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Therefore, an option to purchase nonpublicly traded stock generally does not have a readily ascertaina-
ble FMV.

If an option is not publicly traded and does not have a readily ascertainable FMV, there is no taxable
event when the option is granted. Upon exercise, if all restrictions on the stock have lapsed, the employ-
ee must recognize compensation (ordinary income) in the amount of the FMV of the acquired stock, less
any amount paid for that stock (that is, the option strike price). If the acquired stock is sold at a later
date, the sale is subject to capital gains tax treatment. The holding period (determining whether the gain
or loss will be taxed as long or short term) begins on the date the option is exercised, not the date it is
granted.

The employer granting the options has a corresponding compensation deduction in the year the employ-
ee recognizes ordinary income. The compensation is subject to employment taxes and withholding re-
quirements.

Under IRC Section 83(b), if restrictions on the stock remain, the employee can make an election at the
time of the exercise of the option to recognize ordinary income based on the value of the stock at that
time. Provided the election is properly made and the employee recognizes the income, the employer can
deduct the value of the option at the time of exercise. The subsequent increase in value will be taxed as
capital gain when the stock is sold.

If nonqualified options have, as defined, a readily ascertainable FMV, the recipient recognizes ordinary
income equal to the FMV of the option in the year it is granted. If the option was purchased, the income
recognized is the value of the option minus the cost. If the stock is later sold, the gain is taxed at capital
gain tax rates. The capital gain may be either long or short term, depending on the holding period. The
employee’s basis in the stock is the FMV of the option at the date of grant plus the amount paid for the
stock upon exercise.

Incentive Stock Options (Qualified Options)

The tax attributes of incentive stock options (ISOs) are significantly different than those associated with
nonqualified stock options. No tax is due when an employee receives a grant of ISOs. Unlike nonquali-
fied stock options, the employee realizes no taxable income upon the exercise of ISOs; however, the
employee may be subject to the AMT because an AMT preference is associated with the exercise of an
ISO. The AMT preference is measured by the excess of the FMV of the stock at the date of exercise in
excess of the option exercise price. Whether this results in AMT to the exercising employee is depend-
ent upon the facts and circumstances of the employee’s tax situation for the year of exercise. The AMT
tax comes due despite the fact that the employee did not receive any cash on the date of exercise.

Regardless of whether the employee is subject to AMT at the time of exercise, the employee will be sub-
ject to tax upon the disposition of the stock obtained through the exercise of the ISOs. If the disposition
occurred within two years after the employee received the ISO grant or one year after the options were
exercised and stock was received, ordinary income will be recognized. Ordinary income will be recog-
nized to the extent that the FMV of the stock at the time of exercise of the option exceeded the option
exercise price. This spread is generally referred to as the bargain purchase element. In the event that the
stock has declined in value, the gain will be limited to the excess of the disposition proceeds over the op-
tion exercise price. The employee will also report a capital gain equal to the spread between the FMV of
the stock at the date of exercise of the option and the proceeds received from the disposition of the stock
on the sale date. If the stock is sold within one year of the exercise of the ISO, the capital gain will be a
short-term capital gain taxed at ordinary income tax rates.

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