-6-
rights). ISOs and NSOs allow employees to purchase stock at a
fixed price for a specified period of time. ESPP purchase rights
allow employees to purchase stock at a discount through the use
of payroll deductions. ISOs and ESPP purchase rights receive
special tax treatment and are typically not subject to tax when
they are granted or exercised, but the stock acquired pursuant to
the exercise of these options is subject to tax when such stock
is sold.5 NSOs, however, are, pursuant to section 83,6 Property
Transferred in Connection with the Performance of Services,
subject to tax upon exercise unless the option has a readily
ascertainable fair market value.7 Sec. 83(a). If an NSO has a
5 Pursuant to secs. 422 and 423, respectively, ISOs and
ESPP purchase rights are subject to a holding period requirement.
This period begins on the exercise date and ends on the date that
is the later of 2 years after the grant date or 1 year after the
transfer of the share of stock. Secs. 422(a)(1) and 423(a)(1).
If the employee disposes of the stock before the holding period
expires, this disposition will be considered a “disqualifying
disposition”. A disqualifying disposition requires the employee
to recognize ordinary income (i.e., equal to the stock’s market
price on the exercise date over the exercise price) in the
taxable year in which the disposition occurred. Sec. 421(b).
6 Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
7 An option has a readily ascertainable fair market value
if it is actively traded on an established market or the taxpayer
can establish all of the following conditions: (1) The option is
transferable by the optionee; (2) the option is exercisable
immediately in full by the optionee; (3) the option is not
subject to any restriction which has a significant effect on the
fair market value of the option; and (4) the fair market value of
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