Federal tax law treats the difference between the fair market value (FMV) of the stock on the exercise date and the cost of exercising the option as a tax preference item for calculating the alternative minimum tax. However, there is no recognition event for regular tax purposes until the stock is sold. When the stock is ultimately sold, the difference between the FMV of the stock on the date of sale and the cost of the option is recognized as a capital gain or loss. However, a disqualifying disposition occurs if the stock, once exercised, is not held for the statutory holding period. When a disqualifying disposition occurs, the employee is treated as receiving compensation to the extent that the FMV of the stock on the exercise date exceeds the exercise price. Therefore, any stock appreciation subsequent to the exercise date is treated as a capital gain when the stock is sold. Any decline in the FMV of the stock after the exercise date reduces the amount of compensation recognized.

Is It Income?

When defining New York source income for nonresident individuals, New York Tax Law Sec. 631(b)(1)(B) states that "items of income, gain, loss and deduction derived from or connected with New York sources shall be those items attributable to a business, trade, profession or occupation carried on in this state." In addition, Tax Law Sec. 631(b)(2) states that income from intangible personal property "shall constitute income derived from New York sources only to the extent that such income is from property employed in a business, trade or occupation carried on in this state." Therefore, the question of whether the exercising of an ISO or the subsequent sale of the stock meets the definition of New York source income for a nonresident individual needs to be addressed.

In Michaelson v. State Tax Commission, 67 NY 2d 579 (1986), the court said that IRC Sec. 422 defines a qualified stock option as an option granted by a corporation to an individual for any reason connected with his or her employment with such corporation. Therefore, the court indicated that it was reasonable to conclude that any gain on the sale of stock resulting from the exercise of ISOs was "connected" with New York sources under Sec. 631(b). The court also noted that the taxpayer in this case provided no evidence that the granting of such stock options was anything other than compensation for past or present services. The facts of this case indicated that the taxpayer had made a disqualifying disposition under federal law.

The court ruled that the difference between the FMV of the stock when exercised and the exercise price was compensation which constituted New York source income. By measuring compensation on the date of exercise, the court implied that any stock appreciation after the date of exercise would not be subject to New York tax if the nonresident individual did not employ such stock in a business, trade, profession, or occupation carried on in New York. Therefore, if the nonresident individual held the stock as personal investment, dividends from or future appreciation of the stock would not be New York source income. Furthermore, it appears that the timing of the income recognition for New York purposes will correspond to that for federal purposes (date the stock is sold), regardless of the fact that the amount of the New York source income is measured on the earlier exercise date.

Once the amount of potential New York source income has been determined, New York tax law allows such income to be apportioned. For example, New York State Reg. Sec. 131.18 allows the wages of a nonresident individual who works in New York to apportion his or her wages based upon the number of days worked in New York relative to the total number of days worked in a taxable year. However, in the case of a nonresident individual who receives separate grants of ISOs each year for a number of years, the question arises as to what year(s) should be used as a basis to apportion such income for New York purposes?

Allocating Out of New York

New York State Reg. Sec. 131.20 provides guidance for allocating and apportioning pension and deferred compensation amounts received by nonresident individuals and says that such amounts should be apportioned by using the individual's average percentage of days worked in New York to total days worked each year for the current and the three immediately preceding tax years. However, New York State Reg. Sec. 131.23 allows a nonresident taxpayer to apportion and allocate various types of income in any manner that results in a "fair and equitable" manner provided such method is disclosed on the tax return. Therefore, it appears that there is room to use an allocation method other than the four-year period prescribed by Reg. Sec. 131.20 if it is a fairer and more equitable way of apportioning such income.

Whether planning the timing of a client's exercise of ISOs and selling of the underlying stock or simply preparing such client's tax returns, practitioners need to be aware of the various state tax rules concerning ISOs and nonresident individuals.