Detailed Answer
(c) The requirement is to determine when Ross was
subject to “regular tax” with regard to stock that was acquired
through the exercise of an incentive stock option. There are no
tax consequences when an incentive stock option is granted to an
employee. When the option is exercised, any excess of the stock’s
FMV over the option price is a tax preference item for purposes
of the employee’s alternative minimum tax. However, an employee
is not subject to regular tax until the stock acquired
through exercise of the option is sold.
If the employee holds the stock acquired through exercise of the
option at least two years from the date the option was granted
(and holds the stock itself at least one year), the employee’s realized
gain is treated as long-term capital gain in the year of sale,
and the employer receives no compensation deduction. If the
preceding holding period rules are not met at the time the stock
is sold, the employee must report ordinary income to the extent
that the stock’s FMV at date of exercise exceeded the option
price, with any remaining gain reported as long-term or shortterm
capital gain. As a result, the employer receives a compensation
deduction equal to the amount of ordinary income reported
by the employee.