Taxes and Business Decisions 333exercise, and then pays tax on the growth at a time when she has realized cash
with which to pay the tax at a lower long-term capital gain rate. Although the
employer receives little benefit, it has cost the employer nothing in hard assets,
so any benefit would have been a windfall.
Because this tax scenario is seen as very favorable to the employee, the
IRS has been loathe to allow it in most cases. Generally, the IRS will not rec-
ognize an option as having a readily ascertainable value unless the option is
traded on a recognized exchange. Short of that, a case has occasionally been
made when the underlying stock is publicly traded, such that its value is read-
ily ascertainable. But the IRS has drawn the line at options on privately held
stock and at all options that are not themselves transferable. Since Morris’s cor-
poration is privately held and since he will not tolerate Brad’s reserving the
right to transfer the option to a third party, there is no chance of Brad’s taking
advantage of this beneficial tax treatment.
The second tax scenario attaches to stock options which do not have a
readily ascertainable value. Since, by definition, one cannot include their value
in income on the date of grant (it is unknown), the Code allows the grant to es-
cape taxation. However, upon exercise, the taxpayer must include in income
the difference between the then fair market value of the stock purchased
and the total paid for the option and stock. When the purchased stock is later
sold, the further growth is taxed at the applicable rate for capital gain. The em-
ployer receives a compensation deduction at the time of exercise and no de-
duction at the time of sale. Although the employee receives a deferral of
taxation from grant to exercise in this scenario, this method of taxation is gen-
erally seen as less advantageous to the employee, since a larger amount of in-
come is exposed to ordinary income rates, and this taxation occurs at a time
when the taxpayer has still not received any cash from the transaction with
which to pay the tax.
Recognizing the harshness of this result, Congress invented a third taxa-
tion scenario which attaches to incentive stock options (ISOs). The recipient of
such an option escapes tax upon grant of the option and again upon exercise.
Upon sale of the underlying stock, the employee includes in taxable income the
difference between the price received and the total paid for the stock and op-
tion and pays tax on that amount at long-term capital gain rates. This scenario is
extremely attractive to the employee who defers all tax until the last moment
and pays at a lower rate. Under this scenario, the employer receives no deduc-
tion at all, but since the transaction costs him nothing, that is normally not a
major concern. Lest you believe that ISOs are the perfect compensation de-
vice, however, be aware that, although the employee escapes income taxation
upon exercise of the option, the exercise may be deemed taxable under the al-
ternative minimum tax described later in this chapter.
The Code imposes many conditions upon the grant of an incentive stock
option. Among these are that the options must be granted pursuant to a written
plan setting forth the maximum number of shares available and the class of
employees eligible; only employees are eligible recipients; the options cannot