August 4, 2004
BB 04—86

Final Incentive Stock Option Guidance and Request for Comments on Employee Stock Purchase Plans

On August 2, the Internal Revenue Service (IRS) and the Treasury Department (Treasury) issued final regulations on incentive stock options (ISOs). The regulations finalize, with modest changes, regulations that were proposed in June 2003. The IRS and Treasury also issued Notice 2004-55 requesting comments on whether the final rules governing Employee Stock Purchase Plans (ESPPs) should be amended, and if so, what issues should be addressed or clarified.

ISOs allow employees to acquire employer stock without taxable income when the option is exercised. If the employer and employee meet the statutory and regulatory requirements applicable to ISOs (including a minimum holding period), any gains on the sale of the stock are taxed at long-term capital gains rates but the employer is not entitled to a deduction. The final regulations contain a number of minor changes to the proposed regulations, including rules related to the maximum number of ISOs that can be granted to an employee. Plans must still designate the maximum aggregate number of shares that may be issued under the plan through ISOs but are no longer required to include the maximum number of shares that may be issued pursuant to nonstatutory stock options or other stock-based awards. In addition, if the employee uses a portion of the shares to exercise an option, only the net number of shares issued pursuant to the exercise of the ISO are counted against the maximum number of shares. (Example: exercise price of an option to purchase 100 shares equals the value of 20 shares and employee uses 20 of the 100 shares to pay the exercise price, only 80 shares are counted against the maximum aggregate number of shares.)

The final regulations are effective August 3, 2004. However, for ISOs granted prior to January 1, 2006, the plan can choose to rely on the 2003 proposed regulations, and for ISOs granted on or before June 9, 2003, the plan can also choose to rely on regulations proposed in 1984. Reliance on the final regulations, the 2003 proposed regulations, or the 1984 proposed regulations must be in its entirety and all statutory options granted during the reliance period must be treated consistently.

In Notice 2004-55, Treasury and the IRS note they have received questions concerning whether the final regulations concerning options granted under an ESPP should be interpreted consistently with the proposed ISO regulations. The notice includes eight specific questions and the IRS and Treasury encourage comments on these and other issues that should be addressed or clarified in the final ESPP regulations.

For more information on ISOs or ESPPs, contact Jan Jacobson, the Council's director, retirement policy, at (202) 289-6700.