500K ISO installment sale treatment

[Bay ArEA]

I have a case that I’m not sure about, I’d appreciate it if any of you could please tell me if I’m doing it right. Client has ISO’s in a small business that just got sold. He held the options for five years, then had them exercised and sold to the buyer on the day of sale of the company. Nothing is reported on the w-2 but he did get a 3921 showing the option information.
The buyer only is paying 90% of the sale price in 2013, and the remaining 10% in 2015. The total sale price is around 500K. From what my understanding is, because he did hold the stock option for two years after the grant date, it qualifies for the ISO capital gain treatment, but because it exceeds 100K in one year, most of it does not, and is instead ordinary income.
What my understanding is, is that for the portion that is capital gain, I have an installment sale. For the portion that is ordinary income, since the sale price and stock basis are the same amount, there is no gain on the installment sale as all tax will be paid this year, so I might as well leave it off. Also they don't qualify for any small business stock benefits as they only held the options. Does this seem right to you folks, or do I just have my brain in a knot?

[Gary2]

but because it exceeds 100K in one year, most of it does not, and is instead ordinary income.

I don't see that in the ISO discussion in Pub. 525. Am I missing something?

[Bay ArEA]

I don't see that in the ISO discussion in Pub. 525. Am I missing something?

I pulled that part from TTB page 6/18 "100,000 per year limitation" IRC 422 D 1

"To the extent that the aggregate fair market value of stock with respect to which incentive stock options (determined without regard to this subsection) are exercisable for the 1st time by any individual during any calendar year (under all plans of the individual’s employer corporation and its parent and subsidiary corporations) exceeds $100,000, such options shall be treated as options which are not incentive stock options. "

http://www.law.cornell.edu/uscode/text/26/422

[Bay ArEA]

Actually IRC 422 A 1 In there says "no disposition of such share is made by him within 2 years from the date of the granting of the option nor within 1 year after the transfer of such share to him, and ..."

I thought it was an "or" thing, but it looks like it is a "nor" thing so that makes me think none of it qualifies for ISO treatment now, since it was all sold the day of exercise. So 100% would be taxable ordinary income, with no capital gain, even though they are not getting all of it this year.

However Pub 525 says
"Holding period requirement. You satisfy the holding period requirement if you do not sell the stock until the end of the later of the 1-year period after the stock was transferred to you or the 2-year period after the option was granted. However, you are considered to satisfy the holding period requirement if you sold the stock to comply with conflict-of-interest requirements. "

Which DOES say "or" which seems to conflict with the code. I believe in a conflict the code wins though so ¯\(°_o)/¯

[Gary2]

I pulled that part from TTB page 6/18 "100,000 per year limitation" IRC 422 D 1

"To the extent that the aggregate fair market value of stock with respect to which incentive stock options (determined without regard to this subsection) are exercisable for the 1st time by any individual during any calendar year (under all plans of the individual’s employer corporation and its parent and subsidiary corporations) exceeds $100,000, such options shall be treated as options which are not incentive stock options. "
http://www.law.cornell.edu/uscode/text/26/422

I believe the operative word is exercisable, which is not the same as exercised. If you look at (d)(3), you'll see that it explicitly says the FMV is determined as of the time of grant, not the time of exercise. It's possible that either the employee or the employer erred in labeling this an ISO, but regardless, that determination should have been made earlier. (At least that's my reading; I welcome corrections.)

Actually IRC 422 A 1 In there says "no disposition of such share is made by him within 2 years from the date of the granting of the option nor within 1 year after the transfer of such share to him, and ..."

I thought it was an "or" thing, but it looks like it is a "nor" thing so that makes me think none of it qualifies for ISO treatment now, since it was all sold the day of exercise. So 100% would be taxable ordinary income, with no capital gain, even though they are not getting all of it this year.

However Pub 525 says
"Holding period requirement. You satisfy the holding period requirement if you do not sell the stock until the end of the later of the 1-year period after the stock was transferred to you or the 2-year period after the option was granted. However, you are considered to satisfy the holding period requirement if you sold the stock to comply with conflict-of-interest requirements. "

Which DOES say "or" which seems to conflict with the code. I believe in a conflict the code wins though so ¯\(°_o)/¯

I think you're misusing the common terminology, which is causing you to misunderstand the benefits of an ISO - although your conclusion is more or less correct. Failure to satisfy the holding period requirement doesn't mean you lose ISO treatment. It just means you have a disqualifying disposition of ISO shares.

One of the benefits of an ISO, as compared to a non-statutory stock option, is that the employee doesn't have to recognize any income at the time of the grant. With non-statutory stock options, there can be income at the time of the grant, even if it isn't exercised for several years and kept without selling for several more years. This benefit doesn't disappear with a disqualifying disposition.

In this case, ignoring the $100K issue, you would have a disqualifying disposition of an ISO. Since it's a same-day sale, the capital gain portion will be 0 (assuming the sale prices establishes the FMV for the day), and all the gain will be ordinary - and should be included in the W-2. But note that if he had held it for six months, and the price rose, there would be (short term) capital gains, in spite of it being a disqualifying disposition.

[Bay ArEA]

I believe the operative word is exercisable, which is not the same as exercised. If you look at (d)(3), you'll see that it explicitly says the FMV is determined as of the time of grant, not the time of exercise. It's possible that either the employee or the employer erred in labeling this an ISO, but regardless, that determination should have been made earlier. (At least that's my reading; I welcome corrections.)


I think you're misusing the common terminology, which is causing you to misunderstand the benefits of an ISO - although your conclusion is more or less correct. Failure to satisfy the holding period requirement doesn't mean you lose ISO treatment. It just means you have a disqualifying disposition of ISO shares.

One of the benefits of an ISO, as compared to a non-statutory stock option, is that the employee doesn't have to recognize any income at the time of the grant. With non-statutory stock options, there can be income at the time of the grant, even if it isn't exercised for several years and kept without selling for several more years. This benefit doesn't disappear with a disqualifying disposition.

In this case, ignoring the $100K issue, you would have a disqualifying disposition of an ISO. Since it's a same-day sale, the capital gain portion will be 0 (assuming the sale prices establishes the FMV for the day), and all the gain will be ordinary - and should be included in the W-2. But note that if he had held it for six months, and the price rose, there would be (short term) capital gains, in spite of it being a disqualifying disposition.

Thanks for showing me the distinction between a disqualifying disposition of an ISO and a non-statutory stock option. Yeah it looks like the company did not handle things right when they left this off of the w-2, and I know they did that company wide. I'll just have to list it as ordinary income on line 7. Thanks so much for helping me with this!