[Code of Federal Regulations]
[Title 26, Volume 5]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.421-1]

[Page 889-892]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.421-1  Effective dates and meaning and use of certain terms.

    (a) Option. (1) For the purpose of section 421, the term ``option'' 
includes the right or privilege of an individual to purchase stock from 
a corporation by virtue of an offer of the corporation continuing for a 
stated period of time, whether or not irrevocable, to sell such stock at 
a price determined under paragraph (d) of this section, such individual 
being under no obligation to purchase. Such right or privilege, when 
granted, must be evidenced in writing. The individual who has such right 
or privilege is referred to as the optionee and the corporation offering 
to sell stock under such an arrangement is referred to as the optionor. 
While no particular form of words is necessary, the written option 
should express, among other things, an offer to sell at the option price 
and the period of time during which the offer shall remain open.
    (2) An option may be granted as part of or in conjunction with an 
employee

[[Page 890]]

stock purchase plan or subscription contract.
    (3) An arrangement between a corporation and an employee may involve 
more than one option. For example, if a corporation on June 1, 1954, 
grants to an employee the right to purchase 1,000 shares of its stock on 
or after June 1, 1955, another 1,000 shares on or after June 1, 1956, 
and a further 1,000 shares on or after June 1, 1957, all shares to be 
purchased before June 1, 1958, provided the employee at the time of 
exercise of any of the purchase rights is employed by the corporation, 
such an arrangement will be construed as the grant to the employee on 
June 1, 1954, of three options, each for the purchase of 1,000 shares. 
Similarly, if a corporation grants to an employee on January 1, 1955, 
the right to purchase 1,000 shares of its stock at $85 per share during 
1955, or at $75 per share during 1956, or at $65 per share during 1957, 
such an arrangement will be construed as the grant to the employee on 
January 1, 1955, of three alternative options, one option for the 
purchase of 1,000 shares at $85 per share during 1955, an alternative 
option for the purchase of 1,000 shares at $75 per share during 1956, 
and a third alternative option for the purchase of 1,000 shares at $65 
per share during 1957.
    (b) Time and date of granting of option. (1) For the purpose of 
section 421, the words ``the date of the granting of the option'' and 
``the time such option is granted'', and similar phrases refer to the 
date or time when the corporation completes the corporate action 
constituting an offer of stock for sale to an individual under the terms 
and conditions of a restricted stock option. Ordinarily, if the 
corporate action contemplates an immediate offer of stock for sale to an 
individual or to a class including such individual, or contemplates a 
particular date on which such offer is to be made, the time or date of 
the granting of the option is the time or date of such corporate action 
if the offer is to be made immediately, or the date contemplated as the 
date of the offer, as the case may be. However, an unreasonable delay in 
the giving of notice of such offer to the individual or to the class 
will be taken into account as indicating that the corporation 
contemplated that the offer was to be made at the subsequent date on 
which such notice is given.
    (2) If the corporation imposes conditions on the granting of an 
option (as distinguished from conditions governing the exercise of the 
option), such conditions shall be given effect in accordance with the 
intent of the corporation. A special rule is provided by section 
421(d)(5) for options subject to stockholder approval. If the grant of 
an option is subject to approval by stockholders, the date of grant of 
the option shall be determined as if the option had not been subject to 
such approval. A condition which does not require corporate action, such 
as the approval of some regulatory or governmental agency, for example, 
a stock exchange or the Securities and Exchange Commission, is 
ordinarily considered a condition upon the exercise of the option unless 
the corporate action clearly indicates that the option is not to be 
granted until such condition is satisfied. If an option is granted to an 
individual upon the condition that such individual will become an 
employee of the corporation granting the option or of its parent or 
subsidiary corporation, such option is not granted prior to the date the 
individual becomes such an employee.
    (3) In general, conditions imposed upon the exercise of an option 
will not operate to make ineffective the granting of the option. For 
example, on June 1, 1954, the A Corporation grants to X, an employee, an 
option to purchase 5,000 shares of the corporation stock, exercisable by 
X on or after June 1, 1955, provided he is employed by the corporation 
on June 1, 1955. Such an option is granted to X on June 1, 1954.
    (c) Stock. For the purpose of section 421, the term ``stock'' means 
capital stock of any class, including voting or nonvoting common or 
preferred stock. The term includes both treasury stock and stock of 
original issue. Special classes of stock authorized to be issued to and 
held by employees are within the scope of the term ``stock'' as used in 
section 421, provided such stock otherwise possesses the rights and 
characteristics of capital stock.
    (d) Option price. (1) For the purpose of section 421, the term 
``option price'' or ``price paid under the option'' means the

[[Page 891]]

consideration in money or property which, pursuant to the terms of the 
option, is the price at which the stock subject to the option is 
purchased.
    (2) (i) With respect to its option price, a restricted stock option 
must, when granted, meet either of the following requirements:
    (A) The option price must be fixed or determinable at the time the 
option is granted; or
    (B) In the case of an option exercised during any taxable year of 
the optionee which begins after December 31, 1953, and ends after August 
16, 1954, the option price must be determinable under a variable price 
option as defined in subdivision (ii) of this subparagraph.

An option which does not meet the requirements of either (A) or (B) of 
this subdivision when granted will not be treated as a restricted stock 
option unless it is subsequently changed to meet such requirements. In 
case of such a change, see paragraph (c)(2) of Sec. 1.421-4.
    (ii)(A) The term ``variable price option'' means an option under 
which the option price is determined by a formula in which the only 
variable is the fair market value of the stock at any time during a 
period of six consecutive months which includes the day on which such 
option is exercised. Except as provided in (b) of this subdivision, such 
formula may provide for determining such price by reference to such 
value on any particular day in such 6-month period, or by reference to 
an average value of the stock over either the whole of such 6-month 
period or over any shorter period included in such 6-month period. Such 
6-month period may begin with, end with, or in any other manner span the 
day on which such option is exercised. Such formula may also depend upon 
factors other than such value of the stock, but such other factors must 
not be variable and must be fixed in the option when granted. For 
example, such formula may provide that the option price shall be 85 
percent of the value of the stock on the day the option is exercised, 
but such price shall not be less than $85, nor more than $110. Another 
example of a formula which meets the requirements of this subdivision is 
a provision that the option price shall be 95 percent of the fair market 
value of the stock on the day the option is exercised but not more than 
$95. However, the requirements of this subdivision are not met by a 
formula which provides that if the profits of the employer for the year 
do not exceed $100,000, the option price shall be $15 under the fair 
market value of the stock at the time the option is exercised, but if 
such profits exceed $100,000, the option price shall be $20 under such 
value of the stock. For an example of how to determine whether an option 
which contains a formula meeting the requirements of this subdivision 
also meets the requirement that the option price must be at least 85 
percent of the fair market value of the stock at the time the option is 
granted, see paragraph (a)(1) of Sec. 1.421-2.
    (B) In the case of an option granted after September 30, 1958, the 
term ``variable price option'' does not include any option in which the 
formula provides for determining the option price by reference to the 
fair market value of the stock at any time before the option is 
exercised if such value may be greater than the average fair market 
value of the stock during the calendar month in which the option is 
exercised. Whether an option meets the requirement of this subdivision 
shall be determined solely by reference to the terms of the option, and 
the circumstances existing at the time the option is granted or 
exercised are immaterial. Thus, an option, granted after September 30, 
1958, and containing a pricing formula which takes into consideration 
the value of the stock at any time before the option is exercised, is 
subject to the new limitation and does not meet the requirement of this 
subdivision, even though the option price is not actually based upon 
such prior fair market value either at the time the option is exercised 
or at the time the option price is computed as if it were exercised for 
the purpose of applying the 85 percent test of section 421(d)(1)(A). For 
example, a formula which provides that the option price is to be 45 
percent of the fair market value of the stock 30 days before the date on 
which the option is exercised, but not more than $85, will not qualify 
under this subdivision since under this formula the price may be 
determinable

[[Page 892]]

by reference to a higher prior value. On the other hand, a formula which 
provides that the option price is to be 90 percent of the average value 
of the stock during the month the option is exercised or the average 
value of the stock during the preceding month, whichever is lower, will 
qualify. In the case of an option granted after September 30, 1958, the 
only way that a formula which provides for determining the option price 
by reference to the fair market value of the stock at a time before the 
option is exercised can come within the requirement of this subdivision 
is to provide that the option price is to be determined by reference to 
such fair market value only if such fair market value is not greater 
than the average fair market value of the stock during the month in 
which the option is exercised. If under the terms of an option the price 
is to be determined by reference to the fair market value of the stock 
at a time before the option is exercised, whether such value is higher 
or lower than the average fair market value of the stock during the 
month the option is exercised, such option will not be considered a 
restricted stock option since the option price may be based upon the 
prior value of the stock when such value exceeds the average fair market 
value of the stock during the month the option is exercised. However, if 
an option provides for determining the option price by reference to a 
prior fair market value of the stock only when such value is lower than 
such average value of the stock, such option can qualify as a restricted 
stock option. The average fair market value of the stock during the 
month in which the option is exercised means such value during the 
calendar month the option is exercised and not merely during a 30- or 
31-day period including the time the option is exercised. To compute the 
average fair market value of the stock for the month, it will be 
necessary to ascertain the fair market value of the stock for each day 
during the month, including those days which are not business days. In 
ascertaining the fair market value of the stock for each day, the 
generally accepted principles for ascertaining such value will be 
applied.
    (e) Exercise. For the purpose of section 421, the term ``exercise'', 
when used in reference to an option, means the act of acceptance by the 
optionee of the offer to sell contained in the option. In general, the 
time of exercise is the time when there is a sale or a contract to sell 
between the corporation and the individual. An agreement or undertaking 
by the employee to make payments under a stock purchase plan does not 
constitute the exercise of an option so long as the payments made remain 
subject to withdrawal by the employee.
    (f) Transfer. For the purpose of section 421, the term ``transfer'', 
when used in reference to the transfer to an individual of a share of 
stock pursuant to his exercise of a restricted stock option, means the 
transfer of ownership of such share, or the transfer of substantially 
all the rights of ownership. Such transfer must, within a reasonable 
time, be evidenced on the books of the corporation.
    (g) Effective dates. Sections 1.421-1 through 1.421-5 are applicable 
only to options granted after February 26, 1945, and before January 1, 
1964, and all references therein to sections of the Code are to the 
Internal Revenue Code of 1954, before the amendments made by section 221 
of the Revenue Act of 1964 (78 Stat. 63). Section 1.421-6 is applicable 
only to options granted on or after February 26, 1945, and all 
references to sections of the Code are to the Internal Revenue Code of 
1954, as amended. Sections 1.421-7 and 1.421-8 are applicable only to 
options granted after December 31, 1963, and all references therein to 
sections of the Code are to the Internal Revenue Code of 1954, as 
amended.

[T.D. 6500, 25 FR 11692, Nov. 26, 1960, as amended by T.D. 6527, 26 FR 
410, Jan. 19, 1961, T.D. 6887, 31 FR 8786, June 24, 1966]