Do Employee Stock Options ever have a "fair market value"?

IRS Section 83 allows grantees of ESOs, be the qualified or non qualified, to delay reporting of compensation income to when the ESOs are exercised. This is because there is generally no "fair market value" of ESOs because there are permanent restrictions on the ESOs regarding pledging and transferring.

When the options are exercised, they no longer exist. The grantee now either owns the stock at a cost below the market or he receives the cash equivalent of the intrinsic value. The intrinsic value then becomes taxable on the day of exercise.

If there became a "fair market value" prior to exercise, then the value would be taxable on the day that "fair market value" began to exist. This might make some to justifiably conclude that the Google ESOs that became transferable in 2007 have a "fair market value" and are taxable to the grantee then.

But the principle that as long as there is no "fair market value" there is no tax is correct. So that is why the ESOs are not taxable, even if they are far in-the-money years prior to exercise.

If there was a "fair market value" then the tax occurs then.

So that brings us to Section 1092 of the IRS Code. It says that if there is a sale of a call or the purchase of a put to offset the risks of holding the ESOs, and that offsetting exchanged traded call or put is liquidated at a loss, the loss is deductible only to the extent that the loss is greater than the unrecognized gain on the ESOs. The unrecognized gain is defined as the gain that would result if the ESOs are sold at their "fair market value". Of course the "fair market value" is the same as the "fair market value" in Section 83 (i.e. there is none).

So under section 1092, all of the liquidated loss is deductible currently, be it a loss that is ordinary under 1221 or capital gain under the rules applying to purchases and sales of exchange traded calls and puts. This means that sales of calls and purchases of puts to offset holding ESOs are in effect not subject to section 1092, contrary to what some "options experts" may think.

Res Ipsa Loquitur

John Olagues