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When Did I Purchase My Stock? Grant Date vs. Vesting Date - Corporate Insiders Holding Non-Qualified Stock Options Beware



Under Section 83 of the Internal Revenue Code, employees, independent contractors and others receiving non-qualified stock options (NSO's) without a readily ascertainable value for services provided (compensatory options), do not recognize income upon the grant of the options. Income is recognized when the options are exercised, provided the service provider's rights to the stock obtained are transferable or not subject to a substantial risk of forfeiture. The taxable amount is equal to the fair market value of the stock on the date of exercise minus the option price paid for the stock.

A special rule in Section 83 (c) (3) of the Internal Revenue Code provides that income taxable upon the exercise of an option is deferred so long as the sale of property at a profit could subject a person to suit under Section 16(b) of the Securities Exchange Act of 1934. Where a person's rights are subject to substantial risk of forfeiture and are not transferable, tax deferral is possible. If permitted to defer tax under this rule, the taxpayer will later be taxed on an amount equal to the fair market value of the stock on the date the Section 83 (c) (3) exception no longer applies minus the option price paid for the stock. This rule otherwise known as the "short-swing profit rule" prevents corporate insiders from profiting from the unfair use of information obtained by reason of their relationship to the issuer. Under this rule, profit on a sale made within six months of a purchase of the corporation's stock inures to and is recoverable by the issuer. Section 83 (c) (3) allows the taxpayer to postpone the tax consequences attributable to the exercise of options that could not realistically be liquidated into cash without violating this Section 16(b) rule.

In 1991, the SEC amended Section 16(b) to clarify that the date a stock option is acquired, rather than the date stock is acquired from the exercise of such option is the relevant measurement date for the imposition of the Section 16(b) liability. This 1991 amendment however did not clarify whether there is a difference between the grant of an unvested option and a vested option in determining the acquisition date.

In a recent Ninth Circuit case, Strom, a corporate insider argued that the vesting (which occurred after the exercise) and not the exercise of her options constituted the purchase for Section 16(b) purposes.

When Strom was hired in November 1998, she was granted two traunches of non-vested options to purchase her company's stock on specified future dates, so long as she was not terminated for cause or did not voluntarily leave. A third traunch could vest earlier if certain income milestones were met. Strom exercised options to acquire shares in September and December 1999 and then monthly through July 2000. She resigned from the company in June of 2000.

The Ninth Circuit rejected Strom's argument that the vesting of an NSO was the purchase for Section 16(b) purposes of starting the clock for the six-month period of short-swing profit determination. The question for the Ninth Circuit was whether there was a purchase earlier than the vesting dates? Did a purchase occur when the options were granted, and not yet vested, even if they could not be exercised? The 1991 rules and an accompanying SEC release made clear that the grant or acquisition of a call option constitutes the purchase of the underlying equity security under 16 (b). Thus the potential for insider abuse arises when the option price is fixed and it is that date that is matched as a purchase with the eventual sale. The release goes on to clarify that a purchase occurs on the date the stock or a derivative security (in this case the options) is granted regardless of whether the security is vested when granted. The Court made clear that when an option vests based on continued employment as was the case in Strom, rather than on meeting certain performance criteria, the purchase of the option occurs on the grant date. The Court found that Strom purchased the options when they were granted to her and not on the vesting date. Her six month window for potential liability therefore would have ended in May 1999 (grant date of November 1998 plus six months to April 1999). Because Strom's exercise of her options all occurred more than six months after the grant date (her first exercise being September 1999), she could have immediately sold the stock received upon exercise without an objectively reasonable chance that a suit under 16(b) would have succeeded. Her stock was therefore not subject to a substantial risk of forfeiture and there was no basis to invoke the deferral provision of Section 83(c) (3).

The Ninth Circuit thus reversed the District Court which applied a lower standard than the "objectively reasonable chance" standard that the Ninth Circuit applied. The District Court had concluded that Strom did have a substantial risk of forfeiture due to the possibility of a suit under section 16(b) and the income could be deferred under a timely 83(b) election. The Ninth Circuit however found that an appropriate standard for Section 16 (b) liability should be whether there is an "objectively reasonable chance" that a Section 16 (b) suit would have succeeded. The Court noted that this standard "roughly equates to the determination of whether a reasonably prudent and legally sophisticated person would not have sold their stock because of the possibility that the Section 16 (b) litigation would have forced them to forfeit the profit obtained by the sale. Strom did not demonstrate before the Court that she could have been subject to a 16(b) suit that had an objectively reasonable chance of success had she sold her stock at a profit in 1999 or 2000. The six month window of potential 16(b) liability ended in May 1999 before any exercise. A prudent and legally sophisticated Strom should have felt free to sell her property because if a 16(b) suit had been filed, she would not have been forced to forfeit the profit obtained by the sale. As a result Strom was not entitled to defer the tax consequences from her exercises of options throughout 1999 and 2000.


For the taxpayer in Strom v. U.S., the purchase date meant the difference between deferral and the current recognition of income. Strom was granted stock options subject to a vesting schedule and Section 16(b) restrictions. If the purchase date was held to be the moment when the options vested, Strom could defer the income until six months after the last round of shares vested, even if she had already exercised them. To the contrary, if the purchase date was held to be the grant date, Strom had to recognize the income immediately upon exercise, since it was outside the six-month window starting on the grant date.

The Ninth Circuit, after delving into Section 16(b), determined that the SEC treated the purchase date of options as being the date of grant, not the date of exercise. As a result, Strom had to recognize the compensation income immediately upon exercise, since it was more than six months from the date of grant.

Strom was the first case to raise this issue, so at least for those taxpayers whose case would be heard in the Ninth Circuit, it establishes authority that the six-month Section 16(b) window starts upon the grant of stock options, not upon vesting. The Strom case provides a cautionary warning for those earning equity compensation. When options are involved, it is of paramount importance to determine whether a limit on transferability or a substantial risk of forfeiture exists once the option is exercised. Even after the exercise of the option, a taxpayer does not recognize income until rights to the underlying stock are transferable or are no longer subject to a substantial risk of forfeiture. One must understand the complex interaction between securities and tax laws and engage a tax professional with expertise in compensation planning and property issued for services.




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