26 U.S.C. § 421 — General rules

(a) Effect of qualifying transfer If a share of stock is given to someone through a transfer that meets the requirements of section 422(a) (incentive stock options) or 423(a) (employee stock purchase plans): (1) the person owes no income tax at the time they exercise the option and get the share; (2) the employer corporation — or its parent, subsidiary, or a corporation that took over the option under section 424(a) — gets no business-expense tax deduction for that share, ever; and (3) none of these corporations is treated as having received anything more than the option price for the share. (b) Effect of disqualifying disposition If a stock transfer would have qualified under section 422(a) or 423(a), except that the person didn't hold the stock long enough (missing the holding-period rules in 422(a)(1) or 423(a)(1)), then any resulting increase in the individual's income, or deduction for the employer, is instead counted in the tax year the stock was actually sold or disposed of — not the year it was exercised. No tax withholding under chapter 24 is required on that extra income. (c) Exercise by estate (1) If an option is exercised after the employee dies — by the estate, or by someone who inherited the right to exercise it — subsection (a) still applies as if the employee had exercised it, except the holding-period and employment requirements of sections 422(a) and 423(a) don't apply, and if the estate later transfers the stock, that counts as a "disposition" under section 423(c). (2) If the estate (or heir) has to include an amount in gross income under section 423(c), they get an estate-tax deduction for it, figured under section 691(c) as if the option were "income in respect of a decedent." (3) For stock acquired this way: the stock's basis includes the part of the option's basis attributable to it, but is reduced by any gap between what would have been included in income if the employee had exercised it themselves before dying and what was actually included. And a related basis-increase rule in section 423(c) only applies to the extent the included income is more than the option's basis for that stock. (d) Certain sales to comply with conflict-of-interest requirements If a share is transferred to someone under this part because they exercised a stock option, and they then have to sell that share under a "certificate of divestiture" (to avoid a conflict of interest, as defined in section 1043(b)) — that sale is treated as meeting the holding-period requirement of section 422(a)(1) or 423(a)(1), whichever applies.