TP participates in company A's ESPP. Under A's plan, TP may purchase shares of A at 85% of the lesser of FMV on the grant date and FMV on the exercise date. An offering period begins on 4/1/2007 (the grant date), at which time the FMV of A is $100. On 10/31/07, TP purchases 10 shares under A's ESPP. FMV on 10/31/07 is $90. TPs option price is $76.50, being the lesser of 85% of $100 and 85% of $90. Assume A's plan qualifies under section 423, and TP's sales are all qualifying sales.
1) TP sells all 10 shares in 2010 for $120/share, what compensation should be reported?2) Suppose A spins off B in 2009. What compensation should be reported in 2010 when A shares are sold? If the spunoff shares are sold in
2011, what compensation should be reported then?(more details below)
Here's my thought process; sorry to be so wordy:
QUESTION ONE: In 2010, TP sells all 10 shares for $120/share. Per section 423(c), the compensation element (per share) of TP's sale is the lesser of:
(1) the excess of the fair market value of the share at the time of such disposition over the amount paid for the share under the option, or
(2) the excess of the fair market value of the share at the time the option was granted over the option price.
FMV at disposition = $120/share. FMV on grant date = $100/share. Amount paid for the share = $76.50 Option price = ???
I've found an example in the IRS regs, and a description at fairmark.com, both of which indicate that the meaning of "option price" in (2) is "the option price determined as of the grant date".
Section 423(c) explains that throughout that subsection, if the option price isn't determinable on the grant date (as is the case here), you should compute it as though the option were exercised on the grant date. Assuming that this meaning of "option price" is correct, the "option price" in (2) would be computed as though the option were exercised on the grant date, so it would be 85% of the grant date FMV, or $85. That makes the compensation computation:
the lesser of (1) $120 - $76.50 = $43.50 or (2) $100 - $85 = $15
So TP would report $15/share (so $150 total) as compensation, and add it to his $76.50 basis. His basis would then be $91.50/share, and he would report $28.50/share as capital gain ($120 - $91.50).
If one believes that "option price" in (2) means the "price paid under the option", then (2) would be $100 - $76.50 = $23.50. I don't believe this is the correct meaning, but it's easy to see why such an obvious reading of the text would be convincing. One reason for the uncertainty about the meaning is that, before 2008, Pub 525 paraphrased the two choices in 423(c) this way:
o The amount, if any, by which the price paid under the option was exceeded by the fair market value of the share at the time the option was granted, or
o The amount, if any, by which the price paid under the option was exceeded by the fair market value of the share at the time of the disposition or death.
In other words, the older versions of Pub 525 interpreted "option price" in (2) as meaning "the price paid under the option". Current versions of Pub
525 don't paraphrase the code at all, they quote it verbatim without any clarification. However, the Regs seem to give an unambiguous example- here's the relevant sentence (**'s are mine, of course):
----------------------------------- Compensation in the amount of $5 is includible in P's gross income for the year 2013, 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 ($95) is $55; 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** ($95), is $5.
-----------------------------------
As it turns out, in their example, the "price paid for the share" turns out to be the same number as "the option price, computed as if the option had been exercised at such time", because the price was lower on the grant date than the exercise date. But the **text** is clear as to how the number is to be computed.
My question is whether the tax preparer community generally understands "option price" in (2) to mean "the option price, computed as if the option had been exercised on the grant date", or "the price paid under the option". I'm not sure which is more authoritative, an Example from the regs with no explanatory text, or an old version of Pub 525.
QUESTION TWO (I am assuming here that "option price" in (2) means as of the grant date.)
Assume the same facts as above, except that in 2009 A spins off subsidiary B, distributing one share of B for each share of A to the holders of A shares (to keep the math simple). Just after the spinoff, the FMV of a share of A is $88 and B is $22. That is, the value of the old shares of A has been divided so that 80% is in the A shares and 20% is in the newly distributed B shares. TP adjusts his $76.50 basis in the 10 shares of A down to $61.20 (80%), and the B shares have a basis of $15.30. As before, in 2010 TP sells all 10 shares of A for $120/share. In 2011, he sells all
10 shares of B for $30/share.What is the compensation income to be reported for each sale? It seems that the spinoff should have no impact on the total compensation that TP is ultimately required to report... it should still be $150 total. One approach that works is to apply the 80% adjustment to all the relevant values in the compensation computation. In other words:
For first sale, of 10 A shares FMV at disposition = $120 FMV on option grant date = 80% * $100 = $80 Price paid for the (new) A shares = 80% * $76.50 = $61.20 "Option price" = 80% * $85 = $68
Compensation is lesser of (1) $120 - $61.20 = $58.80, or (2) $80 - $68 = $12
So, report $12/share (or $120 total) compensation for the A shares
For the sale of B shares FMV at disposition = $30 FMV on option grant date = 20% * $100 = $20 Price paid the B shares = 20% * 76.50 = $15.30 "Option price" = 20% * $85 = $17
Compensation is lesser of (1) $30 - $15.30 = $14.70 (2) $20 - $17 = $3
So, report $3/share (or $30 total) compensation for the B shares
That "works" - the reported compensation for the two sales combined adds up to $150, which seems correct. However, I find no support (other than "common sense") for the idea that, for purposes of computing the compensation element for a sale of ESPP shares after a spinoff, the FMV and option price should be adjusted in the same was as the basis, or any mention of the messy side-effect of doing that, namely, that part of the compensation element is carried into the shares of the spun-off company, creating a record keeping nightmare. If HP spins off Agilent which spins off Verigy, etc...
Since (1) is intended to compute your "profit" on the sale, it would seem that the numbers must be adjusted to match what it is you're actually selling, namely post-spinoff shares of A. Also, since one of the numbers (FMV at disposition) is a post-spinoff value, it seems that the other number (price paid for a share under the option) must also be adjust so that it is a post-spinoff value. If those two numbers are post-spinoff, then it seems the numbers in (2) should also be.
So - am I correct that the price paid under the option, and the FMV and option price on the grant date, should all be adjusted by 80% for the spinoff?
Whit Matteson