Employee Stock Purchase Plans Under Internal Revenue Code Section 423, 43875-43890 [E8-17255]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 73, Number 146 (Tuesday, July 29, 2008)]
[Proposed Rules]
[Pages 43875-43890]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E8-17255]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-106251-08]
RIN 1545-BH68


Employee Stock Purchase Plans Under Internal Revenue Code Section 
423

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations relating to 
options granted under an employee stock purchase plan as defined in 
section 423 of the Internal Revenue Code (Code). These proposed 
regulations affect certain taxpayers who participate in the

[[Page 43876]]

transfer of stock pursuant to the exercise of options granted under an 
employee stock purchase plan. These proposed regulations provide 
guidance to assist taxpayers in complying with section 423 in addition 
to clarifying certain rules regarding options granted under an employee 
stock purchase plan. This document also contains proposed regulations 
under sections 421 and 422 of the Code.

DATES: Written or electronic comments must be received by October 27, 
2008.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-106251-08), room 
5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
106251-08), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC, or sent electronically via the Federal 
eRulemaking Portal at https://www.regulations.gov/ (IRS REG-106251-08).

FOR FURTHER INFORMATION CONTACT: Concerning these proposed regulations, 
Thomas Scholz at (202) 622-6030; concerning submissions of comments, 
and/or to request a hearing, Oluwafunmilayo Taylor, at (202) 622-7180 
(not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    This document contains proposed amendments to 26 CFR part 1 under 
section 423 of the Code. This document also contains minor proposed 
amendments to 26 CFR part 1 under sections 421 and 422 of the Code.
    Section 423 was added to the Code by section 221(a) of the Revenue 
Act of 1964, Public Law 88-272 (78 Stat. 63 (1964)). Changes to the 
applicable law concerning section 423 were made by sections 
1402(b)(1)(C) and 1402(b)(2) of the Tax Reform Act of 1976, Public Law 
94-455 (90 Stat. 1731 and 1732-1733 (1976)); section 1001(b)(5) of the 
Deficit Reduction Act of 1984, Public Law 98-369 (98 Stat. 1011 
(1984)); section 1114 of the Tax Reform Act of 1986, Public Law 99-514 
(100 Stat. 2451 (1986)); and sections 11801(c)(9)(D)(i)-(ii) and 
11801(c)(9)(E) of the Omnibus Budget Reconciliation Act of 1990, Public 
Law 101-508 (104 Stat. 1388-525 (1990)).
    Regulations under section 423 were published in the Federal 
Register on June 23, 1966 (TD 6887). These regulations were amended on 
September 27, 1979 (TD 7645), October 31, 1980 (TD 7728), and December 
1, 1988 (TD 8235). In Notice 2004-55, 2004-34 IRB 319 (August 23, 
2004), (see Sec.  601.601(d)(2)(ii)(b)), the IRS and the Treasury 
Department requested comments concerning whether the existing 
regulations under section 423 should be amended, and if so, what issues 
should be addressed. Two comment letters were submitted in response to 
Notice 2005-55 and the suggestions in those letters are addressed in 
this preamble.
    In general, the income tax treatment of the grant of an option to 
purchase stock in connection with the performance of services and of 
the transfer of stock pursuant to the exercise of the option is 
determined under section 83 and the regulations thereunder. However, 
section 421 provides special rules for determining the income tax 
treatment of the transfer of shares of stock pursuant to the exercise 
of an option if the requirements of sections 422(a) or 423(a), as 
applicable, are met. Section 422 applies to incentive stock options and 
section 423 applies to options granted under an employee stock purchase 
plan (collectively, statutory options).
    Under section 421, if a share of stock is transferred to an 
individual pursuant to the exercise of a statutory option, there is no 
income at the time of exercise of the option with respect to the 
transfer and no deduction under section 162 is allowed to the employer 
corporation with respect to the transfer.
    Section 423(a) provides that section 421 applies to the transfer of 
stock to an individual pursuant to the exercise of an option granted 
under an employee stock purchase plan if: (i) no disposition of the 
stock is made within two years from the date of grant of the option or 
within one year from the date of transfer of the share, and (ii) at all 
times during the period beginning on the date of grant and ending on 
the day three months before the exercise of the option, the individual 
is an employee of either the corporation granting the option or a 
parent or subsidiary of such corporation, or a corporation (or a parent 
or subsidiary of such corporation) issuing or assuming a stock option 
in a transaction to which section 424(a) applies. Section 423(b) sets 
forth several requirements that must be met for a plan to qualify as an 
employee stock purchase plan. Section 423(c) provides a special rule 
that is applicable where the option exercise price is between 85 and 
100 percent of the fair market value of the stock at the time the 
option was granted.
    Section 424 provides special rules applicable to statutory options, 
including rules concerning the modification of statutory options and 
the substitution or assumption of an option by reason of a corporate 
merger, consolidation, acquisition of property or stock, separation, 
reorganization, or liquidation. Section 424 also contains definitions 
of certain terms, including disposition, parent corporation, and 
subsidiary corporation. Finally, section 424 provides special rules 
related to attribution of stock ownership and the effect of stockholder 
approval on the date of grant of a statutory option.

Explanation of Provisions

    These proposed regulations would provide a comprehensive set of 
rules governing stock options issued under an employee stock purchase 
plan and would incorporate substantially all of the rules contained in 
the existing regulations under section 423. These proposed regulations 
are comprised of two sections: Section 1.423-1, applicability of 
section 421(a); and Sec.  1.423-2, employee stock purchase plan 
defined. These proposed regulations would amend the existing 
regulations under section 423 in several ways. First, these proposed 
regulations would update the existing regulations to incorporate 
statutory changes and to make them consistent, where appropriate, with 
the regulations under section 422 related to incentive stock options. 
The regulations under section 422 were last updated in 2004. See TD 
9144, 2004-26 IRB 413. Second, these proposed regulations would update 
the existing regulations to provide additional guidance in certain 
areas as discussed below. Finally, these proposed regulations would 
also update the existing regulations to remove obsolete rules.

1. General Requirements

    Under Sec.  1.423-2(a)(1) of these proposed regulations, an 
employee stock purchase plan must meet the requirements of paragraphs 
(i) through (ix) of Sec.  1.423-2(a)(2). The terms of the plan, or an 
offering under the plan, must satisfy the requirements of paragraphs 
(iii) through (ix) of Sec.  1.423-2(a)(2). Consistent with Sec.  1.422-
2(b)(1), Sec.  1.423-2(a)(1) of these proposed regulations would 
provide that the plan and the terms of an offering must be in writing 
or electronic form, provided that such writing or electronic form is 
adequate to establish the terms of the plan or offering.
    Section 1.423-2(a)(2) of these proposed regulations lists the 
requirements that must be met for qualification as an employee stock 
purchase plan and provides cross references to the specific section of

[[Page 43877]]

these regulations that addresses each requirement.
    Under Sec.  1.423-2(a)(3) of these proposed regulations, if the 
terms of an option are inconsistent with the terms of the employee 
stock purchase plan or an offering under the plan, then the option will 
not be treated as granted under an employee stock purchase plan. 
(Section 1.423-2(a)(2) of the existing regulations has been re-numbered 
as Sec.  1.423-2(a)(3) of these proposed regulations.) If an option 
with terms that are inconsistent with the terms of the plan or an 
offering under the plan is granted to an employee who is entitled to 
the grant of an option under the terms of the plan or offering, and the 
employee is not granted an option under the offering that qualifies as 
an option granted under an employee stock purchase plan, then the 
offering will not meet the requirements of Sec.  1.423-2(e) of these 
proposed regulations, which generally requires that options be granted 
to all employees of any corporation whose employees are granted options 
under an employee stock purchase plan. As a result, none of the options 
granted under the offering will be eligible for the special tax 
treatment of section 421. Example 1 in Sec.  1.423-2(a)(4) illustrates 
this principle. Section 1.423-2(a)(4) of these proposed regulations 
contains additional examples to illustrate the principles of Sec.  
1.423-2(a)(3).
    If an option with terms that are inconsistent with the terms of the 
plan or an offering under the plan is granted to an individual who is 
not entitled to the grant of an option under the terms of the plan or 
offering, then the option will not be treated as an option granted 
under an employee stock purchase plan, and the grant of the option will 
not disqualify the options granted under the offering. Examples 2 and 3 
in Sec.  1.423-2(a)(4) of these proposed regulations illustrate this 
principle. Example 2 also appears in Sec.  1.423-2(a)(2) of the 
existing regulations.
    If, at the time of grant, an option qualifies as an option granted 
under an employee stock purchase plan, but the terms of the option are 
not satisfied, then the option will not be treated as granted under an 
employee stock purchase plan. However, this failure to comply with the 
terms of the option will not disqualify the options granted under the 
plan or offering. Example 4 in Sec.  1.423-2(a)(4) of these proposed 
regulations illustrates this principle.

2. Stockholder Approval of the Employee Stock Purchase Plan

    To qualify as an employee stock purchase plan, section 423(b)(2) 
requires that the plan be approved by the stockholders of the granting 
corporation within 12 months before or after the date the plan is 
adopted. These proposed regulations would provide the same basic 
requirements for stockholder approval as those included in the existing 
regulations. Consistent with Sec.  1.422-2(b)(2), these proposed 
regulations would provide additional guidance concerning the 
circumstances under which stockholder approval is required.
    These proposed regulations, like the existing regulations, would 
require stockholder approval if there is a change in the aggregate 
number of shares or in the employees eligible to be granted options 
under the plan. The standard for determining when stockholder approval 
is required under these proposed regulations generally is the same as 
under the existing regulations. These proposed regulations would 
clarify the requirements for stockholder approval and would provide a 
more comprehensive list of situations that require new stockholder 
approval of the plan. In particular, these proposed regulations would 
clarify that new stockholder approval is required if there is a change 
in the shares with respect to which options are issued or a change in 
the granting corporation.
    For example, assume that S, a wholly owned subsidiary of P, adopts 
an employee stock option plan under which options for S stock will be 
granted to S employees, and the plan is approved by the stockholder of 
S (in this case, P) within the applicable 24-month period. If S later 
amends the plan to provide for the grant of options to acquire P stock 
(rather than S stock), S must obtain approval from the stockholders of 
S (in this case, P) within 12 months before or after the date of the 
amendment of the plan because the amendment of the plan to allow the 
grant of options for P stock is considered the adoption of a new plan. 
See paragraph (iii) of Example 1 in Sec.  1.423-2(c)(5) of these 
proposed regulations. This conclusion differs from that in paragraph 
(iii) of Example 1 under Sec.  1.422-2(b)(6), which concludes that the 
stockholders of P rather than the stockholders of S must approve the 
plan as a result of its amendment to provide for the grant of options 
to acquire P stock. The IRS and the Treasury Department invite comment 
on this result and are proposing a conforming change to Example 1, 
paragraph (iii) under Sec.  1.422-2(b)(6).
    These proposed regulations also would provide additional guidance 
regarding the application of the stockholder approval requirements 
where an employee stock purchase plan is assumed in connection with a 
corporate transaction. Example 3 in Sec.  1.423-2(c)(5) of these 
proposed regulations illustrates this principle.

3. Maximum Aggregate Number of Shares

    Section 1.423-2(c)(3) of the existing regulations provides that an 
employee stock purchase plan must designate the maximum aggregate 
number of shares that may be issued under the plan. Consistent with 
Sec.  1.422-2(b)(3)(ii), these proposed regulations would provide that 
the plan may specify that the maximum aggregate number of shares 
available for grants under the plan may increase annually by a 
specified percentage of the authorized, issued, or outstanding shares 
at the date of the adoption of the plan. Further, a plan providing that 
the maximum aggregate number of shares issued subject to options under 
the plan may change based on any other specific circumstances will 
satisfy the requirements of Sec.  1.423-2(c)(3) only if the 
stockholders approve an immediately determinable maximum number of 
shares that may be issued under the plan in any event. Examples 4 and 5 
in Sec.  1.423-2(c)(5) of these proposed regulations illustrate these 
principles.

4. Employees Covered by the Plan

    Section 423(b)(4) permits an employer to exclude from participation 
one or more of the following categories of employees: Employees who 
have been employed less than two years; Employees who customarily work 
20 hours or less per week; Employees who customarily work not more than 
five months in any calendar year; and Highly compensated employees 
(HCEs) within the meaning of section 414(q). Section 1.423-1(e)(1) of 
these proposed regulations has been updated to reflect the 1986 
amendment of section 423(b)(4)(D) to substitute ``highly compensated 
employees (within the meaning of section 414(q))'' for ``officers, 
persons whose principal duties consist of supervising the work of other 
employees, or highly compensated employees.'' See Public Law 99-514, 
section 1114(b)(13).
    One commentator suggested that the regulations clarify that an 
employer may exclude from participation a subset of one of the groups 
set forth in section 423(b)(4). For example, an employer should be 
permitted to exclude a subset of HCEs, such as officers, from 
participation in the plan. The commentator further suggested that the 
regulations clarify that an employer may

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impose shorter service requirements than those permitted. For example, 
an employer should be permitted to exclude employees who have been 
employed less than one year from participation in the plan.
    The IRS and the Treasury Department agree that a more inclusive 
application of the rules of section 423(b)(4) is consistent with the 
intent of section 423. Accordingly, Sec.  1.423-2(e)(2) of these 
proposed regulations would provide that an employee stock purchase plan 
does not fail to satisfy the coverage provision of section 423(b)(4) 
merely because the plan excludes employees who have completed a shorter 
period of service or whose customary employment is for fewer hours per 
week or fewer months in a calendar year than is specified in subparts 
(A), (B) and (C) of section 423(b)(4), provided the exclusion is 
applied in an identical manner to all employees of every corporation 
whose employees are granted options under the plan. In addition, these 
proposed regulations would provide that the terms of an employee stock 
purchase plan may exclude HCEs: (a) with compensation above a certain 
level, or (b) who are officers or subject to the disclosure 
requirements of section 16(a) of the Securities Exchange Act of 1934, 
provided the exclusion is applied in an identical manner to all HCEs of 
every corporation whose employees are granted options under the plan. 
Examples 3, 4, 5, 6, and 7 in Sec.  1.423-2(e)(6) of these proposed 
regulations illustrate these principles. (The examples under Sec.  
1.423-2(e)(3) of the existing regulations have been re-numbered as 
Sec.  1.423-2(e)(6) of these proposed regulations.)
    Another commentator suggested that the regulations permit employers 
to exclude from plan participation employees who are nonresident aliens 
and who receive no earned income that constitutes income from sources 
within the United States. The IRS and the Treasury Department agree 
that it may be appropriate to exclude foreign employees from plan 
participation in certain limited circumstances. However, unlike section 
410(b), section 423 does not provide an exclusion for such nonresident 
aliens. Accordingly, the IRS and the Treasury Department are 
constrained by statutory authority from providing a general exclusion 
from plan participation for employees who are nonresident aliens and 
who receive no United States source income. Therefore, Sec.  1.423-
2(e)(3) of these proposed regulations would provide that employees who 
are citizens or residents of a foreign jurisdiction (without regard to 
whether they are also citizens of the United States or resident aliens 
(within the meaning of Sec.  7701(b)(1)(A))) may be excluded from the 
coverage of an employee stock purchase plan only if the grant of an 
option under the plan to a citizen or resident of the foreign 
jurisdiction is prohibited under the laws of such jurisdiction or if 
compliance with the laws of the foreign jurisdiction would cause the 
plan to violate the requirements of section 423. Example 8 in Sec.  
1.423-2(e)(6) of these proposed regulations illustrates this principle.
    Another commentator suggested that the regulations permit employers 
to exclude collectively bargained employees from plan participation. 
However, unlike section 410(b), section 423 does not provide an 
exclusion for collectively bargained employees. Accordingly, the IRS 
and the Treasury Department are again constrained by statutory 
authority from providing a general exclusion from plan participation 
for collectively bargained employees.
    One commentator suggested that the regulations be amended to 
provide that an offering will not lose its tax-favored status due to 
the inadvertent exclusion of employees from plan participation. Rather, 
the commentator suggested that the granting corporation be permitted to 
correct certain errors in plan administration through a corrections 
program that would permit the excluded employees to participate in past 
offerings under a plan. Such a corrections program is beyond the scope 
of these regulations. However, the IRS and the Treasury Department 
invite comments on whether such a program is appropriate (including the 
statutory authority for such a program) and suggestions for the types 
of violations that might be covered and the methods of correction.
    Section 1.423-2(e)(4) of these proposed regulations includes 
language that appears under Sec.  1.423-2(e)(1) of the existing 
regulations. Section 1.423-2(e)(2) of the existing regulations has been 
re-numbered as Sec.  1.423-2(e)(5) of these proposed regulations.

5. Equal Rights and Privileges

    Section 423(b)(5) requires that, subject to certain exceptions, an 
employee stock purchase plan, by its terms, provide that all employees 
granted options under the plan have the same rights and privileges.
    Section 1.423-2(f)(3) of these proposed regulations includes 
language that appears in Sec.  1.423-2(f)(1) of the existing 
regulations. (The examples in Sec.  1.423-2(f)(2) of the existing 
regulations have been relocated to Examples 1 and 2 of Sec.  1.423-
2(f)(7) of these proposed regulations. The example in Sec.  1.423-
2(f)(4) of the existing regulations has been relocated to Example 3 of 
Sec.  1.423-2(f)(7). Section 1.423-2(f)(4) of the existing regulations 
is re-numbered under these proposed regulations as Sec.  1.423-
2(f)(6)).
    One commentator suggested that a plan or offering should not fail 
to satisfy the equal rights and privileges provision of section 
423(b)(5) if the provisions of the plan or offering applied to foreign 
employees are reasonably designed to avoid adverse consequences for 
such employee under foreign law as a result of plan participation. The 
IRS and the Treasury Department agree that in certain limited 
circumstances it may be appropriate for the terms of an employee stock 
purchase plan to be less favorable with respect to foreign employees 
than those terms are with respect to employees resident in the United 
States. Accordingly, Sec.  1.423-2(f)(4) of these proposed regulations 
would provide that a plan or offering will not fail to satisfy the 
requirements of section 423(b)(5) if, in order to comply with the laws 
of a foreign jurisdiction, the terms of an option granted under a plan 
or offering to citizens or residents of such foreign jurisdiction 
(without regard to whether they are also citizens of the United States 
or resident aliens (within the meaning of Sec.  7701(b)(1)(A))) are 
less favorable than the terms of options granted under the same plan or 
offering to employees resident in the United States. Example 4 in Sec.  
1.423-2(f)(7) of these proposed regulations illustrates this principle.
    A plan or offering will not satisfy the requirements of section 
423(b)(5), however, if, in order to comply with the laws of a foreign 
jurisdiction, the terms of the plan or offering are more favorable with 
respect to citizens or residents of such foreign jurisdiction than the 
terms of the plan or offering are with respect to employees resident in 
the United States.
    Another commentator suggested that the regulations addressing the 
carryover of amounts from one offering to another be clarified. In 
response to this comment, these proposed regulations would clarify 
Sec.  1.423-2(f)(3) of the existing regulations (which has been re-
numbered as Sec.  1.423-2(f)(5)). Generally, a plan permitting one or 
more employees to carry forward amounts that were withheld but not 
applied toward the purchase of stock under an earlier plan or offering 
and apply such amounts toward the purchase of additional stock under a 
subsequent plan or offering will be a violation of the

[[Page 43879]]

equal rights and privileges requirement under section 423(b)(5). 
However, the carry forward of amounts withheld but not applied toward 
the purchase of stock under an earlier plan or offering will not 
violate the equal rights and privileges requirement of section 
423(b)(5) if all other employees participating in the current plan or 
offering are permitted to make direct payments toward the purchase of 
shares under a subsequent plan or offering in an amount equal to the 
excess of: (a) the greatest amount that any employee is allowed to 
carry forward from an earlier plan or offering over (b) the amount, if 
any, the employee will carry forward from an earlier plan or offering. 
Example 5 in Sec.  1.423-2(f)(7) of these proposed regulations 
illustrates this principle.
    Further, a plan will not fail to satisfy the equal rights and 
privileges requirement of section 423(b)(5) merely because employees 
are permitted to carry forward amounts representing a fractional share 
which were withheld but not applied toward the purchase of stock under 
an earlier plan or offering and apply such amounts toward the purchase 
of additional stock under a subsequent plan or offering.

6. Option Price

    Under section 423(b)(6), the option price must not be less than the 
lesser of: (a) an amount equal to 85 percent of the fair market value 
of the stock at the time the option is granted, and (b) an amount not 
less than 85 percent of the fair market value of the stock at the time 
the option is exercised. Consistent with Sec.  1.422-2(e)(1), Sec.  
1.423-2(g)(1) of these proposed regulations would provide that the 
option price may be determined in any reasonable manner, including the 
valuation methods permitted under Sec.  20.2031-2 (Estate Tax 
Regulations), so long as the option price meets the minimum pricing 
requirements of section 423(b)(6).

7. Date of Grant

    Section 1.421-1(c) provides, that for purposes of Sec. Sec.  1.421-
2 through 1.424-1, the language ``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 granting corporation completes the 
corporate action constituting an offer of stock for sale to an 
individual under the terms and conditions of a statutory option. The 
date of grant for an option granted under an employee stock purchase 
plan is important for several reasons. First, the favorable tax 
consequences under section 421 apply to the shares acquired pursuant to 
the exercise of an option granted under an employee stock purchase plan 
if the shares are not disposed of within two years from the date of 
grant of the option or within one year from the date of exercise of the 
option. Second, the $25,000 limitation under section 423(b)(8) is 
determined based on the fair market value of the stock measured on the 
date of grant of the option. The date of grant is also important for 
purposes of determining the employees eligible to participate in the 
plan and, in certain cases, determining the purchase price of stock 
under the plan.
    Section 1.421-1(c) further provides that a corporate action 
constituting an offer of stock for sale is not considered complete 
until the date on which the maximum number of shares that can be 
purchased under the option and the minimum option price are fixed or 
determinable. Because options under an employee stock purchase plan may 
be priced at the lesser of an amount equal to 85 percent of the fair 
market value of the stock at the time the option is granted, and an 
amount not less than 85 percent of the fair market value of the stock 
at the time the option is exercised, it is not always possible to 
determine the minimum option price on the first day of an offering. 
However, many granting corporations intend for the first day of an 
offering to be the date of grant.
    Accordingly, Sec.  1.423-2(h)(2) of these proposed regulations 
would provide that, for purposes of options granted under an employee 
stock purchase plan, the principles of Sec.  1.421-1(c) shall be 
applied without regard to the requirement that the minimum option price 
be fixed or determinable in order for the corporate action constituting 
an offer of stock to be considered complete. As a result, the first day 
of an offering could be the date of grant for an option issued under an 
employee stock purchase plan even though the minimum option price is 
not fixed or determinable on the first day of the offering. These 
proposed regulations include an amendment to Sec.  1.421-1(c).
    One commentator questioned whether it is necessary for a plan to 
contain a limit on the number of shares that can be purchased by each 
participant during an offering in order for the date of grant of the 
option to be the first day of an offering. Section 1.423-2(h)(3) of 
these proposed regulations would provide that the date of grant will be 
the first day of an offering if the terms of an employee stock purchase 
plan or offering designate a maximum number of shares that may be 
purchased by each participant during the offering. Similarly, the date 
of grant will be the first day of an offering if the terms of the plan 
or offering require the application of a formula to establish, on the 
first day of the offering, the maximum number of shares that may be 
purchased by each participant during the offering.
    However, Sec.  1.423-2(h)(3) of these proposed regulations does not 
require that an employee stock purchase plan or offering designate a 
maximum number of shares that may be purchased by each participant 
during the offering or incorporate a formula to establish a maximum 
number of shares that may be purchased by each participant during the 
offering. If the maximum number of shares that can be purchased under 
an option is not fixed or determinable until the date the option is 
exercised, then the date of exercise will be the date of grant of the 
option. The $25,000 limit under section 423(b)(8) and the limit on the 
aggregate number of shares that may be issued under an employee stock 
purchase plan are not sufficient to establish the maximum number of 
shares that can be purchased under an option so that the date of grant 
will be the first day of the offering. Examples 1, 2, 3 and 4 in Sec.  
1.423-2(h)(4) of these proposed regulations illustrate these 
principles.
    Section 1.423-2(h) of the existing regulations is re-numbered as 
Sec.  1.423-2(h)(1) of these proposed regulations.

8. Annual $25,000 Limitation

    Section 423(b)(8) provides that an employee stock purchase plan 
must, by its terms, provide that no employee may be permitted to 
purchase stock under all the employee stock purchase plans of his or 
her employer corporation and its related corporations at a rate which 
exceeds $25,000 in fair market value of the stock (determined on the 
date of grant) for each calendar year in which an option granted to the 
employee is outstanding and exercisable. Section 1.423-2(i) of these 
proposed regulations would provide guidance on the operation of the 
$25,000 limitation that incorporates and clarifies the guidance 
provided in the existing regulations.
    One commentator suggested that the calculation of the amount of 
stock that may be purchased under an employee stock purchase plan be 
determined in a manner consistent with the $100,000 limitation for 
incentive stock options described in Sec.  1.422-4. The proposed 
regulations generally adopt this suggestion and would provide that the 
$25,000 limit for employee stock purchase plans is, to the extent 
possible, calculated in a manner consistent with the $100,000 
limitation for incentive stock options. The timing of both measures is 
based on when the option first becomes exercisable and both

[[Page 43880]]

measures are made based on the fair market value of the stock 
determined at the date of grant. Section 1.423-2(i) of these proposed 
regulations emphasizes that an employee may purchase up to $25,000 of 
stock (based on the fair market value of such stock on the date of 
grant) in each calendar year during which an option granted to the 
employee under an employee stock purchase plan is not only outstanding, 
but also exercisable. Example 5 in Sec.  1.423-2(i)(5) of these 
proposed regulations illustrates this principle.
    For clarification, Example 1 in the existing regulations has been 
separated into Example 1 and Example 4 in Sec.  1.423-2(i)(5) of these 
proposed regulations.

9. Special Rule Where Option Price Is Between 85 Percent and 100 
Percent of the Value of the Stock

    Section 423(c) provides a special rule for calculating the timing 
and amount of compensation income that must be recognized when the 
option price for a share is between 85 and 100 percent of the value of 
the share on the date of grant. Generally, the income recognized is the 
lesser of: (a) the excess of the fair market value of the share on the 
date of grant over the option price, and (b) the excess of the fair 
market value of the share at the time of disposition (or death) over 
the option price. The flush language of section 423(c) provides that if 
the exercise price is not known on the date of grant, the exercise 
price shall be determined as if the option were exercised on the date 
of grant.
    One commentator suggested that it is unclear how this special rule 
and the flush language of section 423(c) apply when the option price is 
determined based on some percentage of the value of a share on the last 
day of an offering. Example 3 of Sec.  1.423-2(k)(3) of the existing 
regulations specifically addresses this issue and has been retained in 
Sec.  1.423-2(k)(3) of these proposed regulations. Example 4 has been 
added under Sec.  1.423-2(k)(3) to illustrate the tax consequences 
under an employee stock purchase plan that uses a look-back feature to 
determine the exercise price of the option.

Proposed Effective Date

    These regulations under section 423 are proposed to apply as of 
January 1, 2010, and will apply to any option issued under an employee 
stock purchase plan that is granted on or after that date. Taxpayers 
may rely on these proposed regulations for the treatment of any option 
issued under an employee stock purchase plan that is granted after 
publication of these proposed regulations in the Federal Register.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It also has 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations, and because 
the regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Code, these regulations have 
been submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on their impact on small business.

Comments and Requests for Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written (a signed original and eight 
(8) copies) or electronic comments that are timely submitted to the 
IRS. The IRS and the Treasury Department request comments on the 
clarity of the proposed rules and how they can be made easier to 
understand. All comments will be available for public inspection and 
copying. A public hearing will be scheduled if requested in writing by 
any person that timely submits written or electronic comments. If a 
public hearing is scheduled, notice of the date, time, and place for 
the hearing will be published in the Federal Register.

Drafting Information

    The principal author of these proposed regulations is Thomas 
Scholz, Office of the Division Counsel/Associate Chief Counsel (Tax 
Exempt and Government Entities). However, other personnel from the IRS 
and the Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. Section 1.421-1, paragraphs (c)(1) and (j)(1) are revised 
to read as follows:


Sec.  1.421-1  Meaning and use of certain terms.

* * * * *
    (c) Time and date of granting option. (1) For purposes of this 
section and Sec. Sec.  1.421-2 through 1.424-1, the language ``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 
granting corporation completes the corporate action constituting an 
offer of stock for sale to an individual under the terms and conditions 
of a statutory option. Except as set forth in Sec.  1.423-2(h)(2), a 
corporate action constituting an offer of stock for sale is not 
considered complete until the date on which the maximum number of 
shares that can be purchased under the option and the minimum option 
price are fixed or determinable.
* * * * *
    (j) Effective/applicability date--(1) In general. Except for 
paragraph (c)(1), these regulations are effective on August 3, 2004. 
Upon the date of publication of the Treasury decision adopting 
paragraph (c)(1) of this section as a final regulation in the Federal 
Register, paragraph (c)(1) will apply as of January 1, 2010.
* * * * *
    Par. 3. Section 1.422-2, paragraph (b)(6), Example 1 (iii) is 
revised to read as follows:


Sec.  1.422-2  Incentive stock options defined.

* * * * *
    (b) * * *
    (6) * * *

    Example (1). * * * (iii) Assume the same facts as in paragraph 
(i) of this Example 1. Assume further that the plan was approved by 
the stockholders of S (in this case, P) on March 1, 2006. On January 
1, 2008, S changes the plan to provide that incentive stock options 
for P stock will be granted to S employees under the plan. Because 
there is a change in the stock available for grant under the plan, 
the change is considered the adoption of a new plan that must be 
approved by the stockholder of S (in this case, P) within 12 months 
before or after January 1, 2008.
* * * * *
    Par. 4. Section 1.422-5, paragraph (f)(1) is revised to read as 
follows:


Sec.  1.422-5  Permissible provisions.

* * * * *
    (f) Effective/applicability date--(1) In general. Except for Sec.  
1.422-2(b)(6), Example 1 (iii), these regulations are effective on 
August 3, 2004. Upon the date of publication of the Treasury decision 
adopting Section 1.422-2(b)(6),

[[Page 43881]]

Example 1 (iii) of this section as a final regulation in the Federal 
Register, Section 1.422-2(b)(6), Example 1 (iii) will apply as of 
January 1, 2010.
* * * * *
    Par. 5. Section 1.423-1 is revised to read as follows:


Sec.  1.423-1  Applicability of section 421(a).

    (a) General rule. Subject to the provisions of section 423(c) and 
paragraph (k) of Sec.  1.423-2, the special rules of income tax 
treatment provided in section 421(a) apply with respect to the transfer 
of a share of stock to an individual pursuant to the individual's 
exercise of an option granted under an employee stock purchase plan if 
the following conditions are satisfied--
    (1) The individual makes no disposition of such share before the 
later of the expiration of the two-year period from the date of the 
grant of the option pursuant to which such share was transferred or the 
expiration of the one-year period from the date of transfer of such 
share to the individual; and
    (2) At all times during the period beginning on the date of the 
grant of the option and ending on the day three months before the date 
of exercise, the individual was an employee of the corporation granting 
the option, a related corporation, or a corporation (or a related 
corporation) substituting or assuming the stock option in a transaction 
to which section 424(a) applies.
    (b) Cross-references. For rules relating to the requisite 
employment relationship, see paragraph (h) of Sec.  1.421-1. For rules 
relating to the effect of a disqualifying disposition, see section 
421(b) and paragraph (b) of Sec.  1.421-2. For the definition of the 
term disposition, see section 424(c) and paragraph (c) of Sec.  1.424-
1. For the definition of the term related corporation, see section 
paragraph (i) of Sec.  1.421-1.
    (c) Effective/applicability date. Upon the date of publication of 
the Treasury decision adopting the rules of this section as a final 
regulation in the Federal Register, these rules will apply as of 
January 1, 2010.

    Par. 6. Section 1.423-2 is revised to read as follows:


Sec.  1.423-2  Employee stock purchase plan defined.

    (a) In general--(1) The term employee stock purchase plan means a 
plan that meets the requirements of paragraph (a)(2)(i) through (ix) of 
this section. If the terms of the plan do not satisfy the requirements 
of paragraph (a)(2)(iii) through (ix) of this section, such 
requirements may be satisfied by the terms of an offering made under 
the plan. However, where the requirements of paragraph (a)(2)(iii) 
through (ix) are satisfied by the terms of an offering, such 
requirements will be treated as satisfied only with respect to options 
exercised under that offering. The plan and the terms of an offering 
must be in writing or electronic form, provided that such writing or 
electronic form is adequate to establish the terms of the plan or 
offering, as applicable.
    (2) To qualify as an employee stock purchase plan under this 
section and Sec.  1.423-1, the plan must meet all of the following 
requirements--
    (i) The plan must provide that options can be granted only to 
employees of the employer corporation or of a related corporation (as 
defined in paragraph (i) of Sec.  1.421-1) to purchase stock in any 
such corporation (see paragraph (b) of this section);
    (ii) The plan must be approved by the stockholders of the granting 
corporation within 12 months before or after the date the plan is 
adopted (see paragraph (c) of this section);
    (iii) Under the terms of the plan, an employee cannot be granted an 
option if, immediately after the option is granted, the employee owns 
stock possessing 5 percent or more of the total combined voting power 
or value of all classes of stock of the employer corporation or of a 
related corporation (see paragraph (d) of this section);
    (iv) Under the terms of the plan, options must be granted to all 
employees of any corporation whose employees are granted any options by 
reason of their employment by the corporation (see paragraph (e) of 
this section);
    (v) Under the terms of the plan, all employees granted options must 
have the same rights and privileges (see paragraph (f) of this 
section);
    (vi) Under the terms of the plan, the option price cannot be less 
than the lesser of--
    (A) An amount equal to 85 percent of the fair market value of the 
stock at the time the option is granted, or
    (B) An amount not less than 85 percent of the fair market value of 
the stock at the time the option is exercised (see paragraph (g) of 
this section);
    (vii) Under the terms of the plan, options cannot be exercised 
after the expiration of--
    (A) Five years from the date the option is granted if, under the 
terms of such plan, the option price cannot be less than 85 percent of 
the fair market value of the stock at the time the option is exercised, 
or
    (B) Twenty-seven months from the date the option is granted, if the 
option price is not determined in the manner described in paragraph (A) 
(see paragraph (h) of this section);
    (viii) Under the terms of the plan, no employee may be granted an 
option that permits the employee's rights to purchase stock under all 
employee stock purchase plans of the employer corporation and its 
related corporations to accrue at a rate that exceeds $25,000 of fair 
market value of the stock (determined at the time the option is 
granted) for each calendar year in which the option is outstanding at 
any time (see paragraph (i) of this section); and
    (ix) Under the terms of the plan, options are not transferable by 
the optionee other than by will or the laws of descent and 
distribution, and are exercisable, during the lifetime of the optionee, 
only by the optionee (see paragraph (j) of this section).
    (3) The determination of whether a particular option is an option 
granted under an employee stock purchase plan is made at the time the 
option is granted. If the terms of an option are inconsistent with the 
terms of the employee stock purchase plan or an offering under the 
plan, the option will not be treated as granted under an employee stock 
purchase plan. If an option with terms that are inconsistent with the 
terms of the plan or an offering under the plan is granted to an 
employee who is entitled to the grant of an option under the terms of 
the plan or offering, and the employee is not granted an option under 
the offering that qualifies as an option granted under an employee 
stock purchase plan, the offering will not meet the requirements of 
paragraph (e) of this section. Accordingly, none of the options granted 
under the offering will be eligible for the special tax treatment of 
section 421. However, if an option with terms that are inconsistent 
with the terms of the plan or an offering under the plan is granted to 
an individual who is not entitled to the grant of an option under the 
terms of the plan or offering, the option will not be treated as an 
option granted under an employee stock purchase plan, and the grant of 
the option will not disqualify the options granted under the plan or 
offering. If, at the time of grant, an option qualifies as an option 
granted under an employee stock purchase plan, but the terms of the 
option are not satisfied, the option will not be treated as granted 
under an employee stock purchase plan and this failure to comply with 
the terms of the option will not disqualify the options granted under 
the plan or offering.
    (4) Examples. The following examples illustrate the principles of 
paragraph (a)(3):


[[Page 43882]]


    Example 1. Corporation A operates an employee stock purchase 
plan under which options for A stock are granted to employees of A. 
The terms of an offering provide that the option price will be 90 
percent of the fair market value of A stock on the date of exercise. 
A grants an option under the offering to Employee Z, an employee of 
A. The terms of the option provide that the option price will be 85 
percent of the fair market value of A stock on the date of exercise. 
Because the terms of Z's option are inconsistent with the terms of 
the offering, the option granted to Z will not be treated as an 
option granted under the employee stock purchase plan. Further, 
unless Z is granted an option under the offering that qualifies as 
an option granted under the employee stock purchase plan, the 
offering will not meet the requirements of paragraph (e) of this 
section and none of the options granted under the offering will be 
eligible for the special tax treatment of section 421.
    Example 2. Corporation B operates an employee stock purchase 
plan that provides that options for B stock may only be granted to 
employees of B. Under the terms of the plan, options may not be 
granted to consultants and other non-employees. B grants an option 
under the plan to Consultant Y, a consultant of B. Because Y is 
ineligible to receive an option under the plan by reason of Y's 
status as a non-employee, the grant of the option to Y is 
inconsistent with the terms of the plan and the option granted to Y 
will not be treated as an option granted under the employee stock 
purchase plan. However, the grant of the option to Y will not 
disqualify the options granted under the plan or offering because Y 
was not entitled to the grant of an option under the plan.
    Example 3. Corporation C operates an employee stock purchase 
plan under which options for C stock are granted to employees of C. 
C grants an option under the plan to Employee X, an employee of C 
who is a highly compensated employee. The terms of the employee 
stock purchase plan exclude highly compensated employees from 
participation in the plan. Because X is ineligible to receive an 
option under the plan by reason of X's exclusion from participation 
in the plan, the option granted to X will not be treated as an 
option granted under the employee stock purchase plan. However, the 
grant of the option to X will not disqualify the options granted 
under the plan or offering because X was not entitled to the grant 
of an option under the plan.
    Example 4. Corporation D operates an employee stock purchase 
plan under which options for D stock are granted to employees of D. 
D grants an option under the plan to Employee W, an employee of D. 
The terms of the option provide that the option price will be 90 
percent of the fair market value of D stock on the date of exercise. 
On the date of exercise, W pays only 85 percent of the fair market 
value of D stock. Because the terms of W's option are not satisfied, 
the option granted to W will not be treated as an option granted 
under the employee stock purchase plan. However, the failure to 
comply with the terms of the option granted to W will not disqualify 
the options granted under the plan or offering.

    (b) Options restricted to employees. An employee stock purchase 
plan must provide that options can be granted only to employees of the 
employer corporation (or employees of its related corporations) to 
purchase stock in the employer corporation (or one of its related 
corporations). If such a provision is not included in the terms of the 
plan, the plan will not be an employee stock purchase plan and options 
granted under the plan will not qualify for the special tax treatment 
of section 421. For rules relating to the employment requirement, see 
paragraph (h) of Sec.  1.421-1.
    (c) Stockholder approval--(1) An employee stock purchase plan must 
be approved by the stockholders of the granting corporation within 12 
months before or after the date such plan is adopted. The approval of 
the stockholders must comply with all applicable provisions of the 
corporate charter, bylaws and applicable State law prescribing the 
method and degree of stockholder approval required for the issuance of 
corporate stock or options. If the applicable State law does not 
prescribe a method and degree of stockholder approval, then an employee 
stock purchase plan must be approved--
    (i) By a majority of the votes cast at a duly held stockholder's 
meeting at which a quorum representing a majority of all outstanding 
voting stock is, either in person or by proxy, present and voting on 
the plan; or
    (ii) By a method and in a degree that would be treated as adequate 
under applicable State law in the case of an action requiring 
stockholder approval (such as an action on which stockholders would be 
entitled to vote if the action were taken at a duly held stockholders' 
meeting).
    (2) For purposes of the stockholder approval required by this 
paragraph (c), ordinarily, a plan is adopted when it is approved by the 
granting corporation's board of directors, and the date of the board's 
action is the reference point for determining whether stockholder 
approval occurs within the applicable 24-month period. However, if the 
board's action is subject to a condition (such as stockholder approval) 
or the happening of a particular event, the plan is adopted on the date 
the condition is met or the event occurs, unless the board's resolution 
fixes the date of approval as the date of the board's action.
    (3) An employee stock purchase plan, as adopted and approved, must 
designate the maximum aggregate number of shares that may be issued 
under the plan, and the corporations or class of corporations whose 
employees may be offered options under the plan. A plan that merely 
provides that the number of shares that may be issued under the plan 
may not exceed a stated percentage of the shares outstanding at the 
time of each offering or grant under the plan does not satisfy the 
requirements of this paragraph (c)(3). However, the maximum aggregate 
number of shares that may be issued under the plan may be stated in 
terms of a percentage of the authorized, issued, or outstanding shares 
on the date of the adoption of the plan. The plan may specify that the 
maximum aggregate number of shares available for grants under the plan 
may increase annually by a specified percentage of the authorized, 
issued, or outstanding shares on the date of the adoption of the plan. 
A plan that provides that the maximum aggregate number of shares that 
may be issued as options under the plan may change based on any other 
specific circumstances satisfies the requirements of this paragraph 
only if the stockholders approve an immediately determinable maximum 
number of shares that may be issued under the plan in any event. If 
there is more than one employee stock purchase plan under which options 
may be granted and stockholders of the granting corporation merely 
approve a maximum aggregate number of shares that are available for 
issuance under the plans, the stockholder approval requirements 
described in paragraph (c)(1) of this section are not satisfied. A 
separate maximum aggregate number of shares available for issuance 
pursuant to options must be specified and approved for each plan.
    (4) Once an employee stock purchase plan is approved by the 
stockholders of the granting corporation, the plan need not be 
reapproved by the stockholders of the granting corporation within the 
prescribed 24-month period unless the plan is amended or changed in a 
manner that is considered the adoption of a new plan. Any increase in 
the aggregate number of shares that may be issued under the plan (other 
than an increase merely reflecting a change in the number of 
outstanding shares, such as a stock dividend or stock split) will be 
considered the adoption of a new plan requiring stockholder approval 
within the prescribed 24-month period. Similarly, a change in the 
designation of corporations whose employees may be offered options 
under the plan will be considered the adoption of a new plan requiring 
stockholder approval within the prescribed 24-month period unless the 
plan provides that designations of participating corporations may be 
made

[[Page 43883]]

from time to time from among a group consisting of the granting 
corporation and its related corporations. The group from among which 
such changes and designations are permitted without additional 
stockholder approval may include corporations having become parents or 
subsidiaries of the granting corporation after the adoption and 
approval of the plan. In addition, a change in the granting corporation 
or the stock available for purchase under the plan will be considered 
the adoption of a new plan requiring stockholder approval within the 
prescribed 24-month period. Any other changes in the terms of an 
employee stock purchase plan are not considered the adoption of a new 
plan and, thus, do not require stockholder approval.
    (5) Examples. The following examples illustrate the principles of 
this paragraph (c):

    Example 1. (i) Corporation E is a subsidiary of Corporation F, a 
publicly traded corporation. On January 1, 2010, E adopts an 
employee stock purchase plan under which options for E stock are 
granted to E employees.
    (ii) To meet the requirements of paragraph (c)(1) of this 
section, the plan must be approved by the stockholders of E (in this 
case, F) within 12 months before or after January 1, 2010.
    (iii) Assume the same facts as in paragraph (i) of this Example 
1, except that the plan was approved by the stockholders of E (in 
this case, F) on March 1, 2010. On January 1, 2012, E changes the 
plan to provide that options for F stock will be granted to E 
employees under the plan. Because there is a change in the stock 
available for grant under the plan, under paragraph (c)(4) of this 
section, the change is considered the adoption of a new plan that 
must be approved by the stockholders of E (in this case, F) within 
12 months before or after January 1, 2012.
    Example 2. (i) Assume the same facts as in paragraph (i) of 
Example 1, except that on March 15, 2011, F completely disposes of 
its interest in E. Thereafter, E continues to grant options for E 
stock to E employees under the plan.
    (ii) The new E options are granted under a plan that meets the 
stockholder approval requirements of paragraph (c)(1) of this 
section without regard to whether E seeks approval of the plan from 
the stockholders of E after F disposes of its interest in E.
    (iii) Assume the same facts as in paragraph (i) of this Example 
2, except that under the plan as adopted on January 1, 2010, only 
options for F stock are granted to E employees. Assume further that, 
after F disposes of its interest in E, E changes the plan to provide 
for the grant of options for E stock to E employees. Because there 
is a change in the stock available for purchase or grant under the 
plan, under paragraph (c)(4) of this section, the stockholders of E 
must approve the plan within 12 months before or after the change to 
the plan to meet the stockholder approval requirements of paragraph 
(c) of this section.
    Example 3. (i) Corporation G maintains an employee stock 
purchase plan. Corporation H does not maintain an employee stock 
purchase plan. On May 15, 2010, G and H consolidate under State law 
to form one corporation. The new corporation is named Corporation H. 
The consolidation agreement describes the G plan, including the 
maximum aggregate number of shares available for issuance under the 
plan after the consolidation. Additionally, the consolidation 
agreement states that the plan will be continued by H after the 
consolidation. The consolidation agreement is unanimously approved 
by the stockholders of G and H on May 1, 2010. H assumes the plan 
formerly maintained by G and continues to grant options under the 
plan to all eligible employees.
    (ii) Because there is a change in the granting corporation (from 
G to H), under paragraph (c)(4) of this section, H is considered to 
have adopted a new plan. Because the plan is fully described in the 
consolidation agreement, including the maximum aggregate number of 
shares available for issuance under the plan, the approval of the 
consolidation agreement by the stockholders constitutes approval of 
the plan. Thus, the stockholder approval of the consolidation 
agreement satisfies the stockholder approval requirements of 
paragraph (c)(1) of this section, and the plan is considered to be 
adopted by H and approved by its stockholders on May 1, 2010.
    Example 4. Corporation I adopts an employee stock purchase plan 
on November 1, 2010. On that date, there are two million shares of I 
stock outstanding. The plan provides that the maximum aggregate 
number of shares that may be issued under the plan may not exceed 15 
percent of the number of shares of I stock outstanding on November 
1, 2010. Because the maximum aggregate number of shares that may be 
issued under the plan is designated in the plan, the requirements of 
paragraph (c)(3) of this section are met.
    Example 5. (i) Corporation J adopts an employee stock purchase 
plan on March 15, 2010. The plan provides that the maximum aggregate 
number of shares of J stock available for issuance under the plan is 
50,000, increased on each anniversary date of the adoption of the 
plan by 5 percent of the then outstanding shares. Because the 
maximum aggregate number of shares is not designated under the plan, 
the requirements of paragraph (c)(3) of this section are not met.
    (ii) Assume the same facts as in paragraph (i) of this Example 
5, except that the plan provides that the maximum aggregate number 
of shares available under the plan is the lesser of (a) 50,000 
shares, increased each anniversary date of the adoption of the plan 
by 5 percent of the then-outstanding shares, or (b) 200,000 shares. 
Because the maximum aggregate number of shares that may be issued 
under the plan is designated as the lesser of two numbers, one of 
which provides an immediately determinable maximum aggregate number 
of shares that may be issued under the plan in any event, the 
requirements of paragraph (c)(3) of this section are met.

    (d) Options granted to certain shareholders--(1) An employee stock 
purchase plan must by its terms provide that an employee cannot be 
granted an option if the employee, immediately after the option is 
granted, owns stock possessing 5 percent or more of the total combined 
voting power or value of all classes of stock of the employer 
corporation or a related corporation. In determining whether the stock 
ownership of an employee equals or exceeds this 5 percent limit, the 
rules of section 424(d) (relating to attribution of stock ownership) 
shall apply, and stock that the employee may purchase under outstanding 
options (whether or not the options qualify for the special tax 
treatment afforded by section 421(a)) shall be treated as stock owned 
by the employee. An option is outstanding for purposes of this 
paragraph (d) although under its terms it may be exercised only in 
installments or after the expiration of a fixed period of time. If an 
option is granted to an employee whose stock ownership (as determined 
under this paragraph (d)) exceeds the limitation set forth in this 
paragraph (d), no portion of the option will be treated as having been 
granted under an employee stock purchase plan.
    (2) The determination of the percentage of the total combined 
voting power or value of all classes of stock of the employer 
corporation (or a related corporation) that is owned by the employee is 
made by comparing the voting power or value of the shares owned (or 
treated as owned) by the employee to the aggregate voting power or 
value of all shares actually issued and outstanding immediately after 
the grant of the option to the employee. The aggregate voting power or 
value of all shares actually issued and outstanding immediately after 
the grant of the option does not include the voting power or value of 
treasury shares or shares authorized for issue under outstanding 
options held by the employee or any other person.
    (3) Examples. The following examples illustrate the principles of 
this paragraph (d):

    Example 1. Employee V, an employee of Corporation K, owns 6,000 
shares of K common stock, the only class of K stock outstanding. K 
has 100,000 shares of its common stock outstanding. Because V owns 6 
percent of the combined voting power or value of all classes of K 
stock, K cannot grant an option to V under K's employee stock 
purchase plan. If V's father and brother each owned 3,000 shares of 
K stock and V did not own any K stock, then the result would be the 
same because, under section 424(d), an individual is treated as 
owning stock held by the person's father and brother. Similarly, the 
result would be the same if, instead of

[[Page 43884]]

actually owning 6,000 shares, V merely held an option on 6,000 
shares of K stock, irrespective of whether the transfer of stock 
under the option could qualify for the special tax treatment of 
section 421, because this paragraph (d) provides that stock the 
employee may purchase under outstanding options is treated as stock 
owned by such employee.
    Example 2. Assume the same facts as in Example 1, except that K 
is a subsidiary corporation of Corporation L. Irrespective of 
whether V owns any L stock, V cannot receive an option from L under 
L's employee stock purchase plan because he owns 5 percent of the 
total combined voting power of all classes of stock of a subsidiary 
of L, in this example, K. An employee who owns (or is treated as 
owning) stock in excess of the limitation of this paragraph (d), in 
any corporation in a group of related corporations, consisting of a 
parent and its subsidiary corporations, cannot receive an option 
under an employee stock purchase plan from any corporation in the 
group.
    Example 3. Employee U is an employee of Corporation M. M has 
only one class of stock, of which 100,000 shares are issued and 
outstanding. Assuming U does not own (and is not treated as owning) 
any stock in M or in any related corporation of M, M may grant an 
option to U under its employee stock purchase plan for 4,999 shares, 
because immediately after the grant of the option, U would not own 5 
percent or more of the combined voting power or value of all classes 
of M stock actually issued and outstanding at such time. The 4,999 
shares that U would be treated as owning under this paragraph (d) 
would not be added to the 100,000 shares actually issued and 
outstanding immediately after the grant for purposes of determining 
whether U's stock ownership exceeds the limitation of this paragraph 
(d).
    Example 4. Assume the same facts as in Example 3 but inste