Stock options are, by far, the most frequently used long-term incentive compensation devices in U.S. industry. They can be found in companies of all sizes. A compensatory stock option, as distinguished from a publicly-traded option, is a contractual right granted to an employee or other service provider at no cost, to purchase a stated number of shares of company stock at a fixed price for a certain number of years. The purchase price of compensatory stock options is generally the value of the stock as of the date of grant, the option term is generally 10 years or less, and the options are generally not transferable by the employee.

Compensatory stock options fall within two categories for tax purposes, nonqualified and incentive. The taxation of nonqualified stock options (NQOs) is not specifically controlled by any section of the IRC, and their tax consequences at grant and exercise are dictated by the rules of Sec. 83 pertaining to transfers of property in connection with the performance of services. Incentive stock options (ISOs) are defined in Sec. 422A and taxed under the special rules of Sec. 421. The majority of options are eventually exercised in due course by the employee to obtain economic gain resulting from appreciation in the underlying stock. This will not occur, however, in the case of the outstanding compensatory options of a company which is being acquired.

In the typical acquisition of a company, from the largest publicly- traded to the smallest closely-held, outstanding compensatory options are cashed out as part of the deal, with option holders surrendering their option contracts for a cash payment. The amount of the case payment generally equals the option "spread," which is the difference between the total exercise price the employee has to pay and the value of the shares purchasable under the option. Depending upon the financing of the deal, the cashout payment may be made by the target company or by the acquiring company. This article reviews the tax consequences of that payment to both the employee surrendering the option, and the employer who granted the option.

General Rules

It appears that all tax aspects of the option cashout transaction are controlled by Sec. 83, "Transfers of Property in Connection with the Performance of Services" and the regulations thereunder. Although taxpayers have often tried to support an alternative approach, a rather substantial string of court cases and Revenue Rulings hold that Sec. 83, specifically Reg. Sec. 1.83-7, controls the taxation of these transactions. While certain tax aspects of the cashout transaction are clear, other results are not, with no authorities directly on point. The author offers his observations on these unsettled areas.