A qualified option (meeting the requirements in sec. 422) must be granted pursuant to a plan approved by the shareholders of the corporation. The option must, by its terms, be exercised within 5 years from the date it is granted and the purchase price of the shares (option price) may not be less than the fair market value of the company's stock on the date when the option is granted to the employee. In addition, any stock acquired under a qualified option may not be disposed of within 3 years after it is transferred to the employee. The option must also be exercised while the option holder is an employee of the corporation, or within three months after the termination of his employment.

By contrast, nonqualified stock options were (and remain) generally subject ot the rules of section 83. Generally, under section 83, the value of a nonqualified stock option constitutes ordinary income to the employee if the option itself had a readily ascertainable fair market value at the time it was granted to the employee. If the option did not have a readily ascertainable value when granted, it would not constitute ordinary income at the time it was granted; when the option is exercised, however, the spread between the option price and the value of the stock at that time constitutes ordinary income to the employee.

As can be seen from the above description, qualified options had the advantage that an executive was not required to pay any ordinary income tax on the value of the option as such when the company grants it to him, or on any "bargain element" which may exist if and when he decided to exercise the option and purchase stock in the company. (The bargain element is the excess of the fair market value of a share of stock over its purchase price.) The employee was only required to pay tax when he sold the shares purchased under the option. Further, if he held the shares for at least 3 years (as required for the option to remain qualified) he was entitled to pay tax at capital gain rates on the full amount of his gain (if any) over the price which he originally paid to buy the shares.

Although an employee did not have to pay tax under the qualified stock option rules at the time he exercised the option and received stock worth more than he paid for it, the bargain element was treated as an item of tax preference. (This rule remains in effect for qualified options granted and exercised under certain transition rules described below.) This means that the excess of the fair market value of the share at the time of exercise over the purchase price paid by the employee was subject to the minimum tax.

Reasons for change

The principal reason for the prior tax treatment of qualified stock options was said to be that such treatment allowed corporate employers to provide "incentives" to key employees by enabling these employees to obtain an equity interest in the corporation. However, it seems doubtful whether a qualified stock option gives key employees more incentive than does any other form of compensation, especially since the value of compensation in the form of a qualified option is subject. to the uncertainties of the stock market. Moreover, even to the extent a qualified option is an incentive, it still represents compensation and the Congress believes that as such it should be subject to tax in much the same manner as other compensation. Moreover, to the extent that

there was an incentive effect resulting from stock options, it could be argued that prior law discriminated in favor of corporations (which were the only kind of employers who could grant qualified options) as opposed to all other forms of business organization.

Explanation of provisions

Under the Act, prior law will not apply to qualified stock options granted after May 20, 1976, except in the case of an option granted under a written plan adopted and approved on or before that date, or under a plan adopted by a board of directors on or before May 20, 1976 (even if the plan is approved by the shareholders after that date). Thus, generally, stock options granted after May 20, 1976, whether or not otherwise qualified (under the requirements of section 422) will be subject to the rules which apply in the case of most nonqualified options granted after June 30, 1969 (sec. 83 of the code). Under these rules, if an employee receives an option which has a readily ascertainable fair market value at the time it is granted, this value (less the price paid for the option, if any) constitutes ordinary income to the employee at that time.2

On the other hand, if the option does not have a readily ascertainable fair market value at the time it is granted, the value of the option does not constitute income to the employee at that time, but would be taxable to the employee when the option is exercised. The ordinary income recognized at that time is the spread between the option price and the value of the stock (unless the stock is nontransferable and subject to a substantial risk of forfeiture).

Any option which is subject to the provisions outlined above (sec. 83) is not treated as a tax preference for purposes of the minimum tax. To illustrate these rules, consider the case of a qualified option granted to a corporate executive to buy 100 shares at $10 per share. The employee exercises the option in full when the shares are selling at $15 per share in the open market. Under the act, this transaction would be treated (under sec. 83) as follows:

(a) At the time that the company grants the option to the executive, if the option as such has a readily ascertainable fair market value, the value of the option (less any amount which he may have been paid for it) is taxable to the executive as ordinary income.

(b) If the option itself does not have a readily ascertainable market value, the executive will be subject to tax when he exercises the option and acquires the shares under option to him. In this example, the employee will be taxable on the $5 per share bargain element (or a total of $500) at the time he exercises his option. This income will be treated as compensation taxable at ordinary income rates.3

2 However, if the option is nontransferable and is also subject to a substantial risk of forfeiture, recognition of income would be postponed until one or both of these encumbrances is removed.

As indicated above, recognition of income could be postponed if the stock is not transferable and if it is subject to a substantial risk of forfeiture. In this case, the tax is imposed (at ordinary income rates) at the time when either of these two restrictions is removed and the tax base is the excess of the fair market value of the shares at the time when either of these two restrictions is removed over the amount which the employee originally paid for the property. However, under section 83, an employee who receives stock (or other property) in his employer corporation burdened by restrictions which would free him from paying a tax at that time may, nevertheless, elect to pay tax on the bargain element existing at that time. If the employee makes this election and pays tax when he exercises the option, any later increase in value of the shares will generally be taxable to him as capital gain (rather than compensation income) when he disposes of the shares.

Income recognized by the employee under these rules would generally constitute earned income for purposes of the maximum tax on earned income (sec. 1348).

(c) After the executive pays tax at ordinary income rates on the compensation portion of the transaction, he would be entitled to add the amount of ordinary income recognized to his basis in the shares. Any further gain (realized when the employee sells the shares) would generally be taxable as a capital gain.

(d) The employer corporation is entitled to a deduction (under sec. 83) in an amount equal to the ordinary income realized by an employee under the above rules. The employer's deduction accrues at the time that the employee is considered to have realized compensa

tion income.

The Congress intends that in applying these rules for the future, the Service will make every reasonable effort to determine a fair market value for an option (i.e., in cases where similar property would be valued for estate tax purposes) where the employee irrevocably elects (by reporting the option as income on his tax return or in some other manner to be specified in regulations) to have the option valued at the time it is granted (particularly in the case of an option granted for a new business venture). The Congress intends that the Service will promulgate regulations and rulings setting forth as specifically as possible the criteria which will be weighed in valuing an option which the employee elects to value at the time it is granted.

Of course, merely because the option is difficult to value does not mean that the option has no value. The Congress intends that under these rules, the value of an option would be determined under all the facts and circumstances of a particular case. Among other factors that would be taken into account would be the value of the stock underlying the option (to the extent that this could be ascerained), the length of the option period (the longer the period, the greater the chance the underlying stock might increase in value), the earnings potential of the corporation, and the success (or lack of success) of similar ventures. Corporate assets, including patents, trade secrets and knowhow would also have to be taken into account.

The Congress anticipates that under the Service's rules, certain options, such as those traded publicly, would be treated as having a readily ascertainable fair market value, regardless of whether the employee makes an election. However, the regulations could provide that in certain other cases the option would ordinarily not be valued at the time it is granted unless the employee so elects.

The rules outlined above are not to apply to employee "stock purchase plans" (described in sec. 423 of the Code) under which the rank and file employees of a corporation (as well as the executives) are afforded an opportunity to purchase corporate stock on a nondiscriminatory basis. The prior Federal tax treatment of this type of plan is not affected by this provision of the Act.

The Act also provides certain transition rules so as not to disturb arrangements which were entered into in reliance on prior law. Under the transition rules, prior law will continue to govern qualified stock options granted pursuant to a written qualified stock option plan which was adopted by the board of directors of the corporation before May 21,

1976. For purposes of this rule, it is immaterial whether the shareholders approve the plan before, on, or after the date, although in order to be a qualified plan the shareholders must approve the plan within 12 months before or after its adoption by the board (sec. 422 (b)(1)). In order to retain its qualification the option must be exercised by the employee before May 21, 1981 (i.e., within five years of the May 20, 1976 cutoff date). However, this requirement does not have to be spelled out under the terms of the option; it is sufficient if the option is actually exercised on or before May 20, 1981.

In general, a plan is to be treated as having been "adopted" by the board of directors of the corporation by May 20, 1976, only if all of the action required for adoption has been completed by that date. For example, if the plan had been adopted by the directors of a corporation under procedures which were valid under State law, the plan would generally be treated as having been "adopted" within the meaning of the statute. For purposes of these rules, any amendment of an existing plan to increase the number of shares which may be granted under the plan is to be treated as a new plan. Thus options granted as a result of a plan amendment adopted after May 20, 1976, would not be qualified options. It is not necessary, however, in the case of a plan adopted by May 20, 1976, for options to have been granted under the plan by that date or for the directors or shareholders to have authorized the specific grant of options under the plan to specific individuals. If qualified options are granted under the transition rule, but the options are not exercised until after May 20, 1981, the Congress intends that the option is to be treated as an option which did not have a readily ascertainable fair market value at the time it was granted (within the meaning of sec. 83 (e) (3)). Thus, the value of the option in this case would not constitute income to the employee when granted (or at a time the transition rule expires), but if the option subsequently is exercised, and if the fair market value of the stock exceeds the option price, this excess will constitute ordinary income to the employee at the time of exercise.

The Act also requires that all outstanding restricted stock options (sec. 424) must be exercised on or before May 20, 1981, in order to receive the Federal tax treatment previously accorded these options. As under prior law, in the event of a corporate merger, consolidation or other reorganization, the employer corporation may substitute a new option for an old option, as long as the new option and the old option are substantially equivalent (sec. 425). Thus the surviving corporations in a corporate merger could substitute options on its stock for options on the stock of the nonsurviving corporation, so long as the options were of equivalent value and the new option did not provide for any additional benefits for the employee which he did not have under the old option. These substitutions can occur after May 20, 1976, on the same basis as before that date. (Of course, "old options" could not be granted after May 20, 1976, by the acquired corporation, except as provided under the transition rules. However, if a corporation adopted an option plan in 1974 and is reorganized in 1977 into a holding company with one or more operating subsidiaries, the holding company may adopt the 1974 option plan and continue to grant

qualified stock options to the extent permissible had the reorganization not occurred.)

Effective date

The amendments with respect to qualified stock options apply to taxable years ending after May 20, 1976.

Revenue effect

This program will increase budget receipts by $7 million in fiscal year 1977, $20 million in fiscal year 1978, and $5 million in fiscal year

1981.

5. Treatment of Losses From Certain Nonbusiness Guaranties (sec. 605 of the Act and sec. 166 of the Code)

Prior laws

Under prior law (which remains in effect), in the case of a noncorporate taxpayer, "business" bad debts are deductible as ordinary losses for the year in which the debt becomes worthless or partially worthless. On the other hand, "nonbusiness" bad debts are treated as short-term capital losses, which means that the losses are offset first against the taxpayer's capital gains (if any), and may then be deducted against ordinary income to the extent of $1,000 per year. On the other hand, where the noncorporate taxpayer's loss results from a situation where he guaranteed the debt of a noncorporate person, and was required to make good on that guaranty because the borrower defaulted, section 166 (f) of the code provided that the guarantor could treat the payment under the guaranty as a business bad debt (even though the guaranty did not arise in connection with the guarantor's trade or business) if the proceeds of the loan were used by the borrower in his trade or business, and the debt was worthless when payment was made by the guarantor (i.e., the borrower was insolvent). The deduction is allowed for the year in which the payment is made.

However, the guarantor of a corporate obligation which becomes worthless must treat the guaranty payment as a nonbusiness bad debt (Reg. $ 1.166-8 (b)). Also, if the loan was not used in the borrower's trade or business, the provisions of section 166 (f) did not apply. However, the guarantor's payment was still deductible as a nonbusiness bad debt (short-term capital loss) if the debt was worthless when paid and the guarantor had a right of reimbursement (subrogation) against the borrower.1

Where the guarantor had no right of subrogation, there was some uncertainty as to whether, and under what circumstances, the guarantor was entitled to deduct his guaranty payment. For some time it was believed that the payment could not be deducted as a bad debt on the theory that unless there is a right of recovery against the borrower, there is no "debt" which might become worthless in the hands of the guarantor. However, if the guaranty transaction was entered into in connection with the taxpayer's trade or business, or the agreement was part of a transaction entered into for profit on the part of the taxpayer, then the payment was claimed to be deductible as a loss under

1 If the debt is not worthless, no deduction is generally allowed (on the theory that payment by the guarantor was voluntary).