Valuation of Options1
This chapter focuses on how the Internal Revenue Service (“Service”) treats options and option valuation. There are many code sections, some overlapping and others not, dealing with the valuation of options under different contexts. Whole books are devoted to specific option code sections but such analyses are well beyond the scope of this chapter. Rather, this chapter provides an overview of the specific Internal Revenue Code (“IRC” or “Code”) regulations germane to options.
Options can be thought of as a prediction of the potential future worth of an underlying asset. Options have no intrinsic value, instead deriving their value from the asset they represent. Thus, valuation specialists might find it necessary to predict the future value of the underlying asset to ascertain the option's present value.
This task ranges from challenging to difficult, because the Internal Revenue Service uses complex valuation methods. Generally speaking, option valuation issues may be thought of in four categories: when, how, what, and if.
When determines when options are valued. Under the most common circumstances, tax law limits valuation dates to two possibilities: when the option is received and when it is exercised. The Regulations encourage use of whichever valuation date maximizes tax revenue.
How prescribes valuation methods. There are at least three formulae that are used.
1. Mean between high and low market prices. This formula is used only for ...