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of the stock is characterized as capital gain if the holding
requirements under section 422(a)(1) are satisfied. Secs. 1221
and 1222; sec. 14a.422A-1, Q&A-1, Temporary Income Tax Regs.,
supra.
In order to qualify for capital gain treatment, the
taxpayer must hold the stock he acquires by exercising an ISO for
a period ending no earlier than 2 years after the grant date or 1
year after the transfer of the stock to him. Sec. 422(a)(1).
Selling a share of stock before the holding period expires
results in a disqualifying disposition. Sec. 421(b). If a
disposition is disqualified, recognized gain on the sale of the
stock is characterized as ordinary income up to the fair market
value (FMV) of the stock at the date the option is exercised, and
the balance, if any, is treated as capital gain.8 Sec. 421(b);
sec. 14a.422A-1, Q&A-2(a), Temporary Income Tax Regs., supra.9
8 The gain treated as ordinary income in a disqualifying
disposition is the lesser of: (1) The fair market value of the
stock on the date of exercise minus the option price; or (2) the
amount realized on disposition minus the option price. Sec.
14a.422A-1, Q&A-2(a), Temporary Income Tax Regs., 46 Fed. Reg.
61840 (Dec. 21, 1981).
9 New regulations under sec. 422 became effective Aug. 3,
2004, but are not applicable to the years at issue. Sec. 1.422-
5(f), Income Tax Regs.
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