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Nonqualifying and Disqualifying Stock Options
by Peter Soh, CPA

We would like to inform you about the new IRS position with regards to proper reporting requirements by the employer to claim a tax deduction for nonqualifying and disqualifying stock options.

Old Rule:
In general, an employer is entitled to a tax deduction for property transferred to an employee for the performance of services or a compensatory cancellation of a incentive stock option(nonqualifying stock option). Under the old rules, the employer was allowed to deduct for the excess fair market value of the stock, if ascertainable, over the amount paid for the stock option when the employee was granted an incentive stock option, but the employer must withhold income taxes from the employee for the amount of additional compensation the employee must recognize for the grant of the incentive stock option.

Also, under the statutory stock option rules, an individual does not recognize income as a result of the exercise of the options if the shares are held for two years after the grant date and one year after the transfer of the stock. If the employee disposes of the stock within this period, a disqualifying stock disposition takes place, and the employee must recognize income for this disposition. Under the old proposed regulations, the employer receives a tax deduction for the income the employee must recognize but must properly withhold taxes for the employee for the additional compensation. This situation has created problems for employers because the employer does not immediately know a disqualifying disposition has taken place and may not be able to timely comply with the W-2 reporting requirements.

New Rule:
Under the new proposed regulations, the withholding requirement has been dropped as a precondition to the employer's deduction. Upon timely submission of a W-2, the employer will receive a deduction for any nonqualifying stock options and does not have to verify whether the employee had included additional compensation for the grant of incentive stock options. Thus, the only obligation for the employer is to properly report the additional compensation for the grant of incentive stock options to the employee.

In addition, the employer receives a deduction for the amount of disqualifying stock options if it files a W-2 or W-2c with the IRS for the employee by the time it files the tax return claiming the deduction instead of the proper filing due date for W-2s.

These new proposed regulations apply for all tax years beginning after 1994. Taxpayers can also claim deductions for earlier years, in which the statute of limitations has not yet expired. For instance, under the old proposed regulations, stock transferred to an employee in 1992 as a result of an employee's exercise of a nonstatutory stock option, in which the employer did not withhold tax but did reflect the income on a W-2 by January 31, 1993 cannot be claimed as a tax deduction. If the employer did not claim the deduction, he may be able to amend his 1992 tax return since the withholding requirement has now been dropped.

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