Capital gains treatment of warrants

Dear Tax Talk,
I have warrants that were given to me as an inducement to buy additional shares in a private company that may go public. I also own stock of the company, around 2 percent. The warrant gives me the right to buy shares at $2 in the middle of this year. The company may go public; thereafter I would sell my shares. I received the warrants two years ago. When does my holding period start for purposes of determining long-term capital gain?

Thanks.
— Andrew

Dear Andrew,
An excellent question; unfortunately, though, it may not come with the answer you want. Your holding period commences on the day that you exercise your right to acquire the stock. It does not include the period that you held the warrant, even though that may have been for more than one year. The basis for that conclusion can be found in the tax law itself at Section 1223(5).

If you exercise the options before the stock goes public, you do not recognize any additional income. If you received the warrants in relation to the performance of services, you would have to recognize income upon their exercise to the extent they have value. Since this is not the case, the exercise of the warrants does not imply any additional income recognition. Your basis in the stock is $2 per share.

If you sell the stock within a year, you have short-term capital gain. You would have to wait one year and a day to get long-term capital gain treatment.

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