--- kind: "range" citation: "26 C.F.R. §§ 1.421-1–1.424-1" title: "26" from: "1.421-1" to: "1.424-1" count: 10 url: "https://uscodex.org/cfr/26/1.421-1..1.424-1" --- # §1.421-1. Meaning and use of certain terms. - (a) **Option.** - (1) For purposes of this section and [§§ 1.421-2 through 1.424-1](/cfr/26/1.421-2..1.424-1.md), the term “option” means the right or privilege of an individual to purchase stock from a corporation by virtue of an offer of the corporation continuing for a stated period of time, whether or not irrevocable, to sell such stock at a price determined under [paragraph (e)](#e) of this section, such individual being under no obligation to purchase. The individual who has such right or privilege is referred to as the optionee and the corporation offering to sell stock under such an arrangement is referred to as the optionor. While no particular form of words is necessary, the option must express, among other things, an offer to sell at the option price, the maximum number of shares purchasable under the option, and the period of time during which the offer remains open. The term option includes a warrant that meets the requirements of this [paragraph (a)(1)](#a-1). - (2) An option may be granted as part of or in conjunction with an employee stock purchase plan or subscription contract. See [section 423](/cfr/26/423.md). - (3) An option must be in writing (in paper or electronic form), provided that such writing is adequate to establish an option right or privilege that is enforceable under applicable law. - (b) **Statutory options.** - (1) The term statutory option, for purposes of this section and [§§ 1.421-2 through 1.424-1](/cfr/26/1.421-2..1.424-1.md), means an incentive stock option, as defined in [§ 1.422-2(a)](/cfr/26/1.422-2.md?p=a), or an option granted under an employee stock purchase plan, as defined in [§ 1.423-2](/cfr/26/1.423-2.md). - (2) An option qualifies as a statutory option only if the option is not transferable (other than by will or by the laws of descent and distribution) by the individual to whom the option was granted, and is exercisable, during the lifetime of such individual, only by such individual. See §§ [1.422-2(a)(2)(v)](/cfr/26/1.422-2.md?p=a-2-v) and [1.423-2(j)](/cfr/26/1.423-2.md?p=j). Accordingly, an option which is transferable or transferred by the individual to whom the option is granted during such individual's lifetime, or is exercisable during such individual's lifetime by another person, is not a statutory option. However, if the option or the plan under which the option was granted contains a provision permitting the individual to designate the person who may exercise the option after such individual's death, neither such provision, nor a designation pursuant to such provision, disqualifies the option as a statutory option. A pledge of the stock purchasable under an option as security for a loan that is used to pay the option price does not cause the option to violate the nontransferability requirements of this [paragraph (b)](#b). Also, the transfer of an option to a trust does not disqualify the option as a statutory option if, under [section 671](/cfr/26/671.md) and applicable State law, the individual is considered the sole beneficial owner of the option while it is held in the trust. If an option is transferred incident to divorce (within the meaning of [section 1041](/cfr/26/1041.md)) or pursuant to a domestic relations order, the option does not qualify as a statutory option as of the day of such transfer. For the treatment of nonstatutory options, see [§ 1.83-7](/cfr/26/1.83-7.md). - (3) - (i) The determination of whether an option is a statutory option is made as of the date such option is granted. An option which is a statutory option when granted does not lose its character as such an option by reason of subsequent events, and an option which is not a statutory option when granted does not become such an option by reason of subsequent events. See, however, [paragraph (e)](/cfr/26/1.424-1.md?p=e) of § 1.424-1, relating to modification, extension, or renewal of an option. For rules concerning options that are not statutory options, see [§ 1.83-7](/cfr/26/1.83-7.md). - (ii) The application of this subparagraph may be illustrated by the following examples: - (c) **Time and date of granting option.** - (1) For purposes of this section and [§§ 1.421-2 through 1.424-1](/cfr/26/1.421-2..1.424-1.md), the language “the date of the granting of the option” and “the time such option is granted,” and similar phrases refer to the date or time when the granting corporation completes the corporate action constituting an offer of stock for sale to an individual under the terms and conditions of a statutory option. Except as set forth in [§ 1.423-2(h)(2)](/cfr/26/1.423-2.md?p=h-2), a corporate action constituting an offer of stock for sale is not considered complete until the date on which the maximum number of shares that can be purchased under the option and the minimum option price are fixed or determinable. - (2) If the corporation imposes conditions on the granting of an option (as distinguished from conditions governing the exercise of the option), such conditions shall be given effect in accordance with the intent of the corporation. However, under [section 424(i)](/cfr/26/424.md?p=i), if the grant of an option is subject to approval by stockholders, the date of grant of the option shall be determined as if the option had not been subject to such approval. A condition which does not require corporate action, such as the approval of, or registration with, some regulatory or governmental agency, for example, a stock exchange or the Securities and Exchange Commission, is ordinarily considered a condition upon the exercise of the option unless the corporate action clearly indicates that the option is not to be granted until such condition is satisfied. If an option is granted to an individual upon the condition that such individual will become an employee of the corporation granting the option or of a related corporation, such option is not granted prior to the date the individual becomes such an employee. - (3) In general, conditions imposed upon the exercise of an option will not operate to make ineffective the granting of the option. For example, on June 1, 2004, the A Corporation grants to X, an employee, an option to purchase 5,000 shares of the corporation's stock, exercisable by X on or after June 1, 2005, provided he is employed by the corporation on June 1, 2005, and provided that A's profits during the fiscal year preceding the year of exercise exceed $200,000. Such an option is granted to X on June 1, 2004, and will be treated as outstanding as of such date. - (d) **Stock and voting stock.** - (1) For purposes of this section and [§§ 1.421-2 through 1.424-1](/cfr/26/1.421-2..1.424-1.md), the term stock means capital stock of any class, including voting or nonvoting common or preferred stock. Except as otherwise provided, the term includes both treasury stock and stock of original issue. Special classes of stock authorized to be issued to and held by employees are within the scope of the term stock as used in such sections, provided such stock otherwise possesses the rights and characteristics of capital stock. - (2) For purposes of determining what constitutes voting stock in ascertaining whether a plan has been approved by stockholders under § [1.422-2(b)](/cfr/26/1.422-2.md?p=b) or [1.423-2(c)](/cfr/26/1.423-2.md?p=c) or whether the limitations pertaining to voting power contained in §§ [1.422-2(f)](/cfr/26/1.422-2.md?p=f) and [1.423-2(d)](/cfr/26/1.423-2.md?p=d) have been met, stock which does not have voting rights until the happening of an event, such as the default in the payment of dividends on preferred stock, is not voting stock until the happening of the specified event. Generally, stock which does not possess a general voting power, and may vote only on particular questions, is not voting stock. However, if such stock is entitled to vote on whether a stock option plan may be adopted, it is voting stock. - (3) In general, for purposes of this section and [§§ 1.421-2 through 1.424-1](/cfr/26/1.421-2..1.424-1.md), ownership interests other than capital stock are considered stock. - (e) **Option price.** - (1) For purposes of this section and [§§ 1.421-2 through 1.424-1](/cfr/26/1.421-2..1.424-1.md), the term option price, price paid under the option, or exercise price means the consideration in cash or property which, pursuant to the terms of the option, is the price at which the stock subject to the option is purchased. The term option price does not include any amounts paid as interest under a deferred payment arrangement or treated as interest. - (2) Any reasonable valuation method may be used to determine whether, at the time the option is granted, the option price satisfies the pricing requirements of sections [422(b)(4)](/cfr/26/422.md?p=b-4), [422(c)(5)](/cfr/26/422.md?p=c-5), [422(c)(7)](/cfr/26/422.md?p=c-7), and [423(b)(6)](/cfr/26/423.md?p=b-6) with respect to the stock subject to the option. Such methods include, for example, the valuation method described in [§ 20.2031-2](/cfr/26/20.2031-2.md) of this chapter (Estate Tax Regulations). - (f) **Exercise.** For purposes of this section and §§ [1.421-2 through 1](/cfr/26/1.421-2..1.md),[424-1](/cfr/26/424-1.md), the term “exercise”, when used in reference to an option, means the act of acceptance by the optionee of the offer to sell contained in the option. In general, the time of exercise is the time when there is a sale or a contract to sell between the corporation and the individual. A promise to pay the option price does not constitute an exercise of the option unless the optionee is subject to personal liability on such promise. An agreement or undertaking by the employee to make payments under a stock purchase plan does not constitute the exercise of an option to the extent the payments made remain subject to withdrawal by or refund to the employee. - (g) **Transfer.** For purposes of this section and [§§ 1.421-2 through 1.424-1](/cfr/26/1.421-2..1.424-1.md), the term “transfer”, when used in reference to the transfer to an individual of a share of stock pursuant to his exercise of a statutory option, means the transfer of ownership of such share, or the transfer of substantially all the rights of ownership. Such transfer must, within a reasonable time, be evidenced on the books of the corporation. For purposes of [section 422](/cfr/26/422.md), a transfer may occur even if a share of stock is subject to a substantial risk of forfeiture or is not otherwise transferable immediately after the date of exercise. See [§ 1.422-1(b)(3)](/cfr/26/1.422-1.md?p=b-3) Example 2. A transfer does not fail to occur merely because, under the terms of the arrangement, the individual may not dispose of the share for a specified period of time, or the share is subject to a right of first refusal or a right to reacquire the share at the share's fair market value at the time of sale. - (h) **Employment relationship.** - (1) An option is a statutory option only if, at the time the option is granted, the optionee is an employee of the corporation granting the option, or a related corporation of such corporation. If the option has been assumed or a new option has been substituted in its place under [§ 1.424-1(a)](/cfr/26/1.424-1.md?p=a), the optionee must, at the time of such substitution or assumption, be an employee (or a former employee within the 3-month period following termination of the employment relationship) of the corporation so substituting or assuming the option, or a related corporation of such corporation. The determination of whether the optionee is an employee at the time the option is granted (or at the time of the substitution or assumption under [§ 1.424-1(a)](/cfr/26/1.424-1.md?p=a)) is made in accordance with [section 3401(c)](/cfr/26/3401.md?p=c) and the regulations thereunder. As to the granting of an option conditioned upon employment, see [paragraph (c)(2)](#c-2) of this section. A statutory option must be granted for a reason connected with the individual's employment by the corporation or by its related corporation. - (2) In addition, [§ 1.421-2(a)](/cfr/26/1.421-2.md?p=a) is applicable to the transfer of a share pursuant to the exercise of the statutory option only if the optionee is, at all times during the period beginning with the date of the granting of such option and ending on the day 3 months before the date of such exercise, an employee of either the corporation granting such option, a related corporation of such corporation, or a corporation (or a related corporation of such corporation) substituting or assuming a stock option in a transaction to which [§ 1.424-1(a)](/cfr/26/1.424-1.md?p=a) applies. For purposes of the preceding sentence, the employment relationship is treated as continuing intact while the individual is on military leave, sick leave, or other bona fide leave of absence (such as temporary employment by the Government) if the period of such leave does not exceed 3 months, or if longer, so long as the individual's right to reemployment with the corporation granting the option (or a related corporation of such corporation) or a corporation (or a related corporation of such corporation) substituting or assuming a stock option in a transaction to which [§ 1.424-1(a)](/cfr/26/1.424-1.md?p=a) applies, is provided either by statute or by contract. If the period of leave exceeds 3 months and the individual's right to reemployment is not provided either by statute or by contract, the employment relationship is deemed to terminate on the first day immediately following such three-month period. Thus, if the option is not exercised before such deemed termination of employment, [§ 1.421-2(a)](/cfr/26/1.421-2.md?p=a) applies to the transfer of a share pursuant to an exercise of the option only if the exercise occurs within 3 months from the date the employment relationship is deemed terminated. - (3) For purposes of determining whether an individual meets the requirements of this paragraph, the term “employer corporation”, as used in section [424 (e)](/cfr/26/424.md?p=e) and [(f)](/cfr/26/424.md?p=f), shall be read as “grantor corporation” or “corporation issuing or assuming a stock option in a transaction to which [section 424(a)](/cfr/26/424.md?p=a) is applicable”, as the case may be. For purposes of the employment requirement, a corporation employing an optionee is considered a related corporation if it was a parent or subsidiary of the corporation granting the option or substituting or assuming the option during the entire portion of the requisite period of employment during which it was the employer of such optionee. - (4) The application of this paragraph may be illustrated by the following examples: - (i) **Additional definitions.** - (1) **Corporation.** For purposes of this section and [§§ 1.421-2 through 1.424-1](/cfr/26/1.421-2..1.424-1.md), the term corporation has the meaning prescribed by [section 7701(a)(3)](/cfr/26/7701.md?p=a-3) and [§ 301.7701-2(b)](/cfr/26/301.7701-2.md?p=b) of this chapter. For example, a corporation for purposes of the preceding sentence includes an S corporation (as defined in [section 1361](/cfr/26/1361.md)), a foreign corporation (as defined in [section 7701(a)(5)](/cfr/26/7701.md?p=a-5)), and a limited liability company that is treated as a corporation for all Federal tax purposes. - (2) **Parent corporation and subsidiary corporation.** For the definition of the terms parent corporation (and parent) and subsidiary corporation (and subsidiary), for purposes of this section and [§§ 1.421-2 through 1.424-1](/cfr/26/1.421-2..1.424-1.md), see § [1.424-1(f)(i)](/cfr/26/1.424-1.md?p=f-i) and [(ii)](/cfr/26/1.424-1.md?p=f-ii), respectively. Related corporation as used in this section and in [§§ 1.421-2 through 1.424-1](/cfr/26/1.421-2..1.424-1.md) means either a parent corporation or subsidiary corporation. - (j) **Effective/applicability date—** - (1) **In general.** Except for [paragraph (c)(1)](#c-1) of this section, the regulations under this section are effective on August 3, 2004. [Paragraph (c)(1)](#c-1) of this section is effective on November 17, 2009. [Paragraph (c)(1)](#c-1) of this section applies to statutory options granted on or after January 1, 2010. - (2) **Reliance and transition period.** For statutory options granted on or before June 9, 2003, taxpayers may rely on the 1984 proposed regulations LR-279-81 (49 FR 4504), the 2003 proposed regulations REG-122917-02 (68 FR 34344), or this section until the earlier of January 1, 2006, or the first regularly scheduled stockholders meeting of the granting corporation occurring 6 months after August 3, 2004. For statutory options granted after June 9, 2003, and before the earlier of January 1, 2006, or the first regularly scheduled stockholders meeting of the granting corporation occurring at least 6 months after August 3, 2004, taxpayers may rely on either REG-122917-02 or this section. Taxpayers may not rely on LR-279-81 or REG-122917-02 after December 31, 2005. Reliance on LR-279-81, REG-122917-02, or this section must be in its entirety, and all statutory options granted during the reliance period must be treated consistently. # §1.421-2. General rules. - (a) **Effect of qualifying transfer.** - (1) If a share of stock is transferred to an individual pursuant to the individual's exercise of a statutory option, and if the requirements of [§ 1.422-1(a)](/cfr/26/1.422-1.md?p=a) (relating to incentive stock options) or [§ 1.423-1(a)](/cfr/26/1.423-1.md?p=a) (relating to employee stock purchase plans) whichever is applicable, are met, then— - (i) No income results under [section 83](/cfr/26/83.md) at the time of the transfer of such share to the individual upon the exercise of the option with respect to such share; - (ii) No deduction under sections [83(h)](/cfr/26/83.md?p=h) or [162](/cfr/26/162.md) or the regulations thereunder (relating to trade or business expenses) is allowable at any time with respect to the share so transferred; and - (iii) No amount other than the price paid under the option is considered as received by the employer corporation, a related corporation of such corporation, or a corporation substituting or assuming a stock option in a transaction to which [§ 1.424-1(a)](/cfr/26/1.424-1.md?p=a) (relating to corporate reorganizations, liquidations, etc.) applies, for the share so transferred. - (2) For the purpose of this paragraph, each share of stock transferred pursuant to a statutory option is treated separately. For example, if an individual, while employed by a corporation granting him a statutory option, exercises the option with respect to part of the stock covered by the option, and if such individual exercises the balance of the option more than three months after leaving such employment, the application of [section 421](/cfr/26/421.md) to the stock obtained upon the earlier exercise of the option is not affected by the fact that the income taxes of the employer and the individual with respect to the stock obtained upon the later exercise of the option are not determined under [section 421](/cfr/26/421.md). - (b) **Effect of disqualifying disposition.** - (1) - (i) The disposition (as defined in [§ 1.424-1(c)](/cfr/26/1.424-1.md?p=c)) of a share of stock acquired by the exercise of a statutory option before the expiration of the applicable holding periods as determined under § [1.422-1(a)](/cfr/26/1.422-1.md?p=a) or [1.423-1(a)](/cfr/26/1.423-1.md?p=a) is a disqualifying disposition and makes [paragraph (a)](#a) of this section inapplicable to the transfer of such share. See [section 83(a)](/cfr/26/83.md?p=a) to determine the amount includible on a disqualifying disposition. The income attributable to such transfer (determined without reduction for any brokerage fees or other costs paid in connection with the disposition) is treated by the individual as compensation income received in the taxable year in which such disqualifying disposition occurs. A deduction attributable to such transfer is allowable, to the extent otherwise allowable under [section 162](/cfr/26/162.md), for the taxable year in which such disqualifying disposition occurs to the employer corporation, or a related corporation of such corporation, or a corporation substituting or assuming an option in a transaction to which [§ 1.424-1(a)](/cfr/26/1.424-1.md?p=a) applies. Additionally, the amount allowed as a deduction must be determined as if the requirements of [section 83(h)](/cfr/26/83.md?p=h) and [§ 1.83-6(a)](/cfr/26/1.83-6.md?p=a) apply. No amount is treated as income, and no amount is allowed as a deduction, for any taxable year other than the taxable year in which the disqualifying disposition occurs. If the amount realized on the disposition exceeds (or is less than) the sum of the amount paid for the share and the amount of compensation income recognized as a result of such disposition, the extent to which the difference is treated as gain (or loss) is determined under the rules of section [302](/cfr/26/302.md) or [1001](/cfr/26/1001.md), as applicable. - (ii) **The following examples illustrate the principles of this paragraph (b)—** - (2) If an optionee transfers stock acquired through the optionee's exercise of a statutory option prior to the expiration of the applicable holding periods, [paragraph (a)](#a) of this section continues to apply to the transfer of the stock pursuant to the exercise of the option if such transfer is not a disposition of the stock as defined in [§ 1.424-1(c)](/cfr/26/1.424-1.md?p=c) (for example, a transfer from a decedent to the decedent's estate or a transfer by bequest or inheritance). Similarly, a subsequent transfer by the executor, administrator, heir, or legatee is not a disqualifying disposition by the decedent. If a statutory option is exercised by the estate of the optionee or by a person who acquired the option by bequest or inheritance or by reason of the death of such optionee, see [paragraph (c)](#c) of this section. If a statutory option is exercised by the individual to whom the option was granted and the individual dies before the expiration of the holding periods, see [paragraph (d)](#d) of this section. - (3) For special rules relating to the disqualifying disposition of a share of stock acquired by exercise of an incentive stock option, see §§ [1.422-5(b)(2)](/cfr/26/1.422-5.md?p=b-2) and [1.424-1(c)(3)](/cfr/26/1.424-1.md?p=c-3). - (c) **Exercise by estate.** - (1) If a statutory option is exercised by the estate of the individual to whom the option was granted (or by any person who acquired such option by bequest or inheritance or by reason of the death of such individual), [paragraph (a)](#a) of this section applies to the transfer of stock pursuant to such exercise in the same manner as if the option had been exercised by the deceased optionee. Consequently, neither the estate nor such person is required to include any amount in gross income as a result of a transfer of stock pursuant to the exercise of the option. [Paragraph (a)](#a) of this section applies even if the executor, administrator, or such person disposes of the stock so acquired before the expiration of the applicable holding periods as determined under § [1.422-1(a)](/cfr/26/1.422-1.md?p=a) or [1.423-1(a)](/cfr/26/1.423-1.md?p=a). This special rule does not affect the applicability of [section 423(c)](/cfr/26/423.md?p=c), relating to the estate's or other qualifying person's recognition of compensation income, or [section 1222](/cfr/26/1222.md), relating to what constitutes a short-term and long-term capital gain or loss. [Paragraph (a)](#a) of this section also applies even if the executor, administrator, or such person does not exercise the option within three months after the death of the individual or is not employed as described in [§ 1.421-1(h)](/cfr/26/1.421-1.md?p=h), either when the option is exercised or at any time. However, [paragraph (a)](#a) of this section does not apply to a transfer of shares pursuant to an exercise of the option by the estate or by such person unless the individual met the employment requirements described in [§ 1.421-1(h)](/cfr/26/1.421-1.md?p=h) either at the time of the individual's death or within three months before such time (or, if applicable, within the period described in [§ 1.422-1(a)(3)](/cfr/26/1.422-1.md?p=a-3)). Additionally, [paragraph (a)](#a) of this section does not apply if the option is exercised by a person other than the executor or administrator, or other than a person who acquired the option by bequest or inheritance or by reason of the death of such deceased individual. For example, if the option is sold by the estate, [paragraph (a)](#a) of this section does not apply to the transfer of stock pursuant to an exercise of the option by the buyer, but if the option is distributed by the administrator to an heir as part of the estate, [paragraph (a)](#a) of this section applies to the transfer of stock pursuant to an exercise of the option by such heir. - (2) Any transfer by the estate, whether a sale, a distribution of assets, or otherwise, of the stock acquired by its exercise of the option under this paragraph is a disposition of the stock for purposes of [section 423(c)](/cfr/26/423.md?p=c). Therefore, if [section 423(c)](/cfr/26/423.md?p=c) is applicable, the estate must include an amount as compensation in its gross income. Similarly, if [section 423(c)](/cfr/26/423.md?p=c) is applicable in case of an exercise of the option under this paragraph by a person who acquired the option by bequest or inheritance or by reason of the death of the individual to whom the option was granted, there must be included in the gross income of such person an amount as compensation, either when such person disposes of the stock, or when he dies owning the stock. - (3) - (i) If, under [section 423(c)](/cfr/26/423.md?p=c) an amount is required to be included in the gross income of the estate or of such person, the estate or such person shall be allowed a deduction as a result of the inclusion of the value of the option in the estate of the individual to whom the option was granted. Such deduction shall be computed under [section 691(c)](/cfr/26/691.md?p=c) by treating the option as an item of gross income in respect of a decedent under [section 691](/cfr/26/691.md) and by treating the amount required to be included in gross income under [section 423(c)](/cfr/26/423.md?p=c) as an amount included in gross income under [section 691](/cfr/26/691.md) in respect of such item of gross income. No such deduction shall be allowable with respect to any amount other than an amount includible under [section 423(c)](/cfr/26/423.md?p=c). For the rules relating to the computation of a deduction under [section 691(c)](/cfr/26/691.md?p=c), see [§ 1.691(c)-1](/cfr/26/1.691..1.md). - (ii) The application of subdivision (i) may be illustrated by the following example: - (4) - (i) (a) In the case of the death of an optionee, the basis of any share of stock acquired by the exercise of an option under this [paragraph (c)](#c), determined under [section 1011](/cfr/26/1011.md), shall be increased by an amount equal to the portion of the basis of the option attributable to such share. For example, if a statutory option to acquire 10 shares of stock has a basis of $100, the basis of one share acquired by a partial exercise of the option, determined under [section 1011](/cfr/26/1011.md), would be increased by 1/10th of $100, or $10. The option acquires a basis, determined under [section 1014(a)](/cfr/26/1014.md?p=a) or under [section 1022](/cfr/26/1022.md), if applicable, only if the transfer of the share pursuant to the exercise of such option qualifies for the special tax treatment provided by [section 421(a)](/cfr/26/421.md?p=a). To the extent the option is so exercised, in whole or in part, it will acquire a basis equal to its fair market value (or the basis as determined under [section 1022](/cfr/26/1022.md), if applicable) at the date of the employee's death or, if an election is made under [section 2032](/cfr/26/2032.md), its value at its applicable valuation date. In certain cases, the basis of the share is subject to the adjustments provided by paragraphs (c)(4)(i)(b) and (c) of this section, but such adjustments are only applicable in the case of an option that is subject to [section 423(c)](/cfr/26/423.md?p=c). (b) If the amount which would have been includible in gross income under [section 423(c)](/cfr/26/423.md?p=c) had the employee exercised the option on the date of his death and held the share at the time of his death exceeds the amount which is includible in gross income under such section, the basis of the share, determined under (a) of this subdivision, shall be reduced by such excess. For example, if $15 would have been includible in the gross income of the employee had he exercised the option and held such share at the time of his death, and only $10 is includible under [section 423(c)](/cfr/26/423.md?p=c), the basis of the share, determined under (a) of this subdivision, would be reduced by $5. For purposes of determining the amount which would have been includible in gross income under [section 423(c)](/cfr/26/423.md?p=c), if the employee had exercised the option and held such share at the time of his death, the amount which would have been paid for the share shall be computed as if the option had been exercised on the date the employee died. (c) If the amount includible in gross income under [section 423(c)](/cfr/26/423.md?p=c) exceeds the portion of the basis of the option attributable to the share, the basis of the share, determined under (a) of this subdivision, shall be increased by such excess. Thus, if $15 is includible in gross income under such section, and the basis of the option with respect to the share is $10, the basis of the share, determined under (a) of this subdivision, will be increased by $5. - (ii) If a statutory option is not exercised by the estate of the individual to whom the option was granted, or by the person who acquired such option by bequest or inheritance or by reason of the death of such individual, the option shall be considered to be property that constitutes a right to receive an item of income in respect of a decedent to which the rules of sections [691](/cfr/26/691.md) and [1014(c)](/cfr/26/1014.md?p=c) (or [section 1022(f)](/cfr/26/1022.md?p=f), if applicable) apply. - (iii) The application of this subparagraph may be illustrated by the following examples: - (d) **Option exercised by the individual to whom the option was granted if the individual dies before expiration of the applicable holding periods.** If a statutory option is exercised by the individual to whom the option was granted and such individual dies before the expiration of the applicable holding periods as determined under § [1.422-1(a)](/cfr/26/1.422-1.md?p=a) or [1.423-1(a)](/cfr/26/1.423-1.md?p=a), [paragraph (a)](#a) of this section does not become inapplicable if the executor or administrator of the estate of such individual, or any person who acquired such stock by bequest or inheritance or by reason of the death of such individual, disposes of such stock before the expiration of such applicable holding periods. This rule does not affect the applicability of [section 423(c)](/cfr/26/423.md?p=c), relating to the individual's recognition of compensation income, or [section 1222](/cfr/26/1222.md), relating to what constitutes a short-term and long-term capital gain or loss. - (e) **Incorporation by reference.** Any requirement that an option expressly contain or state a prescribed limitation or term will be considered met if such limitation or term is set forth in a statutory option plan and is incorporated by reference by the option. Thus, if a statutory option plan expressly provides that no option granted thereunder shall be exercisable after five years from the date of grant, and if an option granted thereunder expressly provides that the option is granted subject to the terms and limitations of such plan, the option will be regarded as being, by its terms, not exercisable after the expiration of 5 years from the date such option is granted. - (f) **Effective/applicability date.** - (1) **In general.** These regulations are effective on August 3, 2004. - (2) **Reliance and transition period.** For statutory options granted on or before June 9, 2003, taxpayers may rely on the 1984 proposed regulations LR-279-81 (49 FR 4504), the 2003 proposed regulations REG-122917-02 (68 FR 34344), or this section until the earlier of January 1, 2006, or the first regularly scheduled stockholders meeting of the granting corporation occurring 6 months after August 3, 2004. For statutory options granted after June 9, 2003, and before the earlier of January 1, 2006, or the first regularly scheduled stockholders meeting of the granting corporation occurring at least 6 months after August 3, 2004, taxpayers may rely on either REG-122917-02 or this section. Taxpayers may not rely on LR-279-81 or REG-122917-02 after December 31, 2005. Reliance on LR-279-81, REG-122917-02, or this section must be in its entirety, and all statutory options granted during the reliance period must be treated consistently. - (3) **Application of section 1022.** The provisions of [paragraph (c)](#c) of this section relating to [section 1022](/cfr/26/1022.md) are effective on and after January 19, 2017. # §1.422-1. Incentive stock options; general rules. - (a) **Applicability of section 421(a).** - (1) - (i) [Section 1.421-2(a)](/cfr/26/1.421-2.md?p=a) applies to the transfer of a share of stock to an individual pursuant to the individual's exercise of an incentive stock option if the following conditions are satisfied— - (A) The individual makes no disposition of such share before the later of the expiration of the 2-year period from the date of grant of the option pursuant to which such share was transferred, or the expiration of the 1-year period from the date of transfer of such share to the individual; and - (B) At all times during the period beginning on the date of grant of the option and ending on the day 3 months before the date of exercise, the individual was an employee of either the corporation granting the option, a related corporation of such corporation, or a corporation (or a related corporation of such corporation) substituting or assuming a stock option in a transaction to which [§ 1.424-1(a)](/cfr/26/1.424-1.md?p=a) applies. - (ii) For rules relating to the disposition of shares of stock acquired pursuant to the exercise of a statutory option, see [§ 1.424-1(c)](/cfr/26/1.424-1.md?p=c). For rules relating to the requisite employment relationship, see [§ 1.421-1(h)](/cfr/26/1.421-1.md?p=h). - (2) - (i) The holding period requirement of [section 422(a)(1)](/cfr/26/422.md?p=a-1), described in [paragraph (a)(1)(i)(A)](#a-1-i-A) of this section, does not apply to the transfer of shares by an insolvent individual described in this [paragraph (a)(2)](#a-2). If an insolvent individual holds a share of stock acquired pursuant to the individual's exercise of an incentive stock option, and if such share is transferred to a trustee, receiver, or other similar fiduciary in any proceeding under the Bankruptcy Act or any other similar insolvency proceeding, neither such transfer, nor any other transfer of such share for the benefit of the individual's creditors in such proceeding is a disposition of such share for purposes of this [paragraph (a)](#a). For purposes of this [paragraph (a)(2)](#a-2), an individual is insolvent only if the individual's liabilities exceed the individual's assets or the individual is unable to satisfy the individual's liabilities as they become due. See [section 422(c)(3)](/cfr/26/422.md?p=c-3). - (ii) A transfer by the trustee or other fiduciary that is not treated as a disposition for purposes of this [paragraph (a)](#a) may be a sale or exchange for purposes of recognizing capital gain or loss with respect to the share transferred. For example, if the trustee transfers the share to a creditor in an insolvency proceeding, capital gain or loss must be recognized by the insolvent individual to the extent of the difference between the amount realized from such transfer and the adjusted basis of such share. - (iii) If any transfer by the trustee or other fiduciary (other than a transfer back to the insolvent individual) is not for the exclusive benefit of the creditors in an insolvency proceeding, then whether such transfer is a disposition of the share by the individual for purposes of this [paragraph (a)](#a) is determined under [§ 1.424-1(c)](/cfr/26/1.424-1.md?p=c). Similarly, if the trustee or other fiduciary transfers the share back to the insolvent individual, any subsequent transfer of the share by such individual which is not made in respect of the insolvency proceeding may be a disposition of the share for purposes of this [paragraph (a)](#a). - (3) If the employee exercising an option ceased employment because of permanent and total disability, within the meaning of section [22(e)(3)](/cfr/26/22.md?p=e-3), [1](/cfr/26/1.md) year is used instead of 3 months in the employment period requirement of [paragraph (a)(1)(i)(B)](#a-1-i-B) of this section. - (b) **Failure to satisfy holding period requirements—** - (1) **General rule.** For general rules concerning a disqualifying disposition of a share of stock acquired pursuant to the exercise of an incentive stock option, see [§ 1.421-2(b)(1)](/cfr/26/1.421-2.md?p=b-1). - (2) - (i) **Special rule.** If an individual makes a disqualifying disposition of a share of stock acquired by the exercise of an incentive stock option, and if such disposition is a sale or exchange with respect to which a loss (if sustained) would be recognized to the individual, then, under this [paragraph (b)(2)(i)](#b-2-i), the amount includible (determined without reduction for brokerage fees or other costs paid in connection with the disposition) in the gross income of such individual, and deductible from the income of the employer corporation (or a related corporation of such corporation, or of a corporation substituting or assuming the option in a transaction to which [§ 1.424-1(a)](/cfr/26/1.424-1.md?p=a) applies) as compensation attributable to the exercise of such option, shall not exceed the excess (if any) of the amount realized on such sale or exchange over the adjusted basis of such share. Subject to the special rule provided by this [paragraph (b)(2)(i)](#b-2-i), the amount of compensation attributable to the exercise of the option is determined under [section 83(a)](/cfr/26/83.md?p=a); see [§ 1.421-2(b)(1)(i)](/cfr/26/1.421-2.md?p=b-1-i). - (ii) **Limitation to special rule.** The special rule described in [paragraph (b)(2)(i)](#b-2-i) of this section does not apply if the disposition is a sale or exchange with respect to which a loss (if sustained) would not be recognized by the individual. Thus, for example, if a disqualifying disposition is a sale described in [section 1091](/cfr/26/1091.md) (relating to loss from wash sales of stock or securities), a gift (or any other transaction which is not at arm's length), or a sale described in [section 267(a)(1)](/cfr/26/267.md?p=a-1) (relating to sales between related persons), the special rule described in [paragraph (b)(2)(i)](#b-2-i) of this section does not apply because a loss sustained in any such transaction would not be recognized. - (3) **Examples.** The following examples illustrate the principles of this [paragraph (b)](#b): - (c) **Failure to satisfy employment requirement.** [Section 1.421-2(a)](/cfr/26/1.421-2.md?p=a) does not apply to the transfer of a share of stock pursuant to the exercise of an incentive stock option if the employment requirement, as determined under [paragraph (a)(1)(i)(B)](#a-1-i-B) of this section, is not met at the time of the exercise of such option. Consequently, the effects of such a transfer are determined under the rules of [§ 1.83-7](/cfr/26/1.83-7.md). For rules relating to the employment relationship, see [§ 1.421-1(h)](/cfr/26/1.421-1.md?p=h). # §1.422-2. Incentive stock options defined. - (a) **Incentive stock option defined—** - (1) **In general.** The term incentive stock option means an option that meets the requirements of [paragraph (a)(2)](#a-2) of this section on the date of grant. An incentive stock option is also subject to the $100,000 limitation described in [§ 1.422-4](/cfr/26/1.422-4.md). An incentive stock option may contain a number of permissible provisions that do not affect the status of the option as an incentive stock option. See [§ 1.422-5](/cfr/26/1.422-5.md) for rules relating to permissible provisions of an incentive stock option. - (2) **Option requirements.** To qualify as an incentive stock option under this section, an option must be granted to an individual in connection with the individual's employment by the corporation granting such option (or by a related corporation as defined in [§ 1.421-1(i)(2)](/cfr/26/1.421-1.md?p=i-2)), and granted only for stock of any of such corporations. In addition, the option must meet all of the following requirements— - (i) It must be granted pursuant to a plan that meets the requirements described in [paragraph (b)](#b) of this section; - (ii) It must be granted within 10 years from the date of the adoption of the plan or the date such plan is approved by the stockholders, whichever is earlier (see [paragraph (c)](#c) of this section); - (iii) It must not be exercisable after the expiration of 10 years from the date of grant (see [paragraph (d)](#d) of this section); - (iv) It must provide that the option price per share is not less than the fair market value of the share on the date of grant (see [paragraph (e)](#e) of this section); - (v) By its terms, it must not be transferrable by the individual to whom the option is granted other than by will or the laws of descent and distribution, and must be exercisable, during such individual's lifetime, only by such individual (see §§ [1.421-1(b)(2)](/cfr/26/1.421-1.md?p=b-2) and [1.421-2(c)](/cfr/26/1.421-2.md?p=c)); and - (vi) Except as provided in [paragraph (f)](#f) of this section, it must be granted to an individual who, at the time the option is granted, does not own stock possessing more than 10 percent of the total combined voting power of all classes of stock of the corporation employing such individual or of any related corporation of such corporation. - (3) **Amendment of option terms.** Except as otherwise provided in [§ 1.424-1](/cfr/26/1.424-1.md), the amendment of the terms of an incentive stock option may cause it to cease to be an option described in this section. If the terms of an option that has lost its status as an incentive stock option are subsequently changed with the intent to re-qualify the option as an incentive stock option, such change results in the grant of a new option on the date of the change. See [§ 1.424-1(e)](/cfr/26/1.424-1.md?p=e). - (4) **Terms provide option not an incentive stock option.** If the terms of an option, when granted, provide that it will not be treated as an incentive stock option, such option is not treated as an incentive stock option. - (b) **Option plan—** - (1) **In general.** An incentive stock option must be granted pursuant to a plan that meets the requirements of this [paragraph (b)](#b). The authority to grant other stock options or other stock-based awards pursuant to the plan, where the exercise of such other options or awards does not affect the exercise of incentive stock options granted pursuant to the plan, does not disqualify such incentive stock options. The plan must be in writing or electronic form, provided that such writing or electronic form is adequate to establish the terms of the plan. See [§ 1.422-5](/cfr/26/1.422-5.md) for rules relating to permissible provisions of an incentive stock option. - (2) **Stockholder approval.** - (i) The plan required by this [paragraph (b)](#b) must be approved by the stockholders of the corporation granting the incentive stock option within 12 months before or after the date such plan is adopted. Ordinarily, a plan is adopted when it is approved by the granting corporation's board of directors, and the date of the board's action is the reference point for determining whether stockholder approval occurs within the applicable 24-month period. However, if the board's action is subject to a condition (such as stockholder approval) or the happening of a particular event, the plan is adopted on the date the condition is met or the event occurs, unless the board's resolution fixes the date of approval as the date of the board's action. - (ii) For purposes of [paragraph (b)(2)(i)](#b-2-i) of this section, the stockholder approval must comply with the rules described in [§ 1.422-3](/cfr/26/1.422-3.md). - (iii) The provisions relating to the maximum aggregate number of shares to be issued under the plan (described in [paragraph (b)(3)](#b-3) of this section) and the employees (or class or classes of employees) eligible to receive options under the plan (described in [paragraph (b)(4)](#b-4) of this section) are the only provisions of a stock option plan that, if changed, must be re-approved by stockholders for purposes of [section 422(b)(1)](/cfr/26/422.md?p=b-1). Any increase in the maximum aggregate number of shares that may be issued under the plan (other than an increase merely reflecting a change in the number of outstanding shares, such as a stock dividend or stock split), or change in the designation of the employees (or class or classes of employees) eligible to receive options under the plan is considered the adoption of a new plan requiring stockholder approval within the prescribed 24-month period. In addition, a change in the granting corporation or the stock available for purchase or award under the plan is considered the adoption of a new plan requiring new stockholder approval within the prescribed 24-month period. Any other changes in the terms of an incentive stock option plan are not considered the adoption of a new plan and, thus, do not require stockholder approval. - (3) **Maximum aggregate number of shares.** - (i) The plan required by this [paragraph (b)](#b) must designate the maximum aggregate number of shares that may be issued under the plan through incentive stock options. If nonstatutory options or other stock-based awards may be granted, the plan may separately designate terms for each type of option or other stock-based awards and designate the maximum number of shares that may be issued under such option or other stock-based awards. Unless otherwise specified, all terms of the plan apply to all options and other stock-based awards that may be granted under the plan. - (ii) A plan that merely provides that the number of shares that may be issued as incentive stock options under such plan may not exceed a stated percentage of the shares outstanding at the time of each offering or grant under such plan does not satisfy the requirement that the plan state the maximum aggregate number of shares that may be issued under the plan. However, the maximum aggregate number of shares that may be issued under the plan may be stated in terms of a percentage of the authorized, issued, or outstanding shares at the date of the adoption of the plan. The plan may specify that the maximum aggregate number of shares available for grants under the plan may increase annually by a specified percentage of the authorized, issued, or outstanding shares at the date of the adoption of the plan. A plan which provides that the maximum aggregate number of shares that may be issued as incentive stock options under the plan may change based on any other specified circumstances satisfies the requirements of this [paragraph (b)(3)](#b-3) only if the stockholders approve an immediately determinable maximum aggregate number of shares that may be issued under the plan in any event. - (iii) It is permissible for the plan to provide that, shares purchasable under the plan may be supplied to the plan through acquisitions of stock on the open market; shares purchased under the plan and forfeited back to the plan; shares surrendered in payment of the exercise price of an option; shares withheld for payment of applicable employment taxes and/or withholding obligations resulting from the exercise of an option. - (iv) If there is more than one plan under which incentive stock options may be granted and stockholders of the granting corporation merely approve a maximum aggregate number of shares that are available for issuance under such plans, the stockholder approval requirements described in [paragraph (b)(2)](#b-2) of this section are not satisfied. A separate maximum aggregate number of shares available for issuance pursuant to incentive stock options must be approved for each plan. - (4) **Designation of employees.** The plan described in this [paragraph (b)](#b), as adopted and approved, must indicate the employees (or class or classes of employees) eligible to receive the options or other stock-based awards to be granted under the plan. This requirement is satisfied by a general designation of the employees (or the class or classes of employees) eligible to receive options or other stock-based awards under the plan. Designations such as “key employees of the grantor corporation”; “all salaried employees of the grantor corporation and its subsidiaries, including subsidiaries which become such after adoption of the plan;” or “all employees of the corporation” meet this requirement. This requirement is considered satisfied even though the board of directors, another group, or an individual is given the authority to select the particular employees who are to receive options or other stock-based awards from a described class and to determine the number of shares to be optioned or granted to each such employee. If individuals other than employees may be granted options or other stock-based awards under the plan, the plan must separately designate the employees or classes of employees eligible to receive incentive stock options. - (5) **Conflicting option terms.** An option on stock available for purchase or grant under the plan is treated as having been granted pursuant to a plan even if the terms of the option conflict with the terms of the plan, unless such option is granted to an employee who is ineligible to receive options under the plan, options have been granted on stock in excess of the aggregate number of shares which may be issued under the plan, or the option provides otherwise. - (6) **The following examples illustrate the principles of this paragraph (b)—** - (c) **Duration of option grants under the plan.** An incentive stock option must be granted within 10 years from the date that the plan under which it is granted is adopted or the date such plan is approved by the stockholders, whichever is earlier. To grant incentive stock options after the expiration of the 10-year period, a new plan must be adopted and approved. - (d) **Period for exercising options.** An incentive stock option, by its terms, must not be exercisable after the expiration of 10 years from the date such option is granted, or 5 years from the date such option is granted to an employee described in [paragraph (f)](#f) of this section. An option that does not contain such a provision when granted is not an incentive stock option. - (e) **Option price.** - (1) Except as provided by [paragraph (e)(2)](#e-2) of this section, the option price of an incentive stock option must not be less than the fair market value of the stock subject to the option at the time the option is granted. The option price may be determined in any reasonable manner, including the valuation methods permitted under [§ 20.2031-2](/cfr/26/20.2031-2.md) of this chapter, so long as the minimum price possible under the terms of the option is not less than the fair market value of the stock on the date of grant. For general rules relating to the option price, see [§ 1.421-1(e)](/cfr/26/1.421-1.md?p=e). For rules relating to the determination of when an option is granted, see [§ 1.421-1(c)](/cfr/26/1.421-1.md?p=c). - (2) - (i) If a share of stock is transferred to an individual pursuant to the exercise of an option which fails to qualify as an incentive stock option merely because there was a failure of an attempt, made in good faith, to meet the option price requirements of [paragraph (e)(1)](#e-1) of this section, the requirements of such paragraph are considered to have been met. Whether there was a good-faith attempt to set the option price at not less than the fair market value of the stock subject to the option at the time the option was granted depends on the relevant facts and circumstances. - (ii) For publicly held stock that is actively traded on an established market at the time the option is granted, determining the fair market value of such stock by the appropriate method described in [§ 20.2031-2](/cfr/26/20.2031-2.md) of this chapter establishes that a good-faith attempt to meet the option price requirements of this [paragraph (e)](#e) was made. - (iii) For non-publicly traded stock, if it is demonstrated, for example, that the fair market value of the stock at the date of grant was based upon an average of the fair market values as of such date set forth in the opinions of completely independent and well-qualified experts, such a demonstration generally establishes that there was a good-faith attempt to meet the option price requirements of this [paragraph (e)](#e). The optionee's status as a majority or minority stockholder may be taken into consideration. - (iv) Regardless of whether the stock offered under an option is publicly traded, a good-faith attempt to meet the option price requirements of this [paragraph (e)](#e) is not demonstrated unless the fair market value of the stock on the date of grant is determined with regard to nonlapse restrictions (as defined in [§ 1.83-3(h)](/cfr/26/1.83-3.md?p=h)) and without regard to lapse restrictions (as defined in [§ 1.83-3(i)](/cfr/26/1.83-3.md?p=i)). - (v) Amounts treated as interest and amounts paid as interest under a deferred payment arrangement are not includible as part of the option price. See [§ 1.421-1(e)(1)](/cfr/26/1.421-1.md?p=e-1). An attempt to set the option price at not less than fair market value is not regarded as made in good faith where an adjustment of the option price to reflect amounts treated as interest results in the option price being lower than the fair market value on which the option price was based. - (3) Notwithstanding that the option price requirements of paragraphs [(e)(1)](#e-1) and [(2)](#e-2) of this section are satisfied by an option granted to an employee whose stock ownership exceeds the limitation provided by [paragraph (f)](#f) of this section, such option is not an incentive stock option when granted unless it also complies with [paragraph (f)](#f) of this section. If the option, when granted, does not comply with the requirements described in [paragraph (f)](#f) of this section, such option can never become an incentive stock option, even if the employee's stock ownership does not exceed the limitation of [paragraph (f)](#f) of this section when such option is exercised. - (f) **Options granted to certain stockholders.** - (1) If, immediately before an option is granted, an individual owns (or is treated as owning) stock possessing more than 10 percent of the total combined voting power of all classes of stock of the corporation employing the optionee or of any related corporation of such corporation, then an option granted to such individual cannot qualify as an incentive stock option unless the option price is at least 110 percent of the stock's fair market value on the date of grant and such option by its terms is not exercisable after the expiration of 5 years from the date of grant. For purposes of determining the minimum option price for purposes of this [paragraph (f)](#f), the rules described in [paragraph (e)(2)](#e-2) of this section, relating to the good-faith determination of the option price, do not apply. - (2) For purposes of determining the stock ownership of the optionee, the stock attribution rules of [§ 1.424-1(d)](/cfr/26/1.424-1.md?p=d) apply. Stock that the optionee may purchase under outstanding options is not treated as stock owned by the individual. The determination of the percentage of the total combined voting power of all classes of stock of the employer corporation (or of its related corporations) that is owned by the optionee is made with respect to each such corporation in the related group by comparing the voting power of the shares owned (or treated as owned) by the optionee to the aggregate voting power of all shares of each such corporation actually issued and outstanding immediately before the grant of the option to the optionee. The aggregate voting power of all shares actually issued and outstanding immediately before the grant of the option does not include the voting power of treasury shares or shares authorized for issue under outstanding options held by the individual or any other person. - (3) **Examples.** The rules of this [paragraph (f)](#f) are illustrated by the following examples: # §1.422-3. Stockholder approval of incentive stock option plans. This section addresses the stockholder approval of incentive stock option plans required by [section 422(b)(1)](/cfr/26/422.md?p=b-1) of the Internal Revenue Code. ([Section 422](/cfr/26/422.md) was added to the Code as [section 422A](/cfr/26/422A.md) by section 251 of the Economic Recovery Tax Act of 1981, and was redesignated as [section 422](/cfr/26/422.md) by section 11801 of the Omnibus Budget Reconciliation Act of 1990.) The approval of stockholders must comply with all applicable provisions of the corporate charter, bylaws, and applicable State law prescribing the method and degree of stockholder approval required for the issuance of corporate stock or options. If the applicable State law does not prescribe a method and degree of stockholder approval in such cases an incentive stock option plan must be approved: - (a) By a majority of the votes cast at a duly held stockholders' meeting at which a quorum representing a majority of all outstanding voting stock is, either in person or by proxy, present and voting on the plan; or - (b) By a method and in a degree that would be treated as adequate under applicable State law in the case of an action requiring stockholder approval (i.e., an action on which stockholders would be entitled to vote if the action were taken at a duly held stockholders' meeting). # §1.422-4. $100,000 limitation for incentive stock options. - (a) **$100,000 per year limitation—** - (1) **General rule.** An option that otherwise qualifies as an incentive stock option nevertheless fails to be an incentive stock option to the extent that the $100,000 limitation described in [paragraph (a)(2)](#a-2) of this section is exceeded. - (2) **$100,000 per year limitation.** To the extent that the aggregate fair market value of stock with respect to which an incentive stock option (determined without regard to this section) is exercisable for the first time by any individual during any calendar year (under all plans of the employer corporation and related corporations) exceeds $100,000, such option is treated as a nonstatutory option. See [§ 1.83-7](/cfr/26/1.83-7.md) for rules applicable to nonstatutory options. - (b) **Application.** To determine whether the limitation described in [paragraph (a)(2)](#a-2) of this section has been exceeded, the following rules apply: - (1) An option that does not meet the requirements of [§ 1.422-2](/cfr/26/1.422-2.md) when granted (including an option which, when granted, contains terms providing that it will not be treated as an incentive stock option) is disregarded. See [§ 1.422-2(a)(4)](/cfr/26/1.422-2.md?p=a-4). - (2) **The fair market value of stock is determined as of the date of grant of the option for such stock.** - (3) Except as otherwise provided in [paragraph (b)(4)](#b-4) of this section, options are taken into account in the order in which they are granted. - (4) For purposes of this section, an option is considered to be first exercisable during a calendar year if the option will become exercisable at any time during the year assuming that any condition on the optionee's ability to exercise the option related to the performance of services is satisfied. If the optionee's ability to exercise the option in the year is subject to an acceleration provision, then the option is considered first exercisable in the calendar year in which the acceleration provision is triggered. After an acceleration provision is triggered, the options subject to such provision are then taken into account in accordance with [paragraph (b)(3)](#b-3) of this section for purposes of applying the limitation described in [paragraph (a)(2)](#a-2) of this section to all options first exercisable during a calendar year. However, because an acceleration provision is not taken into account prior to its triggering, an incentive stock option that becomes exercisable for the first time during a calendar year by operation of such a provision does not affect the application of the $100,000 limitation with respect to any option (or portion thereof) exercised prior to such acceleration. For purposes of this [paragraph (b)(4)](#b-4), an acceleration provision includes, for example, a provision that accelerates the exercisability of an option on a change in ownership or control or a provision that conditions exercisability on the attainment of a performance goal. See [paragraph (d)](#d), Example 4 of this section. - (5) - (i) An option (or portion thereof) is disregarded if, prior to the calendar year during which it would otherwise have become exercisable for the first time, the option (or portion thereof) is modified and thereafter ceases to be an incentive stock option described in [§ 1.422-2](/cfr/26/1.422-2.md), is canceled, or is transferred in violation of [§ 1.421-1(b)(2)](/cfr/26/1.421-1.md?p=b-2). - (ii) If an option (or portion thereof) is modified, canceled, or transferred at any other time, such option (or portion thereof) is treated as outstanding according to its original terms until the end of the calendar year during which it would otherwise have become exercisable for the first time. - (6) A disqualifying disposition has no effect on the determination of whether an option exceeds the $100,000 limitation. - (c) **Bifurcation—** - (1) **Options.** The application of the rules described in [paragraph (b)](#b) of this section may result in an option being treated, in part, as an incentive stock option and, in part, as a nonstatutory option. See [§ 1.83-7](/cfr/26/1.83-7.md) for the treatment of nonstatutory options. - (2) **Stock.** A corporation may issue a separate certificate for incentive option stock or designate such stock as incentive stock option stock in the corporation's transfer records or plan records. In such a case, the issuance of separate certificates or designation in the corporation's transfer records or plan records is not a modification under [§ 1.424-1(e)](/cfr/26/1.424-1.md?p=e). In the absence of such an issuance or designation, shares are treated as first purchased under an incentive stock option to the extent of the $100,000 limitation, and the excess shares are treated as purchased under a nonstatutory option. See [§ 1.83-7](/cfr/26/1.83-7.md) for the treatment of nonstatutory options. - (d) **Examples.** The following examples illustrate the principles of this section. In each of the following examples E is an employee of X Corporation. The examples are as follows: # §1.422-5. Permissible provisions. - (a) **General rule.** An option that otherwise qualifies as an incentive stock option does not fail to be an incentive stock option merely because such option contains one or more of the provisions described in paragraphs [(b)](#b), [(c)](#c), and [(d)](#d) of this section. - (b) **Cashless exercise.** - (1) An option does not fail to be an incentive stock option merely because the optionee may exercise the option with previously acquired stock of the corporation that granted the option or stock of the corporation whose stock is being offered for purchase under the option. For special rules relating to the use of statutory option stock to pay the option price of an incentive stock option, see [§ 1.424-1(c)(3)](/cfr/26/1.424-1.md?p=c-3). - (2) All shares acquired through the exercise of an incentive stock option are individually subject to the holding period requirements described in [§ 1.422-1(a)](/cfr/26/1.422-1.md?p=a) and the disqualifying disposition rules of [§ 1.422-1(b)](/cfr/26/1.422-1.md?p=b), regardless of whether the option is exercised with previously acquired stock of the corporation that granted the option or stock of the corporation whose stock is being offered for purchase under the option. If an incentive stock option is exercised with such shares, and the exercise results in the basis allocation described in [paragraph (b)(3)](#b-3) of this section, the optionee's disqualifying disposition of any of the stock acquired through such exercise is treated as a disqualifying disposition of the shares with the lowest basis. - (3) If the exercise of an incentive stock option with previously acquired shares is comprised in part of an exchange to which [section 1036](/cfr/26/1036.md) (and so much of [section 1031](/cfr/26/1031.md) as relates to [section 1036](/cfr/26/1036.md)) applies, then: - (i) The optionee's basis in the incentive stock option shares received in the [section 1036](/cfr/26/1036.md) exchange is the same as the optionee's basis in the shares surrendered in the exchange, increased, if applicable, by any amount included in gross income as compensation pursuant to [sections 421 through 424](/cfr/26/421..424.md) or [section 83](/cfr/26/83.md). Except for purposes of [§ 1.422-1(a)](/cfr/26/1.422-1.md?p=a), the holding period of the shares is determined under [section 1223](/cfr/26/1223.md). For purposes of [§ 1.422-1](/cfr/26/1.422-1.md) and sections [421(b)](/cfr/26/421.md?p=b) and [83](/cfr/26/83.md) and the regulations thereunder, the amount paid for the shares purchased under the option is the fair market value of the shares surrendered on the date of the exchange. - (ii) The optionee's basis in the incentive stock option shares not received pursuant to the [section 1036](/cfr/26/1036.md) exchange is zero. For all purposes, the holding period of such shares begins as of the date that such shares are transferred to the optionee. For purposes of [§ 1.422-1(b)](/cfr/26/1.422-1.md?p=b) and sections [421(b)](/cfr/26/421.md?p=b) and [83](/cfr/26/83.md) and the regulations thereunder, the amount paid for the shares is considered to be zero. - (c) **Additional compensation.** An option does not fail to be an incentive stock option merely because the optionee has the right to receive additional compensation, in cash or property, when the option is exercised, provided such additional compensation is includible in income under [section 61](/cfr/26/61.md) or [section 83](/cfr/26/83.md). The amount of such additional compensation may be determined in any manner, including by reference to the fair market value of the stock at the time of exercise or to the option price. - (d) **Option subject to a condition.** - (1) An option does not fail to be an incentive stock option merely because the option is subject to a condition, or grants a right, that is not inconsistent with the requirements of §§ [1.422-2](/cfr/26/1.422-2.md) and [1.422-4](/cfr/26/1.422-4.md). - (2) An option that includes an alternative right is not an incentive stock option if the requirements of [§ 1.422-2](/cfr/26/1.422-2.md) are effectively avoided by the exercise of the alternative right. For example, an alternative right extending the option term beyond ten years, setting an option price below fair market value, or permitting transferability prevents an option from qualifying as an incentive stock option. If either of two options can be exercised, but not both, each such option is a disqualifying alternative right with respect to the other, even though one or both options would individually satisfy the requirements of §§ [1.422-2](/cfr/26/1.422-2.md), [1.422-4](/cfr/26/1.422-4.md), and this section. - (3) An alternative right to receive a taxable payment of cash and/or property in exchange for the cancellation or surrender of the option does not disqualify the option as an incentive stock option if the right is exercisable only when the then fair market value of the stock exceeds the exercise price of the option and the option is otherwise exercisable, the right is transferable only when the option is otherwise transferable, and the exercise of the right has economic and tax consequences no more favorable than the exercise of the option followed by an immediate sale of the stock. For this purpose, the exercise of the alternative right does not have the same economic and tax consequences if the payment exceeds the difference between the then fair market value of the stock and the exercise price of the option. - (e) **Examples.** The principles of this section are illustrated by the following examples: - (f) **Effective/applicability date—** - (1) **In general.** Except for [§ 1.422-2(b)(6)](/cfr/26/1.422-2.md?p=b-6) Example 1 (iii), the regulations under this section are effective on August 3, 2004. [Section 1.422-2(b)(6)](/cfr/26/1.422-2.md?p=b-6) Example 1 (iii) is effective on November 17, 2009. [Section 1.422-2(b)(6)](/cfr/26/1.422-2.md?p=b-6) Example 1 (iii) applies to statutory options granted on or after January 1, 2010. - (2) **Reliance and transition period.** For statutory options granted on or before June 9, 2003, taxpayers may rely on the 1984 proposed regulations LR-279-81 (49 FR 4504), the 2003 proposed regulations REG-122917-02 (68 FR 34344), or this section until the earlier of January 1, 2006, or the first regularly scheduled stockholders meeting of the granting corporation occurring 6 months after August 3, 2004. For statutory options granted after June 9, 2003, and before the earlier of January 1, 2006, or the first regularly scheduled stockholders meeting of the granting corporation occurring at least 6 months after August 3, 2004, taxpayers may rely on either REG-122917-02 or this section. Taxpayers may not rely on LR-279-81 or REG-122917-02 after December 31, 2005. Reliance on LR-279-81, REG-122917-02, or this section must be in its entirety, and all statutory options granted during the reliance period must be treated consistently. # §1.423-1. Applicability of section 421(a). - (a) **General rule.** Subject to the provisions of [section 423(c)](/cfr/26/423.md?p=c) and [§ 1.423-2(k)](/cfr/26/1.423-2.md?p=k), the special rules of income tax treatment provided in [section 421(a)](/cfr/26/421.md?p=a) apply with respect to the transfer of a share of stock to an individual pursuant to the individual's exercise of an option granted under an employee stock purchase plan, as defined in [§ 1.423-2](/cfr/26/1.423-2.md), if the following conditions are satisfied— - (1) The individual makes no disposition of such share before the later of the expiration of the two-year period from the date of the grant of the option pursuant to which such share was transferred or the expiration of the one-year period from the date of transfer of such share to the individual; and - (2) At all times during the period beginning on the date of the grant of the option and ending on the day three months before the date of exercise, the individual was an employee of the corporation granting the option, a related corporation, or a corporation (or a related corporation) substituting or assuming the stock option in a transaction to which [section 424(a)](/cfr/26/424.md?p=a) applies. - (b) **Cross-references.** For rules relating to the requisite employment relationship, see [§ 1.421-1(h)](/cfr/26/1.421-1.md?p=h). For rules relating to the effect of a disqualifying disposition, see [section 421(b)](/cfr/26/421.md?p=b) and [§ 1.421-2(b)](/cfr/26/1.421-2.md?p=b). For the definition of the term “disposition,” see [section 424(c)](/cfr/26/424.md?p=c) and [§ 1.424-1(c)](/cfr/26/1.424-1.md?p=c). For the definition of the term “related corporation,” see [§ 1.421-1(i)](/cfr/26/1.421-1.md?p=i). - (c) **Effective/applicability date.** The regulations under this section are effective on November 17, 2009. The regulations under this section apply to options granted under an employee stock purchase plan on or after January 1, 2010. # §1.423-2. Employee stock purchase plan defined. - (a) **In general—** - (1) The term “employee stock purchase plan” means a plan that meets the requirements of paragraphs [(a)(2)](#a-2) and [(a)(3)](#a-3) of this section. If the terms of the plan do not satisfy the requirements of [paragraph (a)(3)](#a-3) of this section, then such requirements may be satisfied by the terms of an offering made under the plan. However, where the requirements of [paragraph (a)(3)](#a-3) of this section are satisfied by the terms of an offering, such requirements will be treated as satisfied only with respect to options exercised under that offering. One or more offerings may be made under an employee stock purchase plan. Offerings may be consecutive or overlapping, and the terms of each offering need not be identical provided the terms of the plan and the offering together satisfy the requirements of paragraphs [(a)(2)](#a-2) and [(a)(3)](#a-3) of this section. The plan and the terms of an offering must be in writing or electronic form, provided that such writing or electronic form is adequate to establish the terms of the plan or offering, as applicable. - (2) To satisfy the requirements of this [paragraph (a)(2)](#a-2) and [§ 1.423-1](/cfr/26/1.423-1.md), the plan must meet both of the following requirements— - (i) The plan must provide that options can be granted only to employees of the employer corporation or of a related corporation (as defined in [paragraph (i)](/cfr/26/1.421-1.md?p=i) of § 1.421-1) to purchase stock in any such corporation (see [paragraph (b)](#b) of this section); and - (ii) The plan must be approved by the stockholders of the granting corporation within 12 months before or after the date the plan is adopted (see [paragraph (c)](#c) of this section). - (3) To satisfy the requirements of this [paragraph (a)(3)](#a-3) and [§ 1.423-1](/cfr/26/1.423-1.md), the terms of the plan or offering must meet all of the following requirements— - (i) An employee cannot be granted an option if, immediately after the option is granted, the employee owns stock possessing 5 percent or more of the total combined voting power or value of all classes of stock of the employer corporation or of a related corporation (see [paragraph (d)](#d) of this section); - (ii) Options must be granted to all employees of any corporation whose employees are granted any options by reason of their employment by the corporation (see [paragraph (e)](#e) of this section); - (iii) All employees granted options must have the same rights and privileges (see [paragraph (f)](#f) of this section); - (iv) **The option price cannot be less than the lesser of—** - (A) An amount equal to 85 percent of the fair market value of the stock at the time the option is granted, or - (B) An amount not less than 85 percent of the fair market value of the stock at the time the option is exercised (see [paragraph (g)](#g) of this section). - (v) **Options cannot be exercised after the expiration of—** - (A) Five years from the date the option is granted if, under the terms of such plan, the option price cannot be less than 85 percent of the fair market value of the stock at the time the option is exercised, or - (B) Twenty-seven months from the date the option is granted, if the option price is not determined in the manner described in [paragraph (a)(3)(v)(A)](#a-3-v-A) of this section (see [paragraph (h)](#h) of this section). - (vi) No employee may be granted an option that permits the employee's rights to purchase stock under all employee stock purchase plans of the employer corporation and its related corporations to accrue at a rate that exceeds $25,000 of fair market value of the stock (determined at the time the option is granted) for each calendar year in which the option is outstanding at any time (see paragraph (i) of this section); and - (vii) Options are not transferable by the optionee other than by will or the laws of descent and distribution, and are exercisable, during the lifetime of the optionee, only by the optionee (see [paragraph (j)](#j) of this section). - (4) The determination of whether a particular option is an option granted under an employee stock purchase plan is made at the time the option is granted. If the terms of an option are inconsistent with the terms of the employee stock purchase plan or the offering under the plan pursuant to which the option is granted, the option will not be treated as granted under an employee stock purchase plan. If an option with terms that are inconsistent with the terms of the plan or an offering under the plan is granted to an employee who is entitled to the grant of an option under the terms of the plan or offering, and the employee is not granted an option under the offering that qualifies as an option granted under an employee stock purchase plan, the offering will not meet the requirements of [paragraph (e)](#e) of this section. Accordingly, none of the options granted under the offering will be eligible for the special tax treatment of [section 421](/cfr/26/421.md). However, if an option with terms that are inconsistent with the terms of the plan or an offering under the plan is granted to an individual who is not entitled to the grant of an option under the terms of the plan or offering, the option will not be treated as an option granted under an employee stock purchase plan but the grant of the option will not disqualify the options granted under the plan or offering. If, at the time of grant, an option qualifies as an option granted under an employee stock purchase plan, but after the time of grant one or more of the requirements of [paragraph (a)(3)](#a-3) of this section is not satisfied with respect to the option, the option will not be treated as granted under an employee stock purchase plan but this failure to comply with the terms of the option will not disqualify the other options granted under the plan or offering. - (5) **Examples.** The following examples illustrate the principles of [paragraph (a)](#a): - (b) **Options restricted to employees.** An employee stock purchase plan must provide that options can be granted only to employees of the employer corporation (or employees of its related corporations) to purchase stock in the employer corporation (or one of its related corporations). If such a provision is not included in the terms of the plan, the plan will not be an employee stock purchase plan and options granted under the plan will not qualify for the special tax treatment of [section 421](/cfr/26/421.md). For rules relating to the employment requirement, see [§ 1.421-1(h)](/cfr/26/1.421-1.md?p=h). - (c) **Stockholder approval—** - (1) An employee stock purchase plan must be approved by the stockholders of the granting corporation within 12 months before or after the date such plan is adopted. The approval of the stockholders must comply with all applicable provisions of the corporate charter and bylaws and of applicable State law prescribing the method and degree of stockholder approval required for the issuance of corporate stock or options. If the applicable State law does not prescribe a method and degree of stockholder approval, then an employee stock purchase plan must be approved— - (i) By a majority of the votes cast at a duly held stockholder's meeting at which a quorum representing a majority of all outstanding voting stock is, either in person or by proxy, present and voting on the plan; or - (ii) By a method and in a degree that would be treated as adequate under applicable State law in the case of an action requiring stockholder approval (such as, an action on which stockholders would be entitled to vote if the action were taken at a duly held stockholders' meeting). - (2) For purposes of the stockholder approval required by this [paragraph (c)](#c), ordinarily, a plan is adopted when it is approved by the granting corporation's board of directors, and the date of the board's action is the reference point for determining whether stockholder approval occurs within the applicable 24-month period. However, if the board's action is subject to a condition (such as stockholder approval) or the happening of a particular event, the plan is adopted on the date the condition is met or the event occurs, unless the board's resolution fixes the date of adoption as the date of the board's action. - (3) An employee stock purchase plan, as adopted and approved, must designate the maximum aggregate number of shares that may be issued under the plan, and the corporations or class of corporations whose employees may be offered options under the plan. A plan that merely provides that the number of shares that may be issued under the plan may not exceed a stated percentage of the shares outstanding at the time of each offering or grant under the plan does not satisfy the requirements of this [paragraph (c)(3)](#c-3). However, the maximum aggregate number of shares that may be issued under the plan may be stated in terms of a percentage of the authorized, issued, or outstanding shares on the date of the adoption of the plan. The plan may specify that the maximum aggregate number of shares available for grants under the plan may increase annually by a specified percentage of the authorized, issued, or outstanding shares on the date of the adoption of the plan. A plan that provides that the maximum aggregate number of shares that may be issued as options under the plan may change based on any other specific circumstances satisfies the requirements of this paragraph only if the stockholders approve an immediately determinable maximum number of shares that may be issued under the plan in any event. If there is more than one employee stock purchase plan under which options may be granted and stockholders of the granting corporation merely approve a maximum aggregate number of shares that are available for issuance under the plans, the stockholder approval requirements described in [paragraph (c)(1)](#c-1) of this section are not satisfied. A separate maximum aggregate number of shares available for issuance pursuant to options must be specified and approved for each plan. - (4) Once an employee stock purchase plan is approved by the stockholders of the granting corporation, the plan need not be reapproved by the stockholders of the granting corporation unless the plan is amended or changed in a manner that is considered the adoption of a new plan, in which case the plan must be reapproved within the prescribed 24-month period. Any increase in the aggregate number of shares that may be issued under the plan (other than an increase merely reflecting a change in the number of outstanding shares, such as a stock dividend or stock split) will be considered the adoption of a new plan requiring stockholder approval within the prescribed 24-month period. Similarly, a change in the designation of corporations whose employees may be offered options under the plan will be considered the adoption of a new plan requiring stockholder approval within the prescribed 24-month period unless the plan provides that designations of participating corporations may be made from time to time from among a group consisting of the granting corporation and its related corporations. The group from among which such changes and designations are permitted without additional stockholder approval may include corporations having become parents or subsidiaries of the granting corporation after the adoption and approval of the plan. In addition, a change in the granting corporation or the stock available for purchase under the plan will be considered the adoption of a new plan requiring stockholder approval within the prescribed 24-month period. Any other changes in the terms of an employee stock purchase plan are not considered the adoption of a new plan and, thus, do not require stockholder approval. - (5) **Examples.** The following examples illustrate the principles of this [paragraph (c)](#c): - (d) **Options granted to certain shareholders—** - (1) An employee stock purchase plan or offering must, by its terms, provide that an employee cannot be granted an option if the employee, immediately after the option is granted, owns stock possessing 5 percent or more of the total combined voting power or value of all classes of stock of the employer corporation or a related corporation. In determining whether the stock ownership of an employee equals or exceeds this 5 percent limit, the rules of [section 424(d)](/cfr/26/424.md?p=d) (relating to attribution of stock ownership) shall apply, and stock that the employee may purchase under outstanding options (whether or not the options qualify for the special tax treatment afforded by [section 421(a)](/cfr/26/421.md?p=a)) shall be treated as stock owned by the employee. An option is outstanding for purposes of this [paragraph (d)](#d) although under its terms it may be exercised only in installments or after the expiration of a fixed period of time. If an option is granted to an employee whose stock ownership (as determined under this [paragraph (d)](#d)) exceeds the limitation set forth in this [paragraph (d)](#d), no portion of the option will be treated as having been granted under an employee stock purchase plan. - (2) The determination of the percentage of the total combined voting power or value of all classes of stock of the employer corporation (or a related corporation) that is owned by the employee is made by comparing the voting power or value of the shares owned (or treated as owned) by the employee to the aggregate voting power or value of all shares actually issued and outstanding immediately after the grant of the option to the employee. The aggregate voting power or value of all shares actually issued and outstanding immediately after the grant of the option does not include the voting power or value of treasury shares or shares authorized for issue under outstanding options held by the employee or any other person. - (3) **Examples.** The following examples illustrate the principles of this [paragraph (d)](#d): - (e) **Employees covered by plan—** - (1) Subject to the provisions of this [paragraph (e)](#e) and the limitations of paragraphs [(d)](#d), [(f)](#f) and (i) of this section, an employee stock purchase plan or offering must, by its terms, provide that options are to be granted to all employees of any corporation whose employees are granted any of such options by reason of their employment by that corporation, except that one or more of the following categories of employees may be excluded from the coverage of the plan or offering— - (i) Employees who have been employed less than two years; - (ii) Employees whose customary employment is 20 hours or less per week; - (iii) Employees whose customary employment is for not more than five months in any calendar year; and - (iv) **Highly compensated employees (within the meaning of section 414(q)).** - (2) A plan or offering does not fail to satisfy the coverage provision of [paragraph (e)(1)](#e-1) of this section in the following circumstances— - (i) The plan or offering excludes employees who have completed a shorter period of service or whose customary employment is for fewer hours per week or fewer months in a calendar year than is specified in paragraphs [(e)(1)(i)](#e-1-i), [(ii)](#e-1-ii) and [(iii)](#e-1-iii) of this section, provided the exclusion is applied in an identical manner to all employees of every corporation whose employees are granted options under the plan or offering. - (ii) The plan or offering excludes highly compensated employees (within the meaning of [section 414(q)](/cfr/26/414.md?p=q)) with compensation above a certain level or who are officers or subject to the disclosure requirements of section 16(a) of the Securities Exchange Act of 1934, provided the exclusion is applied in an identical manner to all highly compensated employees of every corporation whose employees are granted options under the plan or offering. - (3) Notwithstanding [paragraph (e)(1)](#e-1) of this section, employees who are citizens or residents of a foreign jurisdiction (without regard to whether they are also citizens of the United States or resident aliens (within the meaning of [section 7701(b)(1)(A)](/cfr/26/7701.md?p=b-1-A))) may be excluded from the coverage of an employee stock purchase plan or offering under the following circumstances— - (i) The grant of an option under the plan or offering to a citizen or resident of the foreign jurisdiction is prohibited under the laws of such jurisdiction; or - (ii) Compliance with the laws of the foreign jurisdiction would cause the plan or offering to violate the requirements of [section 423](/cfr/26/423.md). - (4) No option granted under a plan or offering that excludes from participation any employees, other than those who may be excluded under this [paragraph (e)](#e), and those barred from participation by reason of paragraphs [(d)](#d), [(f)](#f) and (i) of this section, can be regarded as having been granted under an employee stock purchase plan. If an option is not granted to any employee who is entitled to the grant of an option under the terms of the plan or offering, none of the options granted under such offering will be treated as having been granted under an employee stock purchase plan. However, a plan that, by its terms, permits all eligible employees to elect to participate in an offering will not violate the requirements of this paragraph solely because eligible employees who elect not to participate in the offering are not granted options pursuant to such offering. - (5) For purposes of this [paragraph (e)](#e), the existence of the employment relationship between an individual and the corporation participating under the plan will be determined under [§ 1.421-1(h)](/cfr/26/1.421-1.md?p=h). - (6) **Examples.** The following examples illustrate the principles of this [paragraph (e)](#e): - (f) **Equal rights and privileges—** - (1) Except as otherwise provided in [paragraphs (f)(2) through (f)(6)](#f-2..f-6) of this section, an employee stock purchase plan or offering must, by its terms, provide that all employees granted options under the plan or offering shall have the same rights and privileges. Thus, the provisions applying to one option under an offering (such as the provisions relating to the method of payment for the stock and the determination of the purchase price per share) must apply to all other options under the offering in the same manner. If all the options granted under a plan or offering do not, by their terms, give the respective optionees the same rights and privileges, none of the options will be treated as having been granted under an employee stock purchase plan for purposes of [section 421](/cfr/26/421.md). - (2) The requirements of this [paragraph (f)](#f) do not prevent the maximum amount of stock that an employee may purchase from being determined on the basis of a uniform relationship to the total compensation, or the basic or regular rate of compensation, of all employees. - (3) A plan or offering will not fail to satisfy the requirements of this [paragraph (f)](#f) because the plan or offering provides that no employee may purchase more than a maximum amount of stock fixed under the plan or offering. - (4) A plan or offering will not fail to satisfy the requirements of this [paragraph (f)](#f) if, in order to comply with the laws of a foreign jurisdiction, the terms of an option granted under a plan or offering to citizens or residents of such foreign jurisdiction (without regard to whether they are also citizens of the United States or resident aliens (within the meaning of [section 7701(b)(1)(A)](/cfr/26/7701.md?p=b-1-A))) are less favorable than the terms of options granted under the same plan or offering to employees resident in the United States. - (5) - (i) Except as provided in this paragraph and [paragraph (f)(5)(ii)](#f-5-ii) of this section, a plan or offering permitting one or more employees to carry forward amounts that were withheld but not applied toward the purchase of stock under an earlier plan or offering and apply the amounts towards the purchase of additional stock under a subsequent plan or offering will be a violation of the equal rights and privileges under [paragraph (f)(1)](#f-1) of this section. However, the carry forward of amounts withheld but not applied toward the purchase of stock under an earlier plan or offering will not violate the equal rights and privileges requirement of [paragraph (f)(1)](#f-1) of this section, if all other employees participating in the current plan or offering are permitted to make direct payments toward the purchase of shares under a subsequent plan or offering in an amount equal to the excess of the greatest amount which any employee is allowed to carry forward from an earlier plan or offering over the amount, if any, the employee will carry forward from an earlier plan or offering. - (ii) A plan or offering will not fail to satisfy the requirements of this section merely because employees are permitted to carry forward amounts representing a fractional share, that were withheld but not applied toward the purchase of stock under an earlier plan or offering and apply the amounts toward the purchase of additional stock under a subsequent plan or offering. - (6) [Paragraph (f)](#f) does not prohibit the delaying of the grant of an option to any employee who is barred from being granted an option solely by reason of the employee's failing to meet a minimum service requirement set forth in [paragraph (e)(1)](#e-1) of this section until the employee meets such requirement. - (7) **Examples.** The following examples illustrate the principles of this [paragraph (f)](#f): - (g) **Option price—** - (1) An employee stock purchase plan or offering must, by its terms, provide that the option price will not be less than the lesser of— - (i) An amount equal to 85 percent of the fair market value of the stock at the time the option is granted, or - (ii) An amount that under the terms of the option may not be less than 85 percent of the fair market value of the stock at the time the option is exercised. - (2) For purposes of determining the option price, the fair market value of the stock may be determined in any reasonable manner, including the valuation methods permitted under [§ 20.2031-2](/cfr/26/20.2031-2.md). However, the option price must meet the minimum pricing requirements of this [paragraph (g)](#g). For general rules relating to the option price, see [§ 1.421-1(e)](/cfr/26/1.421-1.md?p=e). For rules relating to the determination of when an option is granted, see §§ [1.421-1(c)](/cfr/26/1.421-1.md?p=c) and [1.423-2(h)(2)](#h-2). Any option that does not meet the minimum pricing requirements of this [paragraph (g)](#g) will not be treated as an option granted under an employee stock purchase plan irrespective of whether the plan or offering satisfies those requirements. If an option that does not meet the minimum pricing requirements is granted to an employee who is entitled to the grant of an option under the terms of the plan or offering, and the employee is not granted an option under such offering that qualifies as an option granted under an employee stock purchase plan, the offering will not meet the requirements of [paragraph (e)](#e) of this section. Accordingly, none of the options granted under the offering will be eligible for the special tax treatment of [section 421](/cfr/26/421.md). - (3) The option price may be stated either as a percentage or as a dollar amount. If the option price is stated as a dollar amount, then the requirement of this [paragraph (g)](#g) can only be met by a plan or offering in which the price is fixed at not less than 85 percent of the fair market value of the stock at the time the option is granted. If the fixed price is less than 85 percent of the fair market value of the stock at grant, then the option cannot meet the requirement of this [paragraph (g)](#g) even if a decline in the fair market value of the stock results in such fixed price being not less than 85 percent of the fair market value of the stock at the time the option is exercised, because that result was not certain to occur under the terms of the option. - (4) **Examples.** The following examples illustrate the principles of this [paragraph (g)](#g): - (h) **Option period—** - (1) An employee stock purchase plan or offering must, by its terms, provide that options granted under the plan cannot be exercised after the expiration of 27 months from the date of grant unless, under the terms of the plan or offering, the option price is not less than 85 percent of the fair market value of the stock at the time of the exercise of the option. If the option price is not less than 85 percent of the fair market value of the stock at the time the option is exercised, then the option period provided under the plan must not exceed five years from the date of grant. If the requirements of this [paragraph (h)](#h) are not met by the terms of the plan or offering, then options issued under such plan or offering will not be treated as options granted under an employee stock purchase plan irrespective of whether the options, by their terms, are exercisable beyond the period allowable under this [paragraph (h)](#h). An option that provides that the option price is not less than 85 percent of the fair market value of the stock at exercise may have an option period of 5 years irrespective of whether the fair market value of the stock at exercise is more or less than the fair market value of the stock at grant. However, if the option provides that the option price is 85 percent of the fair market value of the stock at exercise, but not more than some other fixed amount determined in accordance with the provisions of [paragraph (g)](#g) of this section, then irrespective of the price paid on exercise, the option period must not be more than 27 months. - (2) [Section 1.421-1(c)](/cfr/26/1.421-1.md?p=c) provides that, for purposes of [§§ 1.421-1 through 1.424-1](/cfr/26/1.421-1..1.424-1.md), the language “the date of the granting of the option” and the “time such option is granted,” and similar phrases refer to the date or time when the granting corporation completes the corporate action constituting an offer of stock for sale to an individual under the terms and conditions of a statutory option. With respect to options granted under an employee stock purchase plan, the principles of [§ 1.421-1(c)](/cfr/26/1.421-1.md?p=c) shall be applied without regard to the requirement that the minimum option price must be fixed or determinable in order for the corporate action constituting an offer of stock to be considered complete. - (3) The date of grant will be the first day of an offering if the terms of an employee stock purchase plan or offering designate a maximum number of shares that may be purchased by each employee during the offering. Similarly, the date of grant will be the first day of an offering if the terms of the plan or offering require the application of a formula to establish, on the first day of the offering, the maximum number of shares that may be purchased by each employee during the offering. It is not required that an employee stock purchase plan or offering designate a maximum number of shares that may be purchased by each employee during the offering or incorporate a formula to establish a maximum number of shares that may be purchased by each employee during the offering. If the maximum number of shares that can be purchased under an option is not fixed or determinable until the date the option is exercised, then the date of exercise will be the date of grant of the option. - (4) **Examples.** The following examples illustrate the principles of this [paragraph (h)](#h): - (i) **Annual $25,000 limitation—** - (1) An employee stock purchase plan or offering must, by its terms, provide that no employee may be permitted to purchase stock under all the employee stock purchase plans of the employer corporation and its related corporations at a rate that exceeds $25,000 in fair market value of the stock (determined at the time the option is granted) for each calendar year in which any option granted to the employee is outstanding at any time. In applying the foregoing limitation— - (i) The right to purchase stock under an option accrues when the option (or any portion thereof) first becomes exercisable during the calendar year; - (ii) The right to purchase stock under an option accrues at the rate provided in the option, but in no case may such rate exceed $25,000 of fair market value of such stock (determined at the time such option is granted) for any one calendar year; and - (iii) A right to purchase stock that has accrued under one option granted pursuant to the plan may not be carried over to any other option. - (2) If an option is granted under an employee stock purchase plan that satisfies the requirement of this paragraph (i), but the option gives the optionee the right to buy stock in excess of the maximum rate allowable under this paragraph (i), then no portion of the option will be treated as having been granted under an employee stock purchase plan. Furthermore, if the option was granted to an employee entitled to the grant of an option under the terms of the plan or offering, and the employee is not granted an option under the offering that qualifies as an option granted under an employee stock purchase plan, then the offering will not meet the requirements of [paragraph (e)](#e) of this section. Accordingly, none of the options granted under the offering will be eligible for the special tax treatment of [section 421](/cfr/26/421.md). - (3) The limitation of this paragraph (i) applies only to options granted under employee stock purchase plans and does not limit the amount of stock that an employee may purchase under incentive stock options (as defined in [section 422(b)](/cfr/26/422.md?p=b)) or any other stock options except those to which [section 423](/cfr/26/423.md) applies. Stock purchased under options to which [section 423](/cfr/26/423.md) does not apply will not limit the amount that an employee may purchase under an employee stock purchase plan, except for purposes of the 5-percent stock ownership provision of [paragraph (d)](#d) of this section. - (4) Under the limitation of this paragraph (i), an employee may purchase up to $25,000 of stock (based on the fair market value of the stock at the time the option was granted) in each calendar year during which an option granted to the employee under an employee stock purchase plan is outstanding. Alternatively, an employee may purchase more than $25,000 of stock (based on the fair market value of such stock at the time the option was granted) in a calendar year, so long as the total amount of stock that the employee purchases does not exceed $25,000 in fair market value of the stock (determined at the time the option was granted) for each calendar year in which any option was outstanding. If, in any calendar year, the employee holds two or more outstanding options granted under employee stock purchase plans of the employer corporation, or a related corporation, then the employee's purchases of stock attributable to that year under all options granted under employee stock purchase plans must not exceed $25,000 in fair market value of the stock (determined at the time the options were granted). Under an employee stock purchase plan, an employee may not purchase stock in anticipation that the option will be outstanding in some future year. Thus, the employee may purchase only the amount of stock that does not exceed the limitation of this paragraph (i) for the year of the purchase and for preceding years during which the option was outstanding. Thus, the amount of stock that may be purchased under an option depends on the number of years in which the option is actually outstanding. The amount of stock that may be purchased under an employee stock purchase plan may not be increased by reason of the failure to grant an option in an earlier year under such plan, or by reason of the failure to exercise an earlier option. For example, if an option is granted to an individual and expires without having been exercised at all, then the failure to exercise the option does not increase the amount of stock which such individual may be permitted to purchase under an option granted in a year following the year of such expiration. If an option granted under an employee stock purchase plan is outstanding in more than one calendar year, then stock purchased pursuant to the exercise of such an option will be applied first, to the extent allowable under this paragraph (i), against the $25,000 limitation for the earliest year in which the option was outstanding, then, against the $25,000 limitation for each succeeding year, in order. - (5) **Examples.** The following examples illustrate the principles of this paragraph (i): - (j) **Restriction on transferability.** An employee stock purchase plan or offering must, by its terms, provide that options granted under the plan are not transferable by the optionee other than by will or the laws of descent and distribution, and must be exercisable, during the optionee's lifetime, only by the optionee. For general rules relating to the restriction on transferability required by this [paragraph (j)](#j), see [§ 1.421-1(b)(2)](/cfr/26/1.421-1.md?p=b-2). For a limited exception to the requirement of this [paragraph (j)](#j), see [section 424(h)(3)](/cfr/26/424.md?p=h-3). - (k) **Special rule where option price is between 85 percent and 100 percent of value of stock—** - (1) - (i) If all the conditions necessary for the application of [section 421(a)](/cfr/26/421.md?p=a) exist, this [paragraph (k)](#k) provides additional rules that are applicable in cases where, at the time the option is granted, the option price per share is less than 100 percent (but not less than 85 percent) of the fair market value of the share. In that case, upon the disposition of the share by the employee after the expiration of the two-year and the one-year holding periods, or upon the employee's death while owning the share (whether occurring before or after the expiration of such periods), there shall be included in the employee's gross income as compensation (and not as gain upon the sale or exchange of a capital asset) the lesser of— - (A) The amount, if any, by which the price paid under the option was exceeded by the fair market value of the share at the time the option was granted, or - (B) The amount, if any, by which the price paid under the option was exceeded by the fair market value of the share at the time of such disposition or death. - (ii) For purposes of applying the rules of this [paragraph (k)](#k), if the option price is not fixed or determinable at the time the option is granted, the option price will be computed as if the option had been exercised at such time. The amount of compensation resulting from the application of this [paragraph (k)](#k) shall be included in the employee's gross income for the taxable year in which the disposition occurs, or for the taxable year closing with the employee's death, whichever event results in the application of this [paragraph (k)](#k). - (iii) The application of the special rules provided in this [paragraph (k)](#k) shall not affect the rules provided in [section 421(a)](/cfr/26/421.md?p=a) with respect to the employee exercising the option, the employer corporation, or a related corporation. Thus, notwithstanding the inclusion of an amount as compensation in the gross income of an employee, as provided in this [paragraph (k)](#k), no income results to the employee at the time the stock is transferred to the employee, and no deduction under [section 162](/cfr/26/162.md) is allowable at any time to the employer corporation or a related corporation with respect to such amount. - (iv) If, during the employee's lifetime, the employee exercises an option granted under an employee stock purchase plan, but the employee dies before the stock is transferred to the employee pursuant to the exercise of the option, then for the purpose of sections [421](/cfr/26/421.md) and [423](/cfr/26/423.md), on the employee's death, the stock is deemed to be transferred immediately to the employee, and immediately thereafter, the employee is deemed to have transferred the stock to the employee's executor, administrator, trustee, beneficiary by operation of law, heir, or legatee, as the case may be. - (2) If the special rules provided in this [paragraph (k)](#k) are applicable to the disposition of a share of stock by an employee, then the basis of the share in the employee's hands at the time of the disposition, determined under [section 1011](/cfr/26/1011.md), shall be increased by an amount equal to the amount includible as compensation in the employee's gross income under this [paragraph (k)](#k). However, the basis of a share of stock acquired after the death of an employee by the exercise of an option granted to the employee under an employee stock purchase plan shall be determined in accordance with the rules of [section 421(c)](/cfr/26/421.md?p=c) and [§ 1.421-2(c)](/cfr/26/1.421-2.md?p=c). If the special rules provided in this [paragraph (k)](#k) are applicable to a share of stock upon the death of an employee, then the basis of the share in the hands of the estate or the person receiving the stock by bequest or inheritance shall be determined under [section 1014](/cfr/26/1014.md) or under [section 1022](/cfr/26/1022.md), if applicable, and shall not be increased by reason of the inclusion upon the decedent's death of any amount in the decedent's gross income under this [paragraph (k)](#k). See Example (9) of this [paragraph (k)](#k) with respect to the determination of basis of the share in the hands of a surviving joint owner. - (3) **Examples.** The following examples illustrate the principles of this [paragraph (k)](#k): - (l) **Effective/applicability date.** The regulations under this section are effective on November 17, 2009. The regulations under this section apply to options granted under an employee stock purchase plan on or after January 1, 2010. The provisions of this section relating to [section 1022](/cfr/26/1022.md) are effective on and after January 19, 2017. # §1.424-1. Definitions and special rules applicable to statutory options. - (a) **Substitutions and assumptions of options—** - (1) **In general.** - (i) This [paragraph (a)](#a) provides rules under which an eligible corporation (as defined in [paragraph (a)(2)](#a-2) of this section) may, by reason of a corporate transaction (as defined in [paragraph (a)(3)](#a-3) of this section), substitute a new statutory option (new option) for an outstanding statutory option (old option) or assume an old option without such substitution or assumption being considered a modification of the old option. For the definition of modification, see [paragraph (e)](#e) of this section. - (ii) For purposes of [§§ 1.421-1 through 1.424-1](/cfr/26/1.421-1..1.424-1.md), the phrase “substituting or assuming a stock option in a transaction to which [section 424](/cfr/26/424.md) applies,” “substituting or assuming a stock option in a transaction to which [§ 1.424-1(a)](#a) applies,” and similar phrases means a substitution of a new option for an old option or an assumption of an old option that meets the requirements of this [paragraph (a)](#a). For a substitution or assumption to qualify under this [paragraph (a)](#a), the substitution or assumption must meet all of the requirements described in paragraphs [(a)(4)](#a-4) and [(a)(5)](#a-5) of this section. - (2) **Eligible corporation.** For purposes of this [paragraph (a)](#a), the term eligible corporation means a corporation that is the employer of the optionee or a related corporation of such corporation. For purposes of this [paragraph (a)](#a), the determination of whether a corporation is the employer of the optionee or a related corporation of such corporation is based upon all of the relevant facts and circumstances existing immediately after the corporate transaction. See [§ 1.421-1(h)](/cfr/26/1.421-1.md?p=h) for rules concerning the employment relationship. - (3) **Corporate transaction.** For purposes of this [paragraph (a)](#a), the term corporate transaction includes— - (i) A corporate merger, consolidation, acquisition of property or stock, separation, reorganization, or liquidation; - (ii) A distribution (excluding an ordinary dividend or a stock split or stock dividend described in [§ 1.424-1(e)(4)(v)](#e-4-v)) or change in the terms or number of outstanding shares of such corporation; and - (iii) **Such other corporate events prescribed by the Commissioner in published guidance.** - (4) **By reason of.** - (i) For a change in an option or issuance of a new option to qualify as a substitution or assumption under this [paragraph (a)](#a), the change must be made by an eligible corporation (as defined in [paragraph (a)(2)](#a-2) of this section) and occur by reason of a corporate transaction (as defined in [paragraph (a)(3)](#a-3) of this section). - (ii) Generally, a change in an option or issuance of a new option is considered to be by reason of a corporate transaction, unless the relevant facts and circumstances demonstrate that such change or issuance is made for reasons unrelated to such corporate transaction. For example, a change in an option or issuance of a new option will be considered to be made for reasons unrelated to a corporate transaction if there is an unreasonable delay between the corporate transaction and such change in the option or issuance of a new option, or if the corporate transaction serves no substantial corporate business purpose independent of the change in options. Similarly, a change in the number or price of shares purchasable under an option merely to reflect market fluctuations in the price of the stock purchasable under an option is not by reason of a corporate transaction. - (iii) A change in an option or issuance of a new option is by reason of a distribution or change in the terms or number of the outstanding shares of a corporation (as described in [paragraph (a)(3)(ii)](#a-3-ii) of this section) only if the option as changed, or the new option issued, is an option on the same stock as under the old option (or if such class of stock is eliminated in the change in capital structure, on other stock of the same corporation). - (5) **Other requirements.** For a change in an option or issuance of a new option to qualify as a substitution or assumption under this [paragraph (a)](#a), all of the requirements described in this [paragraph (a)(5)](#a-5) must be met. - (i) In the case of an issuance of a new option (or a portion thereof) in exchange for an old option (or portion thereof), the optionee's rights under the old option (or portion thereof) must be canceled, and the optionee must lose all rights under the old option (or portion thereof). There cannot be a substitution of a new option for an old option within the meaning of this [paragraph (a)](#a) if the optionee may exercise both the old option and the new option. It is not necessary to have a complete substitution of a new option for the old option. However, any portion of such option which is not substituted or assumed in a transaction to which this [paragraph (a)](#a) applies is an outstanding option to purchase stock or, to the extent [paragraph (e)](#e) of this section applies, a modified option. - (ii) The excess of the aggregate fair market value of the shares subject to the new or assumed option immediately after the change in the option or issuance of a new option over the aggregate option price of such shares must not exceed the excess of the aggregate fair market value of all shares subject to the old option (or portion thereof) immediately before the change in the option or issuance of a new option over the aggregate option price of such shares. - (iii) On a share by share comparison, the ratio of the option price to the fair market value of the shares subject to the option immediately after the change in the option or issuance of a new option must not be more favorable to the optionee than the ratio of the option price to the fair market value of the stock subject to the old option (or portion thereof) immediately before the change in the option or issuance of a new option. The number of shares subject to the new or assumed option may be adjusted to compensate for any change in the aggregate spread between the aggregate option price and the aggregate fair market value of the shares subject to the option immediately after the change in the option or issuance of the new option as compared to the aggregate spread between the option price and the aggregate fair market value of the shares subject to the option immediately before the change in the option or issuance of the new option. - (iv) The new or assumed option must contain all terms of the old option, except to the extent such terms are rendered inoperative by reason of the corporate transaction. - (v) The new option or assumed option must not give the optionee additional benefits that the optionee did not have under the old option. - (6) **Obligation to substitute or assume not necessary.** For a change in the option or issuance of a new option to meet the requirements of this [paragraph (a)](#a), it is not necessary to show that the corporation changing an option or issuing a new option is under any obligation to do so. In fact, this [paragraph (a)](#a) may apply even when the option that is being replaced or assumed expressly provides that it will terminate upon the occurrence of certain corporate transactions. However, this [paragraph (a)](#a) cannot be applied to revive a statutory option which, for reasons not related to the corporate transaction, expires before it can properly be replaced or assumed under this [paragraph (a)](#a). - (7) **Issuance of stock without meeting the requirements of this paragraph (a).** A change in the terms of an option resulting in a modification of such option occurs if an optionee's new employer (or a related corporation of the new employer) issues its stock (or stock of a related corporation) upon exercise of such option without satisfying all of the requirements described in paragraphs [(a)(4)](#a-4) and [(5)](#a-5) of this section. - (8) **Date of grant.** For purposes of applying the rules of this [paragraph (a)](#a), a substitution or assumption is considered to occur on the date that the optionee would, but for this [paragraph (a)](#a), be considered to have been granted the option that the eligible corporation is substituting or assuming. A substitution or an assumption that occurs by reason of a corporate transaction may occur before or after the corporate transaction. - (9) Any reasonable methods may be used to determine the fair market value of the stock subject to the option immediately before the assumption or substitution and the fair market value of the stock subject to the option immediately after the assumption or substitution. Such methods include the valuation methods described in [§ 20.2031-2](/cfr/26/20.2031-2.md) of this chapter (the Estate Tax Regulations). In the case of stock listed on a stock exchange, the fair market value may be based on the last sale before and the first sale after the assumption or substitution if such sales clearly reflect the fair market value of the stock, or may be based upon an average selling price during a longer period, such as the day or week before, and the day or week after, the assumption or substitution. If the stocks are not listed, or if they are newly issued, it will be reasonable to base the determination on experience over even longer periods. In the case of a merger, consolidation, or other reorganization which is arrived at by arm's-length negotiations, the fair market value of the stocks subject to the option before and after the assumption or substitution may be based upon the values assigned to the stock for purposes of the reorganization. For example, if in the case of a merger the parties treat each share of the merged company as being equal in value to a share of the surviving company, it will be reasonable to assume that the stocks are of equal value so that the substituted option may permit the employee to purchase at the same price one share of the surviving company for each share he could have purchased of the merged company. - (10) **Examples.** The principles of this [paragraph (a)](#a) are illustrated by the following examples: - (b) **Acquisition of new stock.** - (1) [Section 424(b)](/cfr/26/424.md?p=b) provides that the rules provided by [sections 421 through 424](/cfr/26/421..424.md) which are applicable with respect to stock transferred to an individual upon his exercise of an option, shall likewise be applicable with respect to stock acquired by a distribution or an exchange to which section [305](/cfr/26/305.md), [354](/cfr/26/354.md), [355](/cfr/26/355.md), [356](/cfr/26/356.md), or [1036](/cfr/26/1036.md) (or so much of [section 1031](/cfr/26/1031.md) as relates to [section 1036](/cfr/26/1036.md)) applies. Stock so acquired shall, for purposes of [sections 421 through 424](/cfr/26/421..424.md), be considered as having been transferred to the individual upon his exercise of the option. A similar rule shall be applied in the case of a series of such acquisitions. With respect to such acquisitions, [section 424(b)](/cfr/26/424.md?p=b) does not make inapplicable any of the provisions of section [305](/cfr/26/305.md), [354](/cfr/26/354.md), [355](/cfr/26/355.md), [356](/cfr/26/356.md), or [1036](/cfr/26/1036.md) (or so much of [section 1031](/cfr/26/1031.md) as relates to [section 1036](/cfr/26/1036.md)). - (2) The application of this paragraph may be illustrated by the following example: - (c) **Disposition of stock.** - (1) For purposes of [sections 421 through 424](/cfr/26/421..424.md), the term “disposition of stock” includes a sale, exchange, gift, or any transfer of legal title, but does not include— - (i) A transfer from a decedent to his estate or a transfer by bequest or inheritance; or - (ii) An exchange to which is applicable section [354](/cfr/26/354.md), [355](/cfr/26/355.md), [356](/cfr/26/356.md), or [1036](/cfr/26/1036.md) (or so much of [section 1031](/cfr/26/1031.md) as relates to [section 1036](/cfr/26/1036.md)); or - (iii) **A mere pledge or hypothecation.** However, a disposition of the stock pursuant to a pledge or hypothecation is a disposition by the individual, even though the making of the pledge or hypothecation is not such a disposition. - (iv) **A transfer between spouses or incident to divorce (described in section 1041(a)).** The special tax treatment of [§ 1.421-2(a)](/cfr/26/1.421-2.md?p=a) with respect to the transferred stock applies to the transferee. However, see [§ 1.421-1(b)(2)](/cfr/26/1.421-1.md?p=b-2) for the treatment of the transfer of a statutory option incident to divorce. - (2) A share of stock acquired by an individual pursuant to the exercise of a statutory option is not considered disposed of by the individual if such share is taken in the name of the individual and another person jointly with right of survivorship, or is subsequently transferred into such joint ownership, or is retransferred from such joint ownership to the sole ownership of the individual. However, any termination of such joint ownership (other than a termination effected by the death of a joint owner) is a disposition of such share, except to the extent the individual reacquires ownership of the share. For example, if such individual and his joint owner transfer such share to another person, the individual has made a disposition of such share. Likewise, if a share of stock held in the joint names of such individual and another person is transferred to the name of such other person, there is a disposition of such share by the individual. If an individual exercises a statutory option and a share of stock is transferred to another or is transferred to such individual in his name as trustee for another, the individual has made a disposition of such share. However, a termination of joint ownership resulting from the death of one of the owners is not a disposition of such share. For determination of basis in the hands of the survivor where joint ownership is terminated by the death of one of the owners, see [section 1014](/cfr/26/1014.md) or [section 1022](/cfr/26/1022.md), if applicable. - (3) If an optionee exercises an incentive stock option with statutory option stock and the applicable holding period requirements (under [§ 1.422-1(a)](/cfr/26/1.422-1.md?p=a) or [§ 1.423-1(a)](/cfr/26/1.423-1.md?p=a)) with respect to such statutory option stock are not met before such transfer, then sections [354](/cfr/26/354.md), [355](/cfr/26/355.md), [356](/cfr/26/356.md), or [1036](/cfr/26/1036.md) (or so much of 1031 as relates to 1036) do not apply to determine whether there is a disposition of those shares. Therefore, there is a disposition of the statutory option stock, and the special tax treatment of [§ 1.421-2(a)](/cfr/26/1.421-2.md?p=a) does not apply to such stock. - (4) The application of this paragraph may be illustrated by the following examples: - (d) **Attribution of stock ownership.** To determine the amount of stock owned by an individual for purposes of applying the percentage limitations relating to certain stockholders described in §§ [1.422-2(f)](/cfr/26/1.422-2.md?p=f) and [1.423-2(d)](/cfr/26/1.423-2.md?p=d), shares of the employer corporation or of a related corporation that are owned (directly or indirectly) by or for the individual's brothers and sisters (whether by the whole or half blood), spouse, ancestors, and lineal descendants, are considered to be owned by the individual. Also, for such purposes, if a domestic or foreign corporation, partnership, estate, or trust owns (directly or indirectly) shares of the employer corporation or of a related corporation, the shares are considered to be owned proportionately by or for the stockholders, partners, or beneficiaries of the corporation, partnership, estate, or trust. The extent to which stock held by the optionee as a trustee of a voting trust is considered owned by the optionee is determined under all of the facts and circumstances. - (e) **Modification, extension, or renewal of option.** - (1) This [paragraph (e)](#e) provides rules for determining whether a share of stock transferred to an individual upon the individual's exercise of an option after the terms of the option have been changed is transferred pursuant to the exercise of a statutory option. - (2) Any modification, extension, or renewal of the terms of an option to purchase shares is considered the granting of a new option. The new option may or may not be a statutory option. To determine the date of grant of the new option for purposes of section [422](/cfr/26/422.md) or [423](/cfr/26/423.md), see [§ 1.421-1(c)](/cfr/26/1.421-1.md?p=c). - (3) If [section 423(c)](/cfr/26/423.md?p=c) applies to an option then, in case of a modification, extension, or renewal of an option, the highest of the following values shall be considered to be the fair market value of the stock at the time of the granting of such option for purposes of applying the rules of [sections 423(b)(6)](/cfr/26/423.md?p=b-6)— - (i) The fair market value on the date of the original granting of the option, - (ii) The fair market value on the date of the making of such modification, extension, or renewal, or - (iii) The fair market value at the time of the making of any intervening modification, extension, or renewal. - (4) - (i) For purposes of [§§ 1.421-1 through 1.424-1](/cfr/26/1.421-1..1.424-1.md) the term modification means any change in the terms of the option (or change in the terms of the plan pursuant to which the option was granted or in the terms of any other agreement governing the arrangement) that gives the optionee additional benefits under the option regardless of whether the optionee in fact benefits from the change in terms. In contrast, for example, a change in the terms of the option shortening the period during which the option is exercisable is not a modification. However, a change providing an extension of the period during which an option may be exercised (such as after termination of employment) or a change providing an alternative to the exercise of the option (such as a stock appreciation right) is a modification regardless of whether the optionee in fact benefits from such extension or alternative right. Similarly, a change providing an additional benefit upon exercise of the option (such as the payment of a cash bonus) or a change providing more favorable terms for payment for the stock purchased under the option (such as the right to tender previously acquired stock) is a modification. - (ii) If an option is not immediately exercisable in full, a change in the terms of the option to accelerate the time at which the option (or any portion thereof) may be exercised is not a modification for purposes of this section. Additionally, no modification occurs if a provision accelerating the time when an option may first be exercised is removed prior to the year in which it would otherwise be triggered. For example, if an acceleration provision is timely removed to avoid exceeding the $100,000 limitation described in [§ 1.422-4](/cfr/26/1.422-4.md), a modification of the option does not occur. - (iii) A change to an option which provides, either by its terms or in substance, that the optionee may receive an additional benefit under the option at the future discretion of the grantor, is a modification at the time that the option is changed to provide such discretion. In addition, the exercise of discretion to provide an additional benefit is a modification of the option. However, it is not a modification for the grantor to exercise discretion specifically reserved under an option with respect to the payment of a cash bonus at the time of exercise, the availability of a loan at exercise, the right to tender previously acquired stock for the stock purchasable under the option, or the payment of employment taxes and/or required withholding taxes resulting from the exercise of a statutory option. An option is not modified merely because an optionee is offered a change in the terms of an option if the change to the option is not made. An offer to change the terms of an option that remains open less than 30 days is not a modification of the option. However, if an offer to change the terms of an option remains outstanding for 30 days or more, there is a modification of the option as of the date the offer to change the option is made. - (iv) A change in the terms of the stock purchasable under the option that increases the value of the stock is a modification of such option, except to the extent that a new option is substituted for such option by reason of the change in the terms of the stock in accordance with [paragraph (a)](#a) of this section. - (v) If an option is amended solely to increase the number of shares subject to the option, the increase is not considered a modification of the option but is treated as the grant of a new option for the additional shares. Notwithstanding the previous sentence, if the exercise price and number of shares subject to an option are proportionally adjusted to reflect a stock split (including a reverse stock split) or stock dividend, and the only effect of the stock split or stock dividend is to increase (or decrease) on a pro rata basis the number of shares owned by each shareholder of the class of stock subject to the option, then the option is not modified if it is proportionally adjusted to reflect the stock split or stock dividend and the aggregate exercise price of the option is not less than the aggregate exercise price before the stock split or stock dividend. - (vi) Any change in the terms of an option made in an attempt to qualify the option as a statutory option grants additional benefits to the optionee and is, therefore, a modification. However, if the terms of an option are changed to provide that the optionee cannot transfer the option except by will or by the laws of descent and distribution in order to meet the requirements of section [422(b)(5)](/cfr/26/422.md?p=b-5) or [423(b)(9)](/cfr/26/423.md?p=b-9) such change is not a modicication. - (vii) An extension of an option refers to the granting by the corporation to the optionee of an additional period of time within which to exercise the option beyond the time originally prescribed. A renewal of an option is the granting by the corporation of the same rights or privileges contained in the original option on the same terms and conditions. The rules of this paragraph apply as well to successive modifications, extensions, and renewals. - (viii) Any inadvertent change to the terms of an option (or change in the terms of the plan pursuant to which the option was granted or in the terms of any other agreement governing the arrangement) that is treated as a modification under this [paragraph (e)](#e) is not considered a modification of the option to the extent the change in the terms of the option is removed by the earlier of the date the option is exercised or the last day of the calendar year during which such change occurred. Thus, for example, if the terms of an option are inadvertently changed on March 1 to extend the exercise period and the change is removed on November, then if the option is not exercised prior to November 1, the option is not considered modified under this [paragraph (e)](#e). - (5) A statutory option may, as a result of a modification, extension, or renewal, thereafter cease to be a statutory option, or any option may, by modification, extension, or renewal, thereafter become a statutory option. - (6) [Reserved] - (7) The application of this paragraph may be illustrated by the following examples: - (f) **Definitions.** The following definitions apply for purposes of [§§ 1.421-1 through 1.424-1](/cfr/26/1.421-1..1.424-1.md): - (1) **Parent corporation.** The term parent corporation, or parent, means any corporation (other than the employer corporation) in an unbroken chain of corporations ending with the employer corporation if, at the time of the granting of the option, each of the corporations other than the employer corporation owns stock possessing 50 percent or more of the total combined voting power of all classes of stock in one of the other corporations in such chain. - (2) **Subsidiary corporation.** The term subsidiary corporation, or subsidiary, means any corporation (other than the employer corporation) in an unbroken chain of corporations beginning with the employer corporation if, at the time of the granting of the option, each of the corporations other than the last corporation in an unbroken chain owns stock possessing 50 percent or more of the total combined voting power of all classes of stock in one of the other corporations in such chain. - (g) **Effective/applicability date—** - (1) **In general.** Except for [§ 1.424-1(a)(10)](#a-10) Example 9 (iii), the regulations under this section are effective on August 3, 2004. [Section 1.424-1(a)(10)](#a-10) Example 9 (iii) is effective on November 17, 2009. [Section 1.424-1(a)(10)](#a-10) Example 9 (iii) applies to statutory options granted on or after January 1, 2010. - (2) **Reliance and transition period.** For statutory options granted on or before June 9, 2003, taxpayers may rely on the 1984 proposed regulations LR-279-81 (49 FR 4504), the 2003 proposed regulations REG-122917-02 (68 FR 34344), or this section until the earlier of January 1, 2006, or the first regularly scheduled stockholders meeting of the granting corporation occurring 6 months after August 3, 2004. For statutory options granted after June 9, 2003, and before the earlier of January 1, 2006, or the first regularly scheduled stockholders meeting of the granting corporation occurring at least 6 months after August 3, 2004, taxpayers may rely on either REG-122917-02 or this section. Taxpayers may not rely on LR-279-81 or REG-122917-02 after December 31, 2005. Reliance on LR-279-81, REG-122917-02, or this section must be in its entirety, and all statutory options granted during the reliance period must be treated consistently. - (3) **Application of section 1022.** The provisions of [paragraph (c)(2)](#c-2) of this section relating to [section 1022](/cfr/26/1022.md) are effective on and after January 19, 2017.