The treatment of incentive stock options that have been exercised when the employer is acquired during the one year period following exercise of the options is discussed in Chief Counsel Advice 201519031. The key issue is whether the transfer of the shares in the employer for interests in the acquiring company will constitute a disqualifying disposition. And, as with all good tax questions, the answer is “it depends.”

What it depends upon, per this ruling, is whether the transaction qualifies as a tax free corporate reorganization under IRC §368(a).

In general if an employer is issued an incentive stock option then no taxable gain is recognized when the option is exercised and the gain on eventual sale of the shares will be capital gain so long as the taxpayer doesn’t run afoul of the provisions of IRC §422(a)(1).

These requirements are:

No disposition of such share is made by the taxpayer:
- Within 2 years from the date of grant of the option nor
- Within 1 year after the transfer of such share to him, and
At all times during the period beginning on the date of grant of the option and ending on the day three months before the date of such exercise, such individual was an employee of either the corporation granting such option, a parent or subsidiary corporation of such corporation, or a corporation or a parent or subsidiary corporation of such corporation issuing or assuming a stock option in a transfer to which §424(a) applies.

If a taxpayer does not meet these requirements, the difference between the value and the exercise price will be treated as taxable compensation to the recipient—subject to ordinary income rates (as opposed to capital gain rates that would apply to a disposition if the stock were held for the appropriate periods).

The IRS looks at two different corporate acquisitions occurring during the period following the exercise of the option and before the expiration of the one year period.

The first case deals with an acquisition that qualifies as a statutory merger (Type A reorganization under §368(a)). The facts are as follows:

Scenario 1. Corporation X and Corporation Y are unrelated corporations that are incorporated under the laws of State B. On July 1, 2011, Corporation X grants a stock option to A, an employee of Corporation X since January 4, 2011, entitling A to purchase 100 shares of Corporation X voting common stock for $15.00 per share. The stock option qualifies as an incentive stock option, as defined in §422. On December 30, 2011, A exercises the option when the fair market value of Corporation X stock is $25.00 per share, and 100 shares of Corporation X voting common stock are transferred to A on that date.

On January 3, 2012, Corporation X and Corporation Y enter into an agreement (the merger agreement) pursuant to which Corporation Y will acquire Corporation X by forming a new subsidiary (Corporation Z) that will merge with and into Corporation X, with Corporation X surviving (the Merger). Pursuant to the Merger, each outstanding share of Corporation X voting common stock will be converted into one share of Corporation Y voting common stock with a value of $25.00 and $1.50 in cash. The exchange does not have the effect of the distribution of a dividend under §356(a)(2). The stock of Corporation Z will be converted into voting common stock of Corporation X. Corporation Z merges into Corporation X in a transaction that qualifies as a reorganization described in §368(a)(1)(A) by reason of §368(a)(1)(E). Following the Merger, Corporation X continues in existence as a wholly owned subsidiary of Corporation Y. Since January 4, 2011, A and Corporation X have maintained a continuous employment relationship, and on August 1, 2013, A sells the 100 shares of Corporation Y stock for $40.00 per share.

The memo notes that “[s]ection 424(c)(1) and §1.424-1(c) provide that the term ‘disposition’ includes a sale, exchange, gift or a transfer of legal title, but does not include an exchange to which § 354, 355, 356, or 1036 (or so much of §1031 as relates to §1036) applies.”

The memo goes on to note that, with the transaction qualifying as an A reorganization, IRC “§356 applies to the exchange of Corporation X stock for Corporation Y stock plus cash because the exchange would qualify under §354 except for the receipt of cash.” Thus the transaction is not treated as a disposition under the ISO rules.

Therefore the ruling provides the following tax treatment for the employee:

Because A paid $15.00 for each share of Corporation X stock, A's basis in each share of the Corporation X stock is $15.00. Pursuant to §356(a)(1), A recognizes $1.50 of gain for each share of Corporation X stock in the exchange. Because A exchanged 100 shares of Corporation X, A recognizes $150.00 of gain in the exchange. Pursuant to §358(a), A's $15.00 basis in each share of Corporation Y stock received in the exchange is decreased by the $1.50 received by A and increased by the gain of $1.50 recognized by A. A's basis in each share of Corporation Y stock after the exchange is $15.00 and the total basis of A's 100 shares is $1,500.00.

Because the exchange of Corporation X stock for Corporation Y stock is not a disposition of the Corporation X stock, A has satisfied the holding period requirements under §422(a)(1) when A sells the Corporation Y stock. The sale of the shares on August 1, 2013 is a qualifying disposition and A recognizes $2,500.00 ($4,000.00 sale price - $1,500.00 basis) of capital gain.

However what happens if the corporate acquisition is not structured to comply with the requirements of §368(a) to be a tax free reorganization? As you might expect, the results are quite as good for the employee.

Scenario 2 considers this issue:

Scenario 2. Assume the same facts as in Scenario 1, except that each share of Corporation X common stock is converted into one share of Corporation Y common stock with a value of $16.50 and $10.00 in cash. The transaction does not meet the requirements of §368(a)(2)(E)(ii) because shareholders of Corporation X did not exchange for Corporation Y stock voting stock of Corporation X that constitutes control (80 percent) of Corporation X, but rather exchanged more than 20 percent of Corporation X's stock for cash. As a result the transaction does not qualify as a reorganization under §368(a)(1)(A) by reason of §368(a)(2)(E), or any other provision of §368(a).

The memo notes, given there is no qualified reorganization, that “[b]ecause neither §354 nor §356 applies to the exchange, there is a disposition within the meaning of §424(c)(1) of the Corporation X stock held by A and §1001 applies to the exchange.” Or, to put it in simpler terms, A has a disqualifying disposition of the ISO shares.

The IRS details the results below:

Because §1001 applies to the exchange, A recognizes gain on the disposition of the Corporation X stock in the amount of $1,150.00 ($1,650.00 fair market value of Corporation Y stock ($16.50 per share x 100 shares) plus $1,000.00 ($10.00 per share x 100 shares) less $1,500.00 basis in the Corporation X stock)). The exchange is a disqualifying disposition because A has not satisfied the holding period requirements in §422(a)(1) at the time of the exchange. Therefore, on the date of the exchange, A must include in gross income $1,150.00, which includes $1,000 as compensation ($2,500.00 fair market value of Corporation X stock on the date of exercise of the option - $1,500.00 exercise price for the Corporation X stock) and $150.00 as capital gain. A's basis in the 100 shares of Corporation Y stock is $1,650.00 ($16.50 per share). A recognizes a capital gain when A sells 100 shares of Corporation Y stock for $40.00 per share. Pursuant to §1001, the amount of the gain is $2,350.00.