In the standard tax treatment of stock options, the exercise of the options triggers taxes. For NQSOs, ordinary income tax is paid on the value of the spread at exercise. With incentive stock options, the spread at exercise is part of the calculation for the alternative minimum tax. With restricted stock/RSUs, the date of vesting and share delivery is used to calculate taxes on the income represented by the shares you receive.
But what happens if you cannot sell shares to pay the taxes on this stock-based income? Your company may impose a blackout on trading its stock. There may be a lockup, or perhaps the shares temporarily cannot be resold because of other securities law restrictions, such as insider trading prevention or the Section 16 short-swing profit rule. Maybe the shares are not registered with the SEC, or perhaps they are subject to a noncompete clause or a clawback. It would appear unfair to have to pay taxes on stock income received through exercise or vesting if you could not sell the underlying shares at all, even just to pay the taxes.
As unfair as it seems, this is the reality presented by the US tax code, the IRS, and numerous court decisions. Taxation on the stock-based income can be delayed only by a true risk of forfeiture in the grant. In Strom v. United States (2011), the 9th Circuit Court of Appeals recently reinforced the difficulty faced by challenges to this rule. Earlier, the federal district court had supported the plaintiff's arguments that the date for the tax calculation should be delayed if a sale at exercise would trigger penalties under Section 16, but the circuit court rejected this position. By remanding the case back to the district court, the appeals court did show at least some curiosity about the taxpayer's other contention: that the merger rules on pooling accounting which applied at that time, though not now under FASB 141, are another reason for delaying the tax treatment date.
If you challenge existing tax rules, beware of getting too creative. In Notice 2004-28, the IRS indicates the danger of assuming a delay in taxation when completing a tax return. Claims that a tax treatment date is delayed or deferred could be considered "frivolous" and provoke an IRS challenge, along with civil (or even criminal) penalties. The IRS has been aggressively pursuing these cases in various courts—and continues to win them.
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