Need help determining fair market value

[No21]

Hello. My company gave me insentive stock options a couple
of years ago, where each ISO costs me $1. In January, they
issued the fair market value (my company is not currently
publicly traded) for each ISO at a price of $12. A couple
of months ago the company announced that they were going to
merge with another company that is publicly traded and that
for each ISO I have, I will get two of the other company.
This merger will not take place for another couple of
months. The question is, if I exercise options today, can I
use the FMV that my company is currently using, or do I have
to use the price that the other company is currently trading
at? Is there IRS guidance about this? I can't seem to find
any rules from the IRS about this situation. I called the
IRS and they pointed me to pub 525, which states to use the
FMV at the exercise date. However, I have also talked to a
tax advisor who said I would have to use the price of the
stock that the other company is going for. This seems to be
a gray area, one person says one thing, another person says
another thing. Thanks, in advance, for your opinions.

 

[A. G. Kalman]

Hello. My company gave me insentive stock options a couple
of years ago, where each ISO costs me $1. In January, they
issued the fair market value (my company is not currently
publicly traded) for each ISO at a price of $12. A couple
of months ago the company announced that they were going to
merge with another company that is publicly traded and that
for each ISO I have, I will get two of the other company.
This merger will not take place for another couple of
months. The question is, if I exercise options today, can I
use the FMV that my company is currently using, or do I have
to use the price that the other company is currently trading
at? Is there IRS guidance about this? I can't seem to find
any rules from the IRS about this situation. I called the
IRS and they pointed me to pub 525, which states to use the
FMV at the exercise date. However, I have also talked to a
tax advisor who said I would have to use the price of the
stock that the other company is going for. This seems to be
a gray area, one person says one thing, another person says
another thing. Thanks, in advance, for your opinions.

I am going to assume that you meant to say that a couple of
years ago you were granted ISOs to purchase the private
stock of your employer at its then FMV price of $1. In Jan.
2004, the company valued the private stock at $12 FMV. If
you had exercised in Jan. 2004, then you would have used $12
vs $1 to compute your AMT gain. At the present time, the
stock is most probably no longer valued at $12 as some other
company has already agreed to swap stock at a specific
value. As this company is public, the fair market value of
any stock you receive for exercising the options can be
readily determined. It is this value that you would use.
(In a two for one merger, you wind up having an option to
buy one share of the new company for 50 cents.) In addition,
you may discover that your ability to exercise the options
is temporarily frozen until the merger is completed.

 

[Ed Zollars, CPA]

This seems to be
a gray area, one person says one thing, another person says
another thing. Thanks, in advance, for your opinions.

Well, the theoretical answer is easy--the correct price is
the fair market value of the shares on the day you exercise
the option. That is, what would a willing buyer pay a
willing seller for those shares, if both parties were fully
informed of all facts.

The problem is the *practical* answer--because if the stock
isn't traded, we have to determine that value based on
various valuation theories. However, a court would likely
consider the agreed upon deal in looking at purchase price,
since a reasonable buyer or seller would consider that as
well.

That said, a number of questions come up. First, is it
clear that what is being offered is well above or below the
value that had been previously used? Second, how volatile
has the price of the stock of the company offering th stock
been? Third, how sure are we that the deal is going to go
through?

Because of those various uncertainties, it's unlikely the
court would use *exactly* today's price of the stock to be
received in the proposed transaction--rather, it would
influence the price and as we got closer to the date of the
transaction a court would tend to set the price closer to
the amount based on the public company's shares to be
received.

That said, reality is that the transaction isn't likely to
be examined. But the law itself is pretty clear, and if you
are likely to get far more than the old valuation I wouldn't
be comfortable using that price.

 

[Arthur Kamlet]

Hello. My company gave me insentive stock options a couple
of years ago, where each ISO costs me $1. In January, they
issued the fair market value (my company is not currently
publicly traded) for each ISO at a price of $12. A couple
of months ago the company announced that they were going to
merge with another company that is publicly traded and that
for each ISO I have, I will get two of the other company.
This merger will not take place for another couple of
months. The question is, if I exercise options today, can I
use the FMV that my company is currently using, or do I have
to use the price that the other company is currently trading
at? Is there IRS guidance about this? I can't seem to find
any rules from the IRS about this situation. I called the
IRS and they pointed me to pub 525, which states to use the
FMV at the exercise date. However, I have also talked to a
tax advisor who said I would have to use the price of the
stock that the other company is going for. This seems to be
a gray area, one person says one thing, another person says
another thing. Thanks, in advance, for your opinions.

The basis of the private stock you hold, assuming you held
it past the 1 year of vesting and one year of holding after
exercise is the sum of the exercise price plus the bargain
element.

The bargain element is the difference between FMV on
exercise date and Exercise Price.

Notice that Exercise price + bargain element = FMV on date
of exercise, as you have been told.

If exercise price was $1 and FMV on date of exercise was $12
then B.E. was $11, and 1 + 11 = 12, the cost basis.

Assuming that the exchange of private stock for publicly
traded stock is determined to be a tax free exchange, then
the total basis of the new stock equals the total basis of
the private stock. Just divide the number of new shares
you get by the total basis and you know the basis per share.

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Art Kamlet ArtKamlet @ AOL.com Columbus OH K2PZH