.
    Example 9. The laws of Country A require that options granted to 
residents of Country A be transferable during the lifetime of the 
option recipient. Corporation T has a stock purchase plan that 
excludes residents of Country A from participation in the plan. 
Because compliance with the laws of Country A would cause options 
granted to residents of Country A to violate paragraph (j) of this 
section, T may exclude residents of Country A from participation in 
the plan. Assuming all other requirements of paragraph (a)(2) of 
this section are satisfied, T's plan qualifies as an employee stock 
purchase plan under section 423.

    (f) Equal rights and privileges--(1) Except as otherwise provided 
in paragraphs (f)(2) through (f)(6) of this section, an employee stock 
purchase plan or offering must, by its terms, provide that all 
employees granted options under the plan or offering shall have the 
same rights and privileges. Thus, the provisions applying to one option 
under an offering (such as the provisions relating to the method of 
payment for the stock and the determination of the purchase price per 
share) must apply to all other options under the offering in the same 
manner. If all the options granted under a plan or offering do not, by 
their terms, give the respective optionees the same rights and 
privileges, none of the options will be treated as having been granted 
under an employee stock purchase plan for purposes of section 421.
    (2) The requirements of this paragraph (f) do not prevent the 
maximum amount of stock that an employee may purchase from being 
determined on the basis of a uniform relationship to the total 
compensation, or the basic or regular rate of compensation, of all 
employees.
    (3) A plan or offering will not fail to satisfy the requirements of 
this paragraph (f) because the plan or offering provides that no 
employee may purchase more than a maximum amount of stock fixed under 
the plan or offering.
    (4) A plan or offering will not fail to satisfy the requirements of 
this paragraph (f) if, in order to comply with the laws of a foreign 
jurisdiction, the terms of an option granted under a plan or offering 
to citizens or residents of such foreign jurisdiction (without regard 
to whether they are also citizens of the United States or resident 
aliens (within the meaning of section 7701(b)(1)(A))) are less 
favorable than the terms of options granted under the same plan or 
offering to employees resident in the United States.
    (5)(i) Except as provided in this paragraph and paragraph 
(f)(5)(ii) of this section, a plan or offering permitting one or more 
employees to carry forward amounts that were withheld but not applied 
toward the purchase of stock under an earlier plan or offering and 
apply the amounts towards the purchase of additional stock under a 
subsequent plan or offering will be a violation of the equal rights and 
privileges under paragraph (f)(1) of this section. However, the carry 
forward of amounts withheld but not applied toward the purchase of 
stock under an earlier plan or offering will not violate the equal 
rights and privileges requirement of paragraph (f)(1) of this section, 
if all other employees participating in the current plan or offering 
are permitted to make direct payments toward the purchase of shares 
under a subsequent plan or offering in an amount equal to the excess of 
the greatest amount which any employee is allowed to carry forward from 
an earlier plan or offering over the amount, if any, the employee will 
carry forward from an earlier plan or offering.
    (ii) A plan or offering will not fail to satisfy the requirements 
of this section merely because employees are permitted to carry forward 
amounts representing a fractional share, that were withheld but not 
applied toward the purchase of stock under an earlier plan or offering 
and apply the amounts toward the purchase of additional stock under a 
subsequent plan or offering.
    (6) Paragraph (f) does not prohibit the delaying of the grant of an 
option to any employee who is barred from being granted an option 
solely by reason of the employee's failing to meet a minimum service 
requirement set forth in paragraph (e)(1) of this section until the 
employee meets such requirement.
    (7) Examples. The following examples illustrate the principles of 
this paragraph (f):

    Example 1.  Corporation U has an employee stock purchase plan 
that provides

[[Page 59083]]

that the maximum amount of stock that each employee may purchase 
under the offering is one share for each $100 of annual gross pay. 
The plan meets the requirements of this paragraph (f).
    Example 2.  Corporation V has an employee stock purchase plan 
that provides that the maximum amount of stock that each employee 
may purchase under the offering is one share for each $100 of annual 
gross pay up to and including $10,000, and two shares for each $100 
of annual gross pay in excess of $10,000. The plan will not meet the 
requirements of this paragraph (f) because the amount of stock that 
may be purchased under the plan is not based on a uniform 
relationship to the total compensation of all employees.
    Example 3.  Corporation W has an employee stock purchase plan 
that provides that options to purchase stock in an amount equal to 
ten percent of an employee's annual salary at a price equal to 85 
percent of the fair market value on the first day of the offering 
will be granted to all employees other than those who have been 
employed less than 18 months. In addition, the plan provides that 
employees who have not yet met the minimum service requirements on 
the first day of the offering will be granted similar options on the 
date the 18 month service requirement has been attained. The plan 
meets the requirements of this paragraph (f).
    Example 4.  Corporation X is the parent corporation of 
Subsidiary AA, Subsidiary BB and Subsidiary CC. X maintains an 
employee stock purchase plan with AA, BB and CC participating in the 
same offering under the plan. Under the terms of the offering under 
the plan, options to purchase stock at a price equal to 90 percent 
of the fair market value at the time the option is exercised will be 
granted to all employees. Certain employees of AA are residents of 
Country B. The laws of Country B provide that options granted to 
employees who are residents of Country B must have a purchase price 
not less than 95 percent of the fair market value at the time the 
option is exercised. The plan will not fail to satisfy the 
requirements of this paragraph (f) merely because the residents of 
Country B are granted options under the plan to purchase stock at a 
price equal to 95 percent of the fair market value at the time the 
option is exercised.
    Example 5. Assume the same facts as in Example 4, except that 
Corporation X establishes two separate offerings under the plan: A 
separate offering for the employees of AA and a separate offering 
for the employees of BB and CC. Under the separate offering for the 
employees of BB and CC, options are granted to all employees with an 
exercise price equal to 90 percent of the fair market value at the 
time the option is exercised. Under the separate offering for the 
employees of AA, options are granted to all employees with an 
exercise price equal to 95 percent of the fair market value at the 
time the option is exercised. The plan does not violate the equal 
rights and privileges requirement of this paragraph (f) merely 
because the exercise price of options granted under one offering is 
less than the exercise price of options granted under a separate 
offering.
    Example 6.  Corporation Y maintains an employee stock purchase 
plan. Employee T is employed by Y. T is granted an option under the 
current offering to purchase a maximum of 100 shares of Y stock at 
an option price equal to 85 percent of the fair market value of the 
stock at exercise. The plan permits the carry forward of withheld 
but unused amounts from an earlier offering. Prior to the exercise 
date, $2000 of T's salary has been withheld and is available to be 
applied toward the purchase of Y stock. On the exercise date, the 
fair market value of Y stock is $20 per share. T is able to purchase 
100 shares of Y stock at $17 per share for an aggregate purchase 
price of $1700. T can carry forward $300 to the subsequent offering. 
Each employee in the subsequent offering other than T will be 
permitted to make direct payments toward the purchase of shares 
under the subsequent offering in a maximum amount of $300 less any 
amount the employee has carried forward from an earlier offering. 
The plan does not violate the equal rights and privileges 
requirement of this paragraph (f).

    (g) Option price--(1) An employee stock purchase plan or offering 
must, by its terms, provide that the option price will not be less than 
the lesser of--
    (i) An amount equal to 85 percent of the fair market value of the 
stock at the time the option is granted, or
    (ii) An amount that under the terms of the option may not be less 
than 85 percent of the fair market value of the stock at the time the 
option is exercised.
    (2) For purposes of determining the option price, the fair market 
value of the stock may be determined in any reasonable manner, 
including the valuation methods permitted under Sec.  20.2031-2. 
However, the option price must meet the minimum pricing requirements of 
this paragraph (g). 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. Sec.  1.421-1(c) and 1.423-2(h)(2). Any 
option that does not meet the minimum pricing requirements of this 
paragraph (g) will not be treated as an option granted under an 
employee stock purchase plan irrespective of whether the plan or 
offering satisfies those requirements. If an option that does not meet 
the minimum pricing requirements is granted to an employee who is 
entitled to the grant of an option under the terms of the plan or 
offering, and the employee is not granted an option under such offering 
that qualifies as an option granted under an employee stock purchase 
plan, the offering will not meet the requirements of paragraph (e) of 
this section. Accordingly, none of the options granted under the 
offering will be eligible for the special tax treatment of section 421.
    (3) The option price may be stated either as a percentage or as a 
dollar amount. If the option price is stated as a dollar amount, then 
the requirement of this paragraph (g) can only be met by a plan or 
offering in which the price is fixed at not less than 85 percent of the 
fair market value of the stock at the time the option is granted. If 
the fixed price is less than 85 percent of the fair market value of the 
stock at grant, then the option cannot meet the requirement of this 
paragraph (g) even if a decline in the fair market value of the stock 
results in such fixed price being not less than 85 percent of the fair 
market value of the stock at the time the option is exercised, because 
that result was not certain to occur under the terms of the option.
    (4) Examples. The following examples illustrate the principles of 
this paragraph (g):

    Example 1. Corporation Z has an employee stock purchase plan 
that provides that the option price will be 85 percent of the fair 
market value of the stock on the first day of the offering (which is 
the date of grant in this case), or 85 percent of the fair market 
value of the stock at exercise, whichever amount is the lesser. Upon 
the exercise of an option issued under Z's plan, Z agrees to accept 
an option price that is less than the minimum amount allowable under 
the terms of such plan. Notwithstanding that the option was issued 
under an employee stock purchase plan, the transfer of stock 
pursuant to the exercise of such option does not satisfy the 
requirement of this paragraph (g) and cannot qualify for the special 
tax treatment of section 421.
    Example 2. Corporation AA has an employee stock purchase plan 
that provides that the option price is set at 85 percent of the fair 
market value of AA stock at exercise, but not less than $80 per 
share. On the first day of the offering (which is the date of grant 
in this case), the fair market value of AA stock is $100 per share. 
The option satisfies the requirement of this paragraph (g), and can 
qualify for the special tax treatment of section 421.
    Example 3.  Assume the same facts as in Example 2, except that 
the option price is set at 85 percent of the fair market value of AA 
stock at exercise, but not more than $80 per share. This option 
cannot satisfy the requirement of this paragraph (g) irrespective of 
whether, at the time the option is exercised, 85 percent of the fair 
market value of AA stock is $80 or less.

    (h) Option period--(1) An employee stock purchase plan or offering 
must, by its terms, provide that options granted under the plan cannot 
be exercised after the expiration of 27 months from the date of grant 
unless, under the terms of the plan or offering, the option price is 
not less than 85 percent of the fair market value of the stock at the 
time of the exercise of the option. If the option price is not less 
than 85 percent of the fair market value of the stock at the time the 
option is exercised, then the option period provided under the plan 
must

[[Page 59084]]

not exceed five years from the date of grant. If the requirements of 
this paragraph (h) are not met by the terms of the plan or offering, 
then options issued under such plan or offering will not be treated as 
options granted under an employee stock purchase plan irrespective of 
whether the options, by their terms, are exercisable beyond the period 
allowable under this paragraph (h). An option that provides that the 
option price is not less than 85 percent of the fair market value of 
the stock at exercise may have an option period of 5 years irrespective 
of whether the fair market value of the stock at exercise is more or 
less than the fair market value of the stock at grant. However, if the 
option provides that the option price is 85 percent of the fair market 
value of the stock at exercise, but not more than some other fixed 
amount determined in accordance with the provisions of paragraph (g) of 
this section, then irrespective of the price paid on exercise, the 
option period must not be more than 27 months.
    (2) Section 1.421-1(c) provides that, for purposes of Sec. Sec.  
1.421-1 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. With 
respect to options granted under an employee stock purchase plan, the 
principles of Sec.  1.421-1(c) shall be applied without regard to the 
requirement that the minimum option price must be fixed or determinable 
in order for the corporate action constituting an offer of stock to be 
considered complete.
    (3) The date of grant will be the first day of an offering if the 
terms of an employee stock purchase plan or offering designate a 
maximum number of shares that may be purchased by each employee during 
the offering. Similarly, the date of grant will be the first day of an 
offering if the terms of the plan or offering require the application 
of a formula to establish, on the first day of the offering, the 
maximum number of shares that may be purchased by each employee during 
the offering. It is not required that an employee stock purchase plan 
or offering designate a maximum number of shares that may be purchased 
by each employee during the offering or incorporate a formula to 
establish a maximum number of shares that may be purchased by each 
employee during the offering. If the maximum number of shares that can 
be purchased under an option is not fixed or determinable until the 
date the option is exercised, then the date of exercise will be the 
date of grant of the option.
    (4) Examples. The following examples illustrate the principles of 
this paragraph (h):

    Example 1.  (i) Corporation BB has an employee stock purchase 
plan that provides that the option price will be the lesser of 85 
percent of the fair market value of the stock on the first day of an 
offering or 85 percent of the fair market value of the stock on the 
last day of the offering. Options are exercised on the last day of 
the offering. One million shares of BB stock are reserved for 
issuance under the plan. The plan provides that no employee may be 
permitted to purchase stock under the plan at a rate that exceeds 
$25,000 in fair market value of the BB stock (determined on the date 
of grant) for each calendar year during which an option granted to 
the employee is outstanding. The terms of each option granted under 
an offering provide that a maximum of 500 shares may be purchased by 
the option recipient during the offering. Because the maximum number 
of shares that can be purchased under the option is fixed and 
determinable on the first day of the offering, the date of grant for 
the option is the first day of the offering.
    (ii) Assume the same facts as in paragraph (i) of Example 1, 
except that BB's plan excludes all employees who have been employed 
less than 18 months. The plan provides that employees who have not 
yet met the minimum service requirements on the first day of an 
offering will be granted an option on the date the 18-month service 
requirement has been attained. With respect to those employees who 
have been employed less than 18 months on the first day of an 
offering, the date of grant for the option is the date the 18-month 
service requirement has been attained.
    Example 2.  Assume the same facts as in paragraph (i) of Example 
1, except that the terms of each option granted do not provide that 
a maximum of 500 shares may be purchased by the option recipient 
during the offering. Notwithstanding the fixed number of shares 
reserved for issuance under the plan and the $25,000 limitation set 
forth in the plan, the maximum number of shares that can be 
purchased under the option is not fixed or determinable until the 
last day of the offering when the option is exercised. Therefore the 
date of grant for the option is the last day of the offering when 
the option is exercised.
    Example 3.  Corporation CC has an employee stock purchase plan 
that provides that the option price will be 85 percent of the fair 
market value of the stock on the last day of the offering. Options 
are exercised on the last day of the offering. Each offering under 
the plan begins on January 1 and ends on December 31 of the same 
calendar year. The terms of each option granted under an offering 
provide that the maximum number of shares that may be purchased by 
any employee during the offering equals $25,000 divided by the fair 
market value of the stock on the first day of the offering. The 
maximum number of shares that can be purchased under the option is 
fixed and determinable on the first day of the offering and 
therefore the date of grant for the option is the first day of the 
offering.
    Example 4.  Assume the same facts as in Example 3 except that 
the terms of each option granted under an offering provide that the 
maximum number of shares that may be purchased by any employee 
during the offering equals 10 percent of the employee's annual 
salary (determined as of January 1 of the year in which the offering 
commences) divided by the fair market value of the stock on the 
first day of the offering. The maximum number of shares that can be 
purchased under the option is fixed and determinable on the first 
day of the offering and therefore the date of grant for the option 
is the first day of the offering.

    (i) Annual $25,000 limitation--(1) An employee stock purchase plan 
or offering must, by its terms, provide that no employee may be 
permitted to purchase stock under all the employee stock purchase plans 
of the employer corporation and its related corporations at a rate that 
exceeds $25,000 in fair market value of the stock (determined at the 
time the option is granted) for each calendar year in which any option 
granted to the employee is outstanding at any time. In applying the 
foregoing limitation--
    (i) The right to purchase stock under an option accrues when the 
option (or any portion thereof) first becomes exercisable during the 
calendar year;
    (ii) The right to purchase stock under an option accrues at the 
rate provided in the option, but in no case may such rate exceed 
$25,000 of fair market value of such stock (determined at the time such 
option is granted) for any one calendar year; and
    (iii) A right to purchase stock that has accrued under one option 
granted pursuant to the plan may not be carried over to any other 
option.
    (2) If an option is granted under an employee stock purchase plan 
that satisfies the requirement of this paragraph (i), but the option 
gives the optionee the right to buy stock in excess of the maximum rate 
allowable under this paragraph (i), then no portion of the option will 
be treated as having been granted under an employee stock purchase 
plan. Furthermore, if the option was granted to an employee entitled to 
the grant of an option under the terms of the plan or offering, and the 
employee is not granted an option under the offering that qualifies as 
an option granted under an employee stock purchase plan, then the 
offering will not meet the requirements of paragraph (e) of this 
section. Accordingly, none of the options granted under the offering 
will be eligible for the special tax treatment of section 421.

[[Page 59085]]

    (3) The limitation of this paragraph (i) applies only to options 
granted under employee stock purchase plans and does not limit the 
amount of stock that an employee may purchase under incentive stock 
options (as defined in section 422(b)) or any other stock options 
except those to which section 423 applies. Stock purchased under 
options to which section 423 does not apply will not limit the amount 
that an employee may purchase under an employee stock purchase plan, 
except for purposes of the 5-percent stock ownership provision of 
paragraph (d) of this section.
    (4) Under the limitation of this paragraph (i), an employee may 
purchase up to $25,000 of stock (based on the fair market value of the 
stock at the time the option was granted) in each calendar year during 
which an option granted to the employee under an employee stock 
purchase plan is outstanding. Alternatively, an employee may purchase 
more than $25,000 of stock (based on the fair market value of such 
stock at the time the option was granted) in a calendar year, so long 
as the total amount of stock that the employee purchases does not 
exceed $25,000 in fair market value of the stock (determined at the 
time the option was granted) for each calendar year in which any option 
was outstanding. If, in any calendar year, the employee holds two or 
more outstanding options granted under employee stock purchase plans of 
the employer corporation, or a related corporation, then the employee's 
purchases of stock attributable to that year under all options granted 
under employee stock purchase plans must not exceed $25,000 in fair 
market value of the stock (determined at the time the options were 
granted). Under an employee stock purchase plan, an employee may not 
purchase stock in anticipation that the option will be outstanding in 
some future year. Thus, the employee may purchase only the amount of 
stock that does not exceed the limitation of this paragraph (i) for the 
year of the purchase and for preceding years during which the option 
was outstanding. Thus, the amount of stock that may be purchased under 
an option depends on the number of years in which the option is 
actually outstanding. The amount of stock that may be purchased under 
an employee stock purchase plan may not be increased by reason of the 
failure to grant an option in an earlier year under such plan, or by 
reason of the failure to exercise an earlier option. For example, if an 
option is granted to an individual and expires without having been 
exercised at all, then the failure to exercise the option does not 
increase the amount of stock which such individual may be permitted to 
purchase under an option granted in a year following the year of such 
expiration. If an option granted under an employee stock purchase plan 
is outstanding in more than one calendar year, then stock purchased 
pursuant to the exercise of such an option will be applied first, to 
the extent allowable under this paragraph (i), against the $25,000 
limitation for the earliest year in which the option was outstanding, 
then, against the $25,000 limitation for each succeeding year, in 
order.
    (5) Examples. The following examples illustrate the principles of 
this paragraph (i):

    Example 1. Assume that Corporation DD maintains an employee 
stock purchase plan and that Employee S is employed by DD. On June 
1, 2010, DD grants S an option under the plan to purchase a total of 
750 shares of DD stock at $85 per share. On that date, the fair 
market value of DD stock is $100 per share. The option provides that 
it may be exercised at any time but cannot be exercised after May 
31, 2012. Under this paragraph (i), the option must not permit S to 
purchase more than 250 shares of DD stock during the calendar year 
2010, because 250 shares are equal to $25,000 in fair market value 
of DD stock determined at the time of grant. During the calendar 
year 2011, S may purchase under the option an amount of DD stock 
equal to the difference between $50,000 in fair market value of DD 
stock (determined at the time the option was granted) and the fair 
market value of DD stock (determined at the time of grant of the 
option) purchased during the year 2010. During the calendar year 
2012, S may purchase an amount of DD stock equal to the difference 
between $75,000 in fair market value of the stock (determined at the 
time of grant of the option) and the total amount of the fair market 
value of the stock (determined at the time of grant of the option) 
purchased under the option during the calendar years 2010 and 2011. 
S may purchase $25,000 of stock for the year 2010, and $25,000 of 
stock for the year 2012, although the option was outstanding for 
only a part of each of such years. However, S may not be granted 
another option under an employee stock purchase plan of DD or a 
related corporation to purchase stock of DD or a related corporation 
during the calendar years 2010, 2011, and 2012, so long as the 
option granted June 1, 2010, is outstanding.
    Example 2.  Assume the same facts as in Example 1, except that 
the option granted to S in 2010 is terminated in 2011 without any 
part of the option having been exercised, and that subsequent to the 
termination and during 2011, S is granted another option under DD's 
employee stock purchase plan. Under that option, S may be permitted 
to purchase $25,000 of stock for 2011. The failure of S to exercise 
the option granted to S in 2010, does not increase the amount of 
stock that S may be permitted to purchase under the option granted 
to S in 2011.
    Example 3. Assume the same facts as in Example 1, except that, 
on May 31, 2012, S exercised the option granted to S in 2010, and 
purchased 600 shares of DD stock. Five hundred shares, the maximum 
amount of stock that could have been purchased in 2011, under the 
option, are treated as having been purchased for the years 2010 and 
2011. Only 100 shares of the stock are treated as having been 
purchased for 2012. After S's exercise of the option on May 31, 
2012, S is granted another option under DD's employee stock purchase 
plan. S may be permitted under the new option to purchase for 2012 
stock having a fair market value of no more than $15,000 at the time 
the new option is granted.
    Example 4.  Corporation EE maintains an employee stock purchase 
plan and Employee R is employed by EE. On August 1, 2010, EE grants 
R an option under the plan to purchase 150 shares of EE stock at $85 
per share during each of the calendar years 2010, 2011, and 2012. On 
that date, the fair market value of EE stock is $100 per share. The 
option provides that it may be exercised at any time during years 
2010, 2011, and 2012. Because this option permits R to purchase only 
$15,000 of EE's stock for each year the option is outstanding, R 
could be granted another option by EE, or by a related corporation, 
in year 2010, permitting R to purchase an additional $10,000 of 
stock during each of the calendar years 2010, 2011, and 2012.
    Example 5.  Corporation FF maintains an employee stock purchase 
plan and Employee Q is employed by FF. On September 1, 2010, FF 
grants Q an option under the plan that will be automatically 
exercised on August 31, 2011, and August 31, 2012. The terms of the 
option provide that no more than 150 shares may be purchased on each 
date that the option is automatically exercised. On August 31, 2011, 
Q may purchase under the option an amount of FF stock equal to 
$50,000 in fair market value of FF stock (determined at the time the 
option was granted). On August 31, 2012, Q may purchase under the 
option an amount of FF stock equal to the difference between $75,000 
in fair market value of Q stock (determined at the time the option 
was granted) and the fair market value of Q stock (determined at the 
time of grant of the option) purchased during year 2011.

    (j) Restriction on transferability. An employee stock purchase plan 
or offering must, by its terms, provide that options granted under the 
plan are not transferable by the optionee other than by will or the 
laws of descent and distribution, and must be exercisable, during the 
optionee's lifetime, only by the optionee. For general rules relating 
to the restriction on transferability required by this paragraph (j), 
see Sec.  1.421-1(b)(2). For a limited exception to the requirement of 
this paragraph (j), see section 424(h)(3).
    (k) Special rule where option price is between 85 percent and 100 
percent of value of stock--(1)(i) If all the conditions necessary for 
the application of section 421(a) exist, this paragraph (k)

[[Page 59086]]

provides additional rules that are applicable in cases where, at the 
time the option is granted, the option price per share is less than 100 
percent (but not less than 85 percent) of the fair market value of the 
share. In that case, upon the disposition of the share by the employee 
after the expiration of the two-year and the one-year holding periods, 
or upon the employee's death while owning the share (whether occurring 
before or after the expiration of such periods), there shall be 
included in the employee's gross income as compensation (and not as 
gain upon the sale or exchange of a capital asset) the lesser of--
    (A) The amount, if any, by which the price paid under the option 
was exceeded by the fair market value of the share at the time the 
option was granted, or
    (B) The amount, if any, by which the price paid under the option 
was exceeded by the fair market value of the share at the time of such 
disposition or death.
    (ii) For purposes of applying the rules of this paragraph (k), if 
the option price is not fixed or determinable at the time the option is 
granted, the option price will be computed as if the option had been 
exercised at such time. The amount of compensation resulting from the 
application of this paragraph (k) shall be included in the employee's 
gross income for the taxable year in which the disposition occurs, or 
for the taxable year closing with the employee's death, whichever event 
results in the application of this paragraph (k).
    (iii) The application of the special rules provided in this 
paragraph (k) shall not affect the rules provided in section 421(a) 
with respect to the employee exercising the option, the employer 
corporation, or a related corporation. Thus, notwithstanding the 
inclusion of an amount as compensation in the gross income of an 
employee, as provided in this paragraph (k), no income results to the 
employee at the time the stock is transferred to the employee, and no 
deduction under section 162 is allowable at any time to the employer 
corporation or a related corporation with respect to such amount.
    (iv) If, during the employee's lifetime, the employee exercises an 
option granted under an employee stock purchase plan, but the employee 
dies before the stock is transferred to the employee pursuant to the 
exercise of the option, then for the purpose of sections 421 and 423, 
on the employee's death, the stock is deemed to be transferred 
immediately to the employee, and immediately thereafter, the employee 
is deemed to have transferred the stock to the employee's executor, 
administrator, trustee, beneficiary by operation of law, heir, or 
legatee, as the case may be.
    (2) If the special rules provided in this paragraph (k) are 
applicable to the disposition of a share of stock by an employee, then 
the basis of the share in the employee's hands at the time of the 
disposition, determined under section 1011, shall be increased by an 
amount equal to the amount includible as compensation in the employee's 
gross income under this paragraph (k). However, the basis of a share of 
stock acquired after the death of an employee by the exercise of an 
option granted to the employee under an employee stock purchase plan 
shall be determined in accordance with the rules of section 421(c) and 
Sec.  1.421-2(c). If the special rules provided in this paragraph (k) 
are applicable to a share of stock upon the death of an employee, then 
the basis of the share in the hands of the estate or the person 
receiving the stock by bequest or inheritance shall be determined under 
section 1014, and shall not be increased by reason of the inclusion 
upon the decedent's death of any amount in the decedent's gross income 
under this paragraph (k). See Example (9) of this paragraph (k) with 
respect to the determination of basis of the share in the hands of a 
surviving joint owner.
    (3) Examples. The following examples illustrate the principles of 
this paragraph (k):

    Example 1. On June 1, 2010, Corporation GG grants to Employee P, 
an employee of GG, an option under GG's employee stock purchase plan 
to purchase a share of GG stock for $85. The fair market value of GG 
stock on such date is $100 per share. On June 1, 2011, P exercises 
the option and on that date GG transfers the share of stock to P. On 
January 1, 2013, P sells the share for $150, its fair market value 
on that date. P's income tax return is filed on the basis of the 
calendar year. The income tax consequences to P and GG are as 
follows--
    (i) Compensation in the amount of $15 is includible in P's gross 
income for the year 2013, the year of the disposition of the share. 
The $15 represents the difference between the option price ($85) and 
the fair market value of the share on the date the option was 
granted ($100), because the value is less than the fair market value 
of the share on the date of disposition ($150). For the purpose of 
computing P's gain or loss on the sale of the share, P's cost basis 
of $85 is increased by $15, the amount includible in P's gross 
income as compensation. Thus, P's basis for the share is $100. 
Because the share was sold for $150, P realizes a gain of $50, which 
is treated as long-term capital gain; and
    (ii) GG is not entitled to any deduction under section 162 at 
any time with respect to the share transferred to P.
    Example 2.  Assume the same facts as in Example 1, except that P 
sells the share of GG stock on January 1, 2014, for $75, its fair 
market value on that date. Because $75 is less than the option price 
($85), no amount in respect of the sale is includible as 
compensation in P's gross income for the year 2014. P's basis for 
determining gain or loss on the sale is $85. Because P sold the 
share for $75, P realized a loss of $10 on the sale that is treated 
as a long-term capital loss.
    Example 3. Assume the same facts as in Example 1, except that 
the option provides that the option price shall be 90 percent of the 
fair market value of the stock on the day the option is exercised. 
On June 1, 2011, when the option is exercised, the fair market value 
of the stock is $120 per share so that P pays $108 for the share of 
the stock. Compensation in the amount of $10 is includible in P's 
gross income for the year 2013, the year of the disposition of the 
share. This is determined in the following manner: The excess of the 
fair market value of the stock at the time of the disposition ($150) 
over the price paid for the share ($108) is $42; and the excess of 
the fair market value of the stock at the time the option was 
granted ($100) over the option price, computed as if the option had 
been exercised at such time ($90), is $10. Accordingly, $10, the 
lesser, is includible in gross income. In this situation, P's cost 
basis of $108 is increased by $10, the amount includible in P's 
gross income as compensation. Thus, P's basis for the share is $118. 
Because the share was sold for $150, P realizes a gain of $32 that 
is treated as long-term capital gain.
    Example 4. Assume the same facts as in Example 1, except that 
the option provides that the option price shall be the lesser of 95 
percent of the fair market value of the stock on the first day of 
the offering period and 95 percent of the fair market value of the 
stock on the day the option is exercised. On June 1, 2011, when the 
option is exercised, the fair market value of the stock is $120 per 
share. P pays $95 for the share of the stock. Compensation in the 
amount of $5 is includible in P's gross income for the year 2013, 
the year of the disposition of the share. This is determined in the 
following manner: The excess of the fair market value of the stock 
at the time of the disposition ($150) over the price paid for the 
share ($95) is $55; and the excess of the fair market value of the 
stock at the time the option was granted ($100) over the option 
price, computed as if the option had been exercised at such time 
($95), is $5. Accordingly, $5, the lesser, is includible in gross 
income. In this situation, P's cost basis of $95 is increased by $5, 
the amount includible in P's gross income as compensation. Thus, P's 
basis for the share is $100. Because the share was sold for $150, P 
realizes a gain of $50 that is treated as long-term capital gain.
    Example 5. Assume the same facts as in Example 1, except that 
instead of selling the share on January 1, 2013, P makes a gift of 
the share on that day. In that case $15 is includible as 
compensation in P's gross income for 2013. P's cost basis of $85 is 
increased by $15, the amount includible in P's gross income as 
compensation. Thus, P's basis for the share is $100, which becomes

[[Page 59087]]

the donee's basis, as of the time of the gift, for determining gain 
or loss.
    Example 6. Assume the same facts as in Example 2, except that 
instead of selling the share on January 1, 2014, P makes a gift of 
the share on that date. Because the fair market value of the share 
on that day ($75) is less than the option price ($85), no amount in 
respect of the disposition by way of gift is includible as 
compensation in P's gross income for 2014. P's basis for the share 
is $85, which becomes the donee's basis, as of the time of the gift, 
for the purpose of determining gain. The donee's basis for the 
purpose of determining loss, determined under section 1015(a), is 
$75 (fair market value of the share at the date of gift).
    Example 7. Assume the same facts as in Example 1, except that 
after acquiring the share of stock on June 1, 2011, P dies on August 
1, 2012, at which time the share has a fair market value of $150. 
Compensation in the amount of $15 is includible in P's gross income 
for the taxable year closing with P's death, $15 being the 
difference between the option price ($85) and the fair market value 
of the share when the option was granted ($100), because such value 
is less than the fair market value at date of death ($150). The 
basis of the share in the hands of P's estate is determined under 
section 1014 without regard to the $15 includible in the decedent's 
gross income.
    Example 8. Assume the same facts as in Example 7, except that P 
dies on August 1, 2011, at which time the share has a fair market 
value of $150. Although P's death occurred within one year after the 
transfer of the share to P, the income tax consequences are the same 
as in Example 7.
    Example 9. Assume the same facts as in Example 1, except that 
the share of stock was issued in the names of P and P's spouse 
jointly with right of survivorship, and that P and P's spouse sold 
the share on June 15, 2012, for $150, its fair market value on that 
date. Compensation in the amount of $15 is includible in P's gross 
income for the year 2012, the year of the disposition of the share. 
The basis of the share in the hands of P and P's spouse for the 
purpose of determining gain or loss on the sale is $100, that is, 
the cost of $85 increased by the amount of $15 includible as 
compensation in P's gross income. The gain of $50 on the sale is 
treated as long-term capital gain, and is divided equally between P 
and P's spouse.
    Example 10. Assume the same facts as in Example 1, except that 
the share of stock was issued in the names of P and P's spouse 
jointly with right of survivorship, and that P predeceased P's 
spouse on August 1, 2012, at which time the share had a fair market 
value of $150. Compensation in the amount of $15 is includible in 
P's gross income for the taxable year closing with his death. See 
Example 7. The basis of the share in the hands of P's spouse as 
survivor is determined under section 1014 without regard to the $15 
includible in the decedent's gross income.
    Example 11. Assume the same facts as in Example 10, except that 
P's spouse predeceased P on July 1, 2012. Section 423(c) does not 
apply in respect of the death of P's spouse. Upon the subsequent 
death of P on August 1, 2012, the income tax consequences in respect 
of P's taxable year closing with the date of P's death, and in 
respect of the basis of the share in the hands of P's estate, are 
the same as in Example 7. If P had sold the share on July 15, 2012 
(after the death of P's spouse), for $150, its fair market value at 
that time, the income tax consequences would be the same as in 
Example 1.

    (l) Effective/applicability date. The regulations under this 
section are effective on November 17, 2009. The regulations under this 
section apply to options granted under an employee stock purchase plan 
on or after January 1, 2010.

0
Par. 6. Section 1.424-1, paragraphs (a)(10) Example 9 (iii) and (g)(1) 
are revised to read as follows:


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

    (a) * * *
    (10) * * *

    Example 9. * * * (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 (in 
this case, Y) must approve the plan within 12 months before or after 
the date of the amendment of the plan. If the stockholders of X (in 
this case, Y) 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).

* * * * *
    (g) Effective/applicability date--(1) In general. Except for Sec.  
1.424-1(a)(10) Example 9 (iii), the regulations under this section are 
effective on August 3, 2004. Section 1.424-1(a)(10) Example 9 (iii) is 
effective on November 17, 2009. Section 1.424-1(a)(10) Example 9 (iii) 
applies to statutory options granted on or after January 1, 2010.
* * * * *

Linda E. Stiff,
Deputy Commissioner for Services and Enforcement.
    Approved: November 9, 2009.

Michael F. Mundaca,
Acting Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. E9-27452 Filed 11-16-09; 8:45 am]
BILLING CODE 4830-01-P