[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: 26CFR1.421-5]

[Page 900-907]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.421-5  Operation of section 421.

    (a) Rules applicable to all restricted stock options--(1) In 
general. If a share of stock is transferred to an individual pursuant to 
his timely exercise of a restricted stock option and is not disposed of 
by him within two years from the date of the granting of the option nor 
within 1 year (6 months for taxable years before 1977; 9 months for 
taxable years beginning in 1977) after the transfer of such share to 
him, then, under section 421(a)--
    (i) No income shall result at the time of the transfer of such share 
to the individual upon his exercise of the option with respect to such 
share;
    (ii) No deduction under section 162 shall be allowable at any time 
to the employer corporation of such individual or its parent or 
subsidiary corporation, or to a corporation which assumed or issued the 
option under section 421(g), with respect to the share so transferred; 
and
    (iii) No amount other than the option price shall be considered as 
received by any of such corporations for the share so transferred.

For the purpose of subdivisions (i), (ii), and (iii) of this 
subparagraph, each share of stock transferred pursuant to a restricted 
stock option is treated separately. For example, if an individual, while 
employed by a corporation granting him a restricted stock option, 
exercises the option with respect to part of the stock covered by the 
option, and if such individual exercises the balance of the option more 
than three months after leaving such employment, the application of 
section 421 to the stock obtained upon the earlier exercise of the 
option is not affected by the fact that the income taxes of the employer 
and the individual with respect to the stock obtained upon the later 
exercise of the option are not determined under section 421.
    (2) Holding period. The special rules provided in section 421(a) are 
not applicable if the individual disposes of the share of stock within 
two years from the date the option is granted or within six months after 
the transfer of such share to him. Section 421 is not made inapplicable 
by a transfer within the 2-year or 1-year (6 months for taxable years 
beginning before 1977; 9 months for taxable years beginning in 1977) 
period if such transfer is not a disposition of the stock as defined in 
subparagraph (3) of this paragraph, for example, a transfer from the 
decedent to his estate or a transfer by bequest or inheritance. 
Similarly, a disposition by the executor, administrator, heir, or 
legatee is not a disposition by the decedent. In case a restricted stock 
option is exercised by the estate of the individual to whom the option 
was granted, or by a person who acquired the option by bequest or 
inheritance or by reason of the death of such individual, see paragraph 
(d) of this section.
    (3) Disposition of stock. (i) For the purpose of section 421, the 
term ``disposition'' includes a sale, exchange, gift, or any transfer of 
legal title, but does not include--
    (a) A transfer from a decedent to his estate or a transfer by 
bequest or inheritance; or
    (b) An exchange which occurs in a taxable year of the optionee 
beginning after December 31, 1953, and ending after August 16, 1954, and 
to which is applicable section 354, 355, 356, or 1036 (or so much of 
section 1031 as relates to section 1036) or a corresponding provision of 
the Internal Revenue Code of 1939; or
    (c) A mere pledge or hypothecation. However, a disposition of the 
stock pursuant to a pledge or hypothecation is a disposition by the 
individual, even though the making of the pledge or hypothecation is not 
such a disposition.
    (ii) If an individual exercises a restricted stock option, a share 
of stock acquired pursuant to such exercise is not considered disposed 
of by the individual if such share is taken in the name of the 
individual and another person jointly with right of survivorship, or is 
subsequently transferred

[[Page 901]]

into such joint ownership, or is retransferred from such joint ownership 
to the sole ownership of the individual. However, any termination of 
such joint ownership is a disposition of such share, except to the 
extent that the individual reacquires ownership of the share. For 
example, if such individual and his joint owner transfer such share to 
another person, the individual has made a disposition of such share. 
Likewise, if a share of stock held in the joint names of such individual 
and another person is transferred to the name of such other person, 
there is a disposition of such share by the individual. If an individual 
exercises a restricted stock option and a share of stock is transferred 
to another or is transferred to such individual in his name as trustee 
for another, the individual has made a disposition of such share.
    (4) Examples. The rules of section 421(a) may be illustrated by the 
following examples:

    Example (1). On June 1, 1954, the X Corporation grants to E, an 
employee, a restricted stock option to purchase 100 shares of X 
Corporation stock at $95 per share. On that date, the fair market value 
of X Corporation stock is $100 per share. On June 1, 1955, while 
employed by X Corporation, E exercises the option in full and pays X 
Corporation $9,500, and on that day X Corporation transfers to E 100 
shares of its stock having a fair market value of $12,000. Before June 
1, 1956, E makes no disposition of the 100 shares so purchased. E 
realizes no income on June 1, 1955, with respect to the transfer to him 
of the 100 shares of X Corporation stock. X Corporation is not entitled 
to any deduction at any time with respect to its transfer to E of the 
stock. E's basis for such 100 shares is $9,500.
    Example (2). Assume, in example (1), that on August 1, 1956, two 
years and two months after the granting of the option and one year and 
two months after the transfer of the shares to him, E sells the 100 
shares of X Corporation stock for $13,000, which is the fair market 
value of the stock on that date. For the taxable year in which the sale 
occurs, E realizes a gain of $3,500 ($13,000 minus E's basis of $9,500), 
which is treated as long-term capital gain.
    Example (3). Assume, in example (2), that on August 1, 1956, E makes 
a gift of the 100 shares of X Corporation stock to his son. Such 
disposition results in no realization of gain to E either for the 
taxable year in which the option is exercised or the taxable year in 
which the gift is made. E's basis of $9,500 becomes the donee's basis 
for determining gain or loss.
    Example (4). Assume, in example (1), that on May 1, 1956, one year 
and 11 months after the granting of the option and 11 months after the 
transfer of the shares to him, E sells the 100 shares of X Corporation 
stock for $13,000. The special rules of section 421(a) are not 
applicable to the transfer of the stock by X Corporation to E, because 
disposition of the stock was made by E within two years from the date 
the option was granted. See paragraph (e) of this section for the effect 
of a disqualifying disposition.
    Example (5). Assume, in example (1), that E dies on September 1, 
1955, owning the 100 shares of X Corporation stock acquired by him 
pursuant to his exercise on June 1, 1955, of the restricted stock 
option. On the date of death, the fair market value of the stock is 
$12,500. No income is realized by E by reason of the transfer of the 100 
shares to his estate. If the stock is valued as of the date of E's death 
for estate tax purposes, the basis of the 100 shares in the hands of the 
executor is $12,500.

    (b) Additional rules applicable where the option price is between 85 
percent and 95 percent of the value of the stock--(1) In general. (i) If 
all the conditions necessary for the application of section 421(a) 
exist, section 421(b) provides additional rules which are applicable in 
cases where, at the time the restricted stock option is granted, the 
option price per share is less than 95 percent (but not less than 85 
percent) of the fair market value of such share. In such case, upon the 
disposition of such share by the individual after the expiration of the 
2-year and 1-year (6 months for taxable years beginning before 1977; 9 
months for taxable years beginning in 1977) periods, or upon his death 
while owning such share (whether occurring before or after the 
expiration of such periods), there shall be included in the individual's 
gross income as compensation (and not as gain upon the sale or exchange 
of a capital asset) an amount determined in the following manner. If the 
option qualified under section 421(d)(1)(A)(i) (see paragraph 
(d)(2)(i)(a) of Sec. 1.421-1), such amount shall be the amount, if any, 
by which the option price is exceeded by the lesser of the fair market 
value of the share at the time the option was granted or the fair market 
value of the share at the time of such disposition or death. However, if 
the option qualified under section 421(d)(1)(A)(ii) (see paragraph 
(d)(2)(i)(b) of Sec. 1.421-1), such amount

[[Page 902]]

shall be whichever of the following amounts is lesser:
    (a) The excess of the fair market value of the share at the time of 
such disposition or death over the price paid under the option, or
    (b) The excess of the fair market value of the share at the time the 
option was granted over the option price, computed as if the option had 
been exercised at such time.


The amount of such compensation shall be included in the individual's 
gross income for the taxable year in which the disposition occurs or for 
the taxable year closing with his death, whichever event results in the 
application of section 421(b).
    (ii) The application of the special rules provided in section 421(b) 
shall not affect the rules provided in section 421(a) with respect to 
the individual exercising the option, the employer corporation, or its 
parent or subsidiary corporation. Thus, notwithstanding the inclusion of 
an amount as compensation in the gross income of an individual, as 
provided in section 421(b), no income results to the individual at the 
time the stock is transferred to him, and no deduction under section 162 
is allowable at any time to the employer corporation or its parent or 
subsidiary with respect to such amount.
    (iii) If the individual exercises a restricted stock option during 
his lifetime and dies before the stock is transferred to him pursuant to 
his exercise of the option, the transfer of such stock to the 
individual's executor, administrator, heir, or legatee is deemed, for 
the purpose of section 421, to be a transfer of the stock to the 
individual exercising the option and a further transfer by reason of 
death from such individual to his executor, administrator, heir, or 
legatee.
    (2) Basis. If the special rules provided in section 421(b) are 
applicable to the disposition of a share of stock by an individual, the 
basis of such share in the individual's hands at the time of such 
disposition, determined under section 1011, shall be increased by an 
amount equal to the amount includible as compensation in his gross 
income under section 421(b). However, in the case of a share of stock 
acquired by the exercise of a restricted stock option after the death of 
the employee to whom the option was granted, the basis of such share 
shall be determined in accordance with the rules of paragraph (d)(4) of 
this section. If the special rules provided in section 421(b) are 
applicable to a share of stock upon the death of an individual, the 
basis of such share in the hands of the estate or the person receiving 
the stock by bequest or inheritance shall be determined under section 
1014, and shall not be increased by reason of the inclusion upon the 
decedent's death of any amount in his gross income under section 421(b). 
See example (9) of this paragraph with respect to the determination of 
basis of the share in the hands of a surviving joint owner.
    (3) Examples. The operation of section 421(b) may be illustrated by 
the following examples:

    Example (1). On June 1, 1954, the X Corporation grants to E, an 
employee, a restricted stock option to purchase a share of X 
Corporation's stock for $85. The fair market value of the X Corporation 
stock on such date is $100 per share. On June 1, 1955, E exercises the 
restricted stock option and on that date the X Corporation transfers the 
share of stock to E. On January 1, 1957, E sells the share for $150, its 
fair market value on that date. E makes his income tax return on the 
basis of the calendar year. The income tax consequences to E and X 
Corporation are as follows: (i) Compensation in the amount of $15 is 
includible in E's gross income for 1957, the year of the disposition of 
the share. The $15 represents the difference between the option price 
($85) and the fair market value of the share on the date the option was 
granted ($100), since such value is less than the fair market value of 
the share on the date of disposition ($150). For the purpose of 
computing E's gain or loss on the sale of the share, E's cost basis of 
$85 is increased by $15, the amount includible in E's gross income as 
compensation. Thus, E's basis for the share is $100. Since the share was 
sold for $150, E realizes a gain of $50, which is treated as long-term 
capital gain; (ii) The X Corporation is entitled to no deduction under 
section 162 at any time with respect to the share transferred to E.
    Example (2). Assume, in example (1), that E sells the share of X 
Corporation stock on January 1, 1958, for $75, its fair market value on 
that date. Since $75 is less than the option price ($85), no amount in 
respect of the sale is includible as compensation in E's gross income 
for 1958. E's basis for determining gain or loss on the sale is $85. 
Since E sold the share for $75, E realized a loss of $10 on the

[[Page 903]]

sale, which loss is treated as a long-term capital loss.
    Example (3). Assume, in example (1), that the option provides that 
the option price shall be 90 percent of the fair market value of a share 
of the stock on the day the option is exercised. On June 1, 1955, when 
the option is exercised, the fair market value of the stock is $120 per 
share so that E pays $108 for the share of stock. Compensation in the 
amount of $10 is includible in E's gross income for 1957, the year of 
the disposition of the share. This is determined in the following 
manner. The excess of the fair market value of the stock at the time of 
the disposition ($150) over the price paid for the share ($108) is $42; 
and the excess of the fair market value of the stock at the time the 
option was granted ($100) over the option price, computed as if the 
option had been exercised at such time ($90), is $10. Accordingly, $10 
the lesser, is includible in gross income. In this situation, E's cost 
basis of $108 is increased by $10, the amount includible in E's gross 
income as compensation. Thus, E's basis for the share is $118. Since the 
share was sold for $150, E realizes a gain of $32, which is treated as 
long-term capital gain.
    Example (4). Assume, in example (1), that instead of selling the 
share on January 1, 1957, E makes a gift of the share on that day. In 
such case, $15 is includible as compensation in E's gross income for 
1957. E's cost basis of $85 is increased by $15, the amount includible 
in E's gross income as compensation. Thus, E's basis for the share is 
$100, which becomes the donee's basis, as of the time of the gift, for 
determining gain or loss.
    Example (5). Assume, in example (2), that instead of selling the 
share on January 1, 1958, E makes a gift of the share on that date. 
Since the fair market value of the share on that day ($75) is less than 
the option price ($85), no amount in respect of the disposition by way 
of gift is includible as compensation in E's gross income for 1958. E's 
basis for the share is $85, which becomes the donee's basis, as of the 
time of the gift, for the purpose of determining gain. The donee's basis 
for the purpose of determining loss, determined under section 1015(a), 
is $75 (fair market value of the share at the date of gift).
    Example (6). Assume, in example (1), that after acquiring the share 
of stock on June 1, 1955, E dies on August 1, 1956, at which time the 
share has a fair market value of $150. Compensation in the amount of $15 
is includible in E's gross income for the taxable year closing with his 
death, such $15 being the difference between the option price ($85) and 
the fair market value of the share when the option was granted ($100), 
since such value is less than the fair market value at date of death 
($150). The basis of the share in the hands of E's estate is determined 
under section 1014 without regard to the $15 includible in the 
decedent's gross income.
    Example (7). Assume, in example (6), that E dies on August 1, 1955, 
at which time the share has a fair market value of $150. Although E's 
death occurred within two years from the date of the granting of the 
option and within six months after the transfer of the share to him, the 
income tax consequences are the same as in example (6).
    Example (8). Assume the same facts as in example (1), except that 
the share of stock was issued in the names of E and his wife jointly 
with right of survivorship, and except that E and his wife sold the 
share on June 15, 1956, for $150, its fair market value on that date. 
Compensation in the amount of $15 is includible in E's gross income for 
1956, the year of the disposition of the share. The basis of the share 
in the hands of E and his wife for the purpose of determining gain or 
loss on the sale is $100, that is, the cost of $85 increased by the 
amount of $15 includible as compensation in E's gross income. The gain 
of $50 on the sale is treated as long-term capital gain, and is divided 
equally between E and his wife.
    Example (9). Assume the same facts as in example (1), except that 
the share of stock was issued in the names of E and his wife jointly 
with right of survivorship, and except that E predeceased his wife on 
August 1, 1956, at which time the share had a fair market value of $150. 
Compensation in the amount of $15 is includible in E's gross income for 
the taxable year closing with his death. See example (6). The basis of 
the share in the hands of E's wife as survivor is determined under 
section 1014 without regard to the $15 includible in the decedent's 
gross income.
    Example (10). Assume, in example (9), that E's wife predeceased him 
on July 1, 1956. Section 421(b) does not apply in respect of her death. 
Upon the subsequent death of E on August 1, 1956, the income tax 
consequences in respect of E's taxable year closing with the date of his 
death, and in respect of the basis of the share in the hands of his 
estate, are the same as in example (6). If E had sold the share on July 
15, 1956 (after the death of his wife), for $150, its fair market value 
at that time, the income tax consequences would be the same as in 
example (1).

    (c) Acquisition of other stock. (1) Section 421(c) provides that the 
special rules stated in section 421 (a) and (b), if applicable with 
respect to stock transferred to an individual upon his exercise of an 
option, shall likewise be applicable with respect to stock acquired by a 
distribution or an exchange to which is applicable section 305, 354, 
355, 356, or 1036 (or so much of section 1031 as relates to section 
1036) or a corresponding provision of the Internal

[[Page 904]]

Revenue Code of 1939. Stock so acquired shall, for the purpose of 
section 421, be considered as having been transferred to the individual 
upon his exercise of the option. A similar rule shall be applied in the 
case of a series of such acquisitions. With respect to such 
acquisitions, section 421(c) does not make inapplicable any of the 
provisions of section 305, 354, 355, 356, or 1036 (or so much of section 
1031 as relates to section 1036). Section 421(c) is applicable only with 
respect to such acquisitions which occur in any taxable year of the 
shareholder which begins after December 31, 1953, and ends after August 
16, 1954. As to acquisitions occurring in earlier taxable years, see 
section 130A(c) of the Internal Revenue Code of 1939.
    (2) The application of subparagraph (1) of this paragraph may be 
illustrated by the following example:

    Example. If, with respect to stock transferred pursuant to the 
timely exercise of a restricted stock option, there is a distribution of 
new stock to which section 305(a) is applicable, and if there is a 
disposition of such new stock within two years after the option was 
granted, such disposition makes section 421 inapplicable to the transfer 
of the original stock pursuant to the exercise of the option to the 
extent that the disposition effects a reduction of the individual's 
total interest in the old and new stock. However, if the new stock, as 
well as the old stock, is not disposed of within two years after the 
option was granted, nor within 1 year (6 months for taxable years 
beginning before 1977; 9 months for taxable years beginning in 1977) 
after the transfer of the old stock pursuant to the exercise of the 
option, section 421 is applicable.

    (d) Exercise after death. (1) If a restricted stock option is 
exercised by the estate of the individual to whom the option was 
granted, or by any person who acquired such option by bequest or 
inheritance or by reason of the death of such individual, and if such 
exercise occurs in a taxable year of the estate or of such person 
beginning after December 31, 1953, and ending after August 16, 1954, 
section 421 applies to such exercise in the same manner as if such 
option had been exercised by such deceased individual. Consequently, 
neither the estate nor such person is required to include any amount in 
gross income as a result of a transfer of stock pursuant to such 
exercise of the option. Nor does section 421 become inapplicable if such 
executor, administrator, or person disposes of the stock so acquired 
within two years after the granting of such option or within 1 year (6 
months for taxable years beginning before 1977; 9 months for taxable 
years beginning in 1977) after the transfer of the stock pursuant to the 
exercise of such option. This exception as to the applicability of 
section 421 does not affect the applicability of section 1222, relating 
to what constitutes a short-term and long-term capital gain or loss. The 
executor, administrator, or such person need not exercise the option 
within three months after the death of the individual to whom the option 
was granted for section 421 to be applicable. However, the exercise of 
the option must be pursuant to the terms of the option, and any change 
in the terms of the option is subject to the rules of Sec. 1.421-4, 
relating to the modification, extension, or renewal of the option. 
Section 421 is applicable even though such executor, administrator, or 
person is not employed by the corporation granting the option, or a 
parent or subsidiary thereof, either when the option is exercised or at 
any time. However, section 421 is not applicable to an exercise of the 
option by the estate or by such person, unless the individual to whom 
the option was granted met the requirements of paragraph (b) of Sec. 
1.421-3, relating to the employment of such individual, either at the 
time of his death or within three months before such time. If the option 
is exercised by a person other than the executor or administrator, or 
other than a person who acquired the option by bequest or inheritance or 
by reason of the death of such deceased individual, section 421 is not 
applicable to the exercise. For example, if the option is sold by the 
estate, section 421 does not apply to an exercise of the option by such 
buyer; but if the option is distributed by the administrator to an heir 
as part of the estate, section 421 is applicable to an exercise of the 
option by such heir.
    (2) Any transfer by the estate, whether a sale, a distribution of 
assets, or otherwise, of the stock acquired by its exercise of the 
option under this paragraph is a disposition of the stock.

[[Page 905]]

Therefore, if section 421(b) is applicable, the estate must include an 
amount as compensation in its gross income. Similarly, if section 421(b) 
is applicable in case of an exercise of the option under this paragraph 
by a person who acquired the option by bequest or inheritance or by 
reason of the death of the individual to whom the option was granted, 
there must be included in the gross income of such person an amount as 
compensation, either when such person disposes of the stock, or when he 
dies owning the stock.
    (3)(i) If under section 421(b) an amount is required to be included 
in the gross income of the estate or of such person, the estate or such 
person shall be allowed a deduction as a result of the inclusion of the 
value of the restricted stock option in the estate of the individual to 
whom the option was granted. Such deduction shall be computed under 
section 691(c) by treating the restricted stock option as an item of 
gross income in respect of a decedent under section 691 and by treating 
the amount required to be included in gross income under section 421(b) 
as an amount included in gross income under section 691 in respect of 
such item of gross income. No such deduction shall be allowable with 
respect to any amount other than an amount includible under section 
421(b). For the rules relating to the computation of a deduction under 
section 691(c), see Sec. 1.691(c)-1.
    (ii) The application of subdivision (i) may be illustrated by the 
following example:

    Example. On June 1, 1953, E was granted a restricted stock option to 
purchase for $85 one share of the stock of his employer. On such day, 
the fair market value of such stock was $100 a share. E died on February 
1, 1954, without having exercised such option. The option was, however, 
exercisable by his estate, and for purposes of the estate tax was valued 
at $30. On March 1, 1955, the estate exercised the option, and on March 
15, 1955, sold for $150 the share of stock so acquired. For its taxable 
year including March 15, 1955, the estate is required by section 421(b) 
to include in its gross income as compensation the amount of $15. During 
such taxable year, no amounts of income were properly paid, credited, or 
distributable to the beneficiaries of the estate. However, under section 
421(d)(6)(B), the estate is entitled to a deduction determined in the 
following manner. E's estate includes no other items of income in 
respect of a decedent referred to in section 691(a), and no deductions 
referred to in section 691(b), so that the value for estate tax purposes 
of the restricted stock option, $30, is also the net value of all items 
of income in respect of the decedent. The estate tax attributable to the 
inclusion of the restricted stock option in the estate of E is $10. 
Since $15, the amount includible in gross income by reason of section 
421(b), is less than the value for estate tax purposes of the option, 
only \15/30\ of the estate tax attributable to the inclusion of the 
option in the estate is deductible; that is, \15/30\ of $10, or $5. No 
deduction under section 421(d)(6)(B) is allowable with respect to any 
capital gain.

    (4)(i) In the case of an employee dying before January 1, 1957, the 
basis of any share of stock acquired by the exercise of the option under 
this paragraph, determined under section 1011, shall be increased by an 
amount equal to the amount includible as compensation in his gross 
income under section 421(b). The basis of the share shall not be 
increased by reason of the inclusion of the value of the restricted 
stock option in the estate for estate tax purposes.
    (ii)(A) In the case of an employee dying after December 31, 1956, 
the basis of any share of stock acquired by the exercise of the option 
under this paragraph, determined under section 1011, shall be increased 
by an amount equal to the portion of the basis of the option 
attributable to such share. For example, if a restricted stock option to 
acquire 10 shares of stock has a basis of $100, the basis of one share 
acquired by a partial exercise of the option, determined under section 
1011, would be increased by \1/10\ of $100, or $10. The option acquires 
a basis, determined under section 1014(a), only if it is exercised in 
accordance with section 421. Therefore, to the extent the option is so 
exercised, in whole or in part, it will acquire a basis equal to its 
fair market value at the date of the employee's death or, if an election 
is made under section 2032, its value at its applicable valuation date. 
In certain cases, the basis of the share is subject to the adjustments 
provided by (B) and (C) of this subdivision, but such adjustments are 
only applicable in the case of an option which is subject to section 
421(b).
    (B) If the amount which would have been includible in gross income 
under

[[Page 906]]

section 421(b) had the employee exercised the option and held the share 
at the time of his death exceeds the amount which is includible in gross 
income under section 421(b), the basis of the share, determined under 
(A) of this subdivision, shall be reduced by such excess. For example, 
if $15 would have been includible in the gross income of the employee 
had he exercised the option and held such share at the time of his 
death, and only $10 is includible under section 421(b), the basis of the 
share, determined under (A) of this subdivision, would be reduced by $5. 
For purposes of determining the amount which would have been includible 
in gross income under section 421(b) if the employee had exercised the 
option and held such share at the time of his death, the amount which 
would have been paid for the share shall be computed as if the option 
had been exercised on the date the employee died.
    (C) If the amount includible in gross income under section 421(b) 
exceeds the portion of the basis of the option attributable to the 
share, the basis of the share, determined under (A) of this subdivision, 
shall be increased by such excess. Thus, if $15 is includible in gross 
income under section 421(b), and the basis of the option with respect to 
the share is $10, the basis of the share, determined under (A) of this 
subdivision, will be increased by $5.
    (iii) If a restricted stock option is not exercised by the estate of 
the individual to whom the option was granted, or by the person who 
acquired such option by bequest or inheritance or by reason of the death 
of such individual, the option shall be considered to be property which 
constitutes a right to receive an item of income in respect of a 
decedent to which the rules of sections 691 and 1014(c) apply.
    (iv) The application of this subparagraph may be illustrated by the 
following examples:

    Example (1). On June 1, 1954, the X Corporation granted to E, an 
employee, a restricted stock option to purchase a share of X 
Corporation's stock for $85. The fair market value of the X Corporation 
stock on such date was $100 per share. On June 1, 1955, E died. The fair 
market value of X Corporation stock on such date exceeded $100 per share 
and the fair market value of the option on the applicable valuation date 
was $35. On August 1, 1956, the estate of E exercised the option and 
sold the share of X Corporation stock at a time when the fair market 
value of the share was $90. The estate is required by section 421(b) to 
include $5 in its gross income as compensation. Since E died before 
January 1, 1957, the basis of the share is $90 (the $85 paid for the 
stock plus the $5 includible in gross income as compensation), and the 
basis of the share is not increased by reason of the inclusion of the 
value of the option in the estate of E (see section 1014(d)). Thus, no 
gain or loss is realized on the disposition of the share since the basis 
of the share is equal to the sale price.
    Example (2). On June 1, 1956, the X Corporation granted to E, an 
employee, a restricted stock option to purchase a share of X Corporation 
stock for $85. The fair market value of X Corporation stock on such date 
was $100 per share. On June 1, 1957, E died. The fair market value of X 
Corporation stock on such date exceeded $100 per share and the fair 
market value of the option on the applicable valuation date was $35. On 
August 1, 1958, the estate of E exercised the option and sold the share 
of X Corporation stock at a time when the fair market value of the share 
was $120. The basis of the share is $120 (the $85 paid for the stock 
plus the $35 basis of the option). When the share is sold for $120, the 
estate is required to include $15 in its gross income as compensation. 
Since $15 would have been includible in E's gross income if he had 
exercised the option and held such share at the time of his death, 
subdivision (ii)(B) of this subparagraph does not apply. Moreover, since 
the $15 includible in the gross income of the estate does not exceed the 
basis of the option ($35), subdivision (ii)(C) of this subparagraph does 
not apply. Since the basis of the stock and the sale price are the same, 
no gain or loss is realized by the estate on the disposition of the 
share.
    Example (3). Assume the same facts as in example (2), except that 
the fair market value of the share of stock at the time if its sale was 
$90. The basis of the share, determined under subdivision (ii)(A) of 
this subparagraph, is $120 (the $85 paid for the stock plus the $35 
basis of the option). When the share is sold for $90, the estate is 
required to include $5 in its gross income as compensation. If the 
employee had exercised the option and held the share at the time of this 
death, $15 would have been includible in gross income as compensation 
for the taxable year ending with his death. Since such amount exceeds by 
$10 the amount which the estate is required to include in its gross 
income, subdivision (ii)(B) of this subparagraph applies, and the basis 
of the share ($120), determined under subdivision (ii)(A) of this 
subparagraph is reduced by $10. Accordingly, the basis is $110, and a 
capital loss of $20 is realized on the disposition of the share.

[[Page 907]]

    Example (4). Assume the same facts as in example (2), except that 
the fair market value of the option on the applicable valuation date was 
$5, and that the fair market value of X Corporation stock on the date 
the employee died did not exceed $100. The basis of the share, 
determined under subdivision (ii)(A) of this subparagraph, is $90 (the 
$85 paid for the stock plus the $5 basis of the option). When the share 
is sold for $120, the estate is required to include $15 in its gross 
income as compensation. Since such amount exceeds by $10 the basis of 
the option, subdivision (ii)(C) of this subparagraph applies, and the 
basis of the share ($90), determined under subdivision (ii)(A) of this 
subparagraph, is increased by $10. Accordingly, the basis is $100 and a 
capital gain of $20 is realized on the disposition of the share.
    Example (5). Assume the same facts as in example (2), except that on 
June 1, 1957, the date the employee died, the fair market value of X 
Corporation stock was $98, and that on June 1, 1958, the alternate 
valuation date, the fair market value of the stock had declined 
substantially, and the fair market value of the option was $5. On August 
1, 1958, the estate of E exercised the option and sold the share when 
its fair market value was $92. The basis of the share, determined under 
subdivision (ii)(A) of this subparagraph, is $90 (the $85) paid for the 
stock plus the $5 basis of the option). When the share is sold for $92, 
the estate is required to include $7 in its gross income as 
compensation. Since $13 would have been includible in E's gross income 
if he had exercised the option and held such share at the time of his 
death, subdivision (ii)(B) of this subparagraph applies, and the basis 
of the share ($90), determined under subdivision (ii)(A) of this 
subparagraph, is reduced by $6 to $84. Furthermore, since the $7 that 
the estate is required to include in its gross income when the share is 
sold for $92 exceeds by $2 the basis of the option, subdivision (ii)(C) 
of this subparagraph applies, and the basis of the share ($84), 
determined under subdivision (ii)(A) and (ii)(B) of this subparagraph, 
is increased by $2. Accordingly, the basis is $86 and a capital gain of 
$6 is realized on the disposition of the share.

    (e) Disqualifying disposition. The disposition of a share of stock, 
acquired by the exercise of a restricted stock option, within two years 
after the granting of the option or within 1 year (6 months for taxable 
years beginning before 1977; 9 months for taxable years beginning in 
1977) after the transfer of the share pursuant to such exercise makes 
section 421 inapplicable to such transfer of the share. If such 
disqualifying disposition occurs in a taxable year of the individual 
which begins after December 31, 1953, and ends after August 16, 1954, 
the income attributable to such transfer shall be treated by the 
individual as income received in the taxable year in which such 
disposition occurs. Similarly, if such disposition occurs in a taxable 
year of the employer which begins after December 31, 1953, and ends 
after August 16, 1954, the deduction attributable to the transfer of the 
share of stock pursuant to the exercise of the option shall be allowable 
for the taxable year in which such disposition occurs. In such cases, no 
amount shall be treated as income, and no amount shall be allowed as a 
deduction, for any taxable year other than the taxable year in which 
occurs the disposition. However, if the stock was transferred pursuant 
to the exercise of the option in a taxable year other than the taxable 
year of the disposition, the amount of the deduction shall be 
determinded as if the employee had been paid compensation at the time 
provided in paragraph (d) of Sec. 1.421-6.

[T.D. 6500, 25 FR 11696, Nov. 26, 1960, as amended by T.D. 6527, 26 FR 
411, Jan. 19, 1961; T.D. 7728, 45 FR 72650, Nov. 3, 1980]