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tax news

Treatment of stock options

Volume 00-4 July/August 2001

Continued from page 1

TAX NEWS is a bimonthly publication of the Communications Services Bureau, California Franchise Tax Board. Its primary objective is to provide information to income tax practitioners about state income tax laws, regulations, policies and procedures.
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Nonresident taxpayers who performed services both within and outside of California must allocate to California that portion of total compensation reasonably attributed to services performed in this state (California Regulation 17951-5). One reasonable method is an allocation based on time.

The period of time includes the total amount of time from the date of grant to the date of exercise (or the date employment ended, if earlier). The basis for this position is that we properly characterize the income upon exercise as compensation for services during the time the stock increased in value.

The ratio used in allocating the stock option income is (allocation ratio):

California workdays from date of grant to date of exercise
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Total workdays from date of grant to date of exercise

Income taxable by California = Total stock option income x allocation ratio

If a taxpayer performs services for the corporation entirely within California, but exercises the option after terminating employment and becoming a nonresident, the difference between the fair market value of the stock on the date of exercise and the option price has a source in California even though the underlying value of the stock may have increased after the taxpayer became a nonresident.

Incentive Stock Options

When a taxpayer exercises an ISO while a California resident or while a nonresident and then disposes of the stock in a disqualifying disposition (the holding period requirements under IRC section 422 are not met) while a nonresident, the income from the disqualifying disposition is functionally equivalent to income from the exercise of an NQSO and we properly characterize it as wages.

The wage income is equal to the difference between the fair market value (FMV) of the shares on the date of exercise (or the sale price, if lower) and the amount paid for the shares. If the FMV of the shares on the date of sale is greater than the FMV of the shares on the date of exercise, we treat the further increase in value as capital gain income (Proposed Treasury Regulation 1.422A-1(b)(3)). Here are some examples:

Example 1: Mr. Smith, a resident of California, worked for X Company. He performed all his services in California during his entire career. On April 1, 1996, Mr. Smith's company granted him an option to purchase stock under its incentive stock option plan. On April 1, 1999, while still living and working in California, Mr. Smith exercised his option to purchase 30,000 shares of his company's stock. The option price on April 1, 1996, was $10 per share. The FMV on April 1, 1999, was $50 per share. On December 30, 1999, Mr. Smith retired and permanently moved to Florida. On March 15, 2000, he sold the 30,000 shares for $35 per share.

We characterize income from the disqualifying disposition of ISOs as wages. Because Mr. Smith performed all his services in California between the grant date and the date of exercise of the option, we treat 100 percent of the income as wages from a California source as follows:

FMV of stock, date of sale:
$1,050,000 (30,000 shares @ $35* per share)

Less: 
Option price, date of grant:

$300,000 (30,000 shares @ $10 per share)

Equal:
Wage income, California source:$750,000

*We used the sale price of $35 to compute the wage income because it is less than the exercise price of $50.

Continued on page 3

July/August 2001

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