Lesson 1.2: Special Types of Equity Securities

Question 1

Rule 144 applies to the sale of all of the following:

Answer 1

I. unregistered securities by an officer of the issuer.
II. registered securities by an officer of the issuer.
III. unregistered securities by a nonaffiliated shareholder of the issuer.

Rule 144 applies to the sale of unregistered securities owned by affiliates or nonaffiliates and the sale of control stock. It does not apply to the sale of registered securities by nonaffiliated persons.

Question 2

If a customer owns 7% of a publicly traded company’s stock and his spouse owns 6% and wants to sell her shares:

Answer 2

The spouse is an affiliate and Rule 144 applies

Together, the client and spouse own 13% of the company’s stock, so the spouse is considered an affiliate and is bound by Rule 144. If there is a 10% or more ownership interest among members of an immediate family living at the same residence, then all members are considered control persons (affiliates) subject to Rule 144. For exam purposes, assume that spouses share the same residence.

Question 3

An employee wishing to obtain long-term capital gain treatment would prefer the employer to offer:

Answer 3

incentive stock options (ISO)

Assuming the time limit conditions are met, exercise of an ISO can result in long-term capital gains while nonqualified options are always treated as ordinary income.

Question 4

Incentive Stock Options (ISOs)

Answer 4

I. the exercise of ISOs does not create taxable income

II. upon the exercise of an ISO, income for AMT purposes is created

III. if the holding period is satisfied, the gain upon the sale of ISO shares will be a long-term capital gain

IV. The favorable tax treatment is lost if the shares acquired through the ISO exercise are sold before 1 year from the date of EXERCISE or 2 years from the date of GRANT. You are not taxed upon exercise, only upon sale, but the incentive portion of the option could be considered a preference item for purposes of AMT.

Question 5

Which of the following are subject to the holding period requirements of Rule 144 of the Securities Exchange Act of 1934?

I. Registered securities held by a control person
II. Unregistered securities held by a noncontrol person
III. Registered securities held by a noncontrol person
IV. Unregistered securities held by a control person

Answer 5

II & IV
The holding period requirement of Rule 144 applies to unregistered securities, no matter who the owner is.

Question 6

What sell transactions is not subject to the holding period restriction specified in SEC Rule 144?

Answer 6

Stock acquired on the NYSE by a corporate affiliate

The holding period rule applies only to unregistered stock, which may or may not be control stock. Unregistered stock results from either private placements or the exercise of a corporate stock option. Because this question asked which securities were not subject to the Rule 144 holding period, only stock acquired on the NYSE by a corporate affiliate is the correct answer. However, the affiliated person is subject to volume restrictions.

Question 7

One way in which incentive stock options (ISOs) differ from nonqualified stock options (NQSOs) is that

Answer 7

the bargain element of the ISO is an AMT preference item.

The only true statement here is that the bargain element (the difference between the current market price at the time of exercise and the strike price) of the ISO (but not the NQSO) is one of the preference items for the alternative minimum tax. It is the bargain element of the NQSO that is reported as wages and it is possible, although difficult, to have long-term capital gains on both. Only the ISO has a maximum time limit and it is 10 years, not five.

Question 8

An employee is offered a nonqualified stock option with an exercise price of $20 per share. If the option is exercised when the current market value of the stock is $30, the employee:

Answer 8

is taxed on $10 per share as if it were salary.

In the case of NSOs, the difference between the exercise (or strike) price and the current market value is considered salary to the employee.

Question 9

Corporations have found that one way to increase employee motivation is to grant options to purchase stock in the company. Incentive (qualified) options differ from nonqualified options in all of the following respects:

Answer 9

I. ISOs may only be granted to employees, while NSOs may be given to virtually anyone.

II. there is a maximum 10-year limit for exercising an ISO; no such time limit exists for an NSO.

III. the holder of an ISO can recognize capital gain (loss) as a result of exercise and sale, whereas ordinary income (loss) is the result with an NSO.

Whether the grant is of an ISO (qualified) or an NSO (nonqualified), there are no tax consequences to the recipient at the time of the grant. It is only after exercise (NSO) and sale after exercise (ISO) that the recipient of the grant has tax consequences. Each of the other choices represents a difference. ISOs can only be granted to employees, while the NSO can also be granted to members of the board of directors and even to vendors. With an ISO, capital gain (loss) treatment is available upon the sale of the stock if the recipient holds the stock purchased through exercise at least one year from the date of exercise and at least two years from the date of the grant. With an NSO, the recipient can only have ordinary income (loss) based on the difference between the exercise price and the market value when the option is exercised. Finally, if the recipient of an ISO does not exercise the option within 10 years of the grant, it is treated as an NSO for tax purposes.

Question 10

Under Rule 144, who is subject to volume limitations?

Answer 10

Control persons are always subject to volume limitations.