The following article is adapted and reprinted from the M&A Tax Report, Vol. 9, No. 11, June 2001, Panel Publishers, New York, NY.


By Robert W. Wood

The May issue of The M&A Tax Report (Volume 9, Number 10), contained an error. The article entitled "Tax and Accounting Primer for Nonqualified Stock Options" suggests that it is possible to make a Section 83(b) election for nonqualified stock options (NSOs) which do not have a readily ascertainable fair market value. That is not so. Several M&A Tax Report readers were kind enough to point out the error.

NSOs which do not have a readily ascertainable fair market value are simply not considered property for purposes of Section 83. Hence, a Section 83(b) election would not be available. The term "readily ascertainable fair market value" is defined in Reg. §1.83-7. It is pretty clear that the 83(b) election simply doesn't work here.

One M&A Tax Report reader (Kenneth Kail of Morgan, Lewis & Bockius in New York) was kind enough to send along a case, Richard A. and Alice D. Cramer, et al. v. Commissioner, 101 T.C. 225 (1993). The Cramer case squarely considers this issue — which I suppose means that at least someone thought the issue was worth arguing about and trying in Tax Court — and flatly refuses to give the taxpayer a break. It is an interesting case, and there were several quite prominent counsel at the taxpayer's counsel table. Both Brookes Billman (of the New York University School of Law) and Michael Saltzman (of White & Case in New York) were involved as counsel for the taxpayers. Needless to say, neither one of these lawyers is a slouch.

They argued, I thought quite persuasively, that the options in Cramer did have a fair market value and that the Section 83(b) election was available and worked. It is hard to disagree with the statute though. Section 83(e)(3) flatly states that Section 83 "shall not apply to...the transfer of an option without a readily ascertainable fair market value." Although the legislative history does not say much, if anything, about this, Judge Cohen considered this provision as well as the regulations and case law in concluding that there was no value here and that the Section 83(b) election didn't work. Interestingly, the Tax Court's opinion in Cramer cites Brookes Billman, who wrote Nonstatutory Stock Options, 383 Tax Management A-8 (1984). Billman and others are cited for the proposition that commentators believe the 1976 Act's legislative history indicates Congress' disapproval with the regulations that specify when the value of an option is "readily ascertainable." Judge Cohen evidently doesn't put much stock in these commentators.

Indeed, Judge Cohen also flatly rejects the taxpayer's arguments in Cramer that the fact that a Section 83(b) election was made bootstraps the option into definitely having a readily ascertainable fair market value. The taxpayers cited Walt Disney Productions v. U.S., 480 F.2d 66 (9th Cir. 1973), for the proposition that the 1976 Conference Report (legislative history subsequent to the Section 83 regulations) should be given considerable weight. According to Judge Cohen, no matter how much weight is given to all of this, the argument just doesn't fly.

I thought it quite interesting that the taxpayers in Cramer also argued that their advisors (blame it on the advisors!) relied on Alves v. Commissioner, 79 T.C. 864 (1982), aff'd, 734 F.2d 478 (9th Cir. 1984), in determining the tax treatment of the options. The taxpayers in Cramer cited the dissent in Alves for the proposition that the court agreed that zero income could be reported at the time of the grant of an option, and that capital gains could then be reported on its sale.

Alves, clearly an important (and even bellwether) case, involved the question whether Section 83 applied where the taxpayer had paid fair market value for the stock when he received it, and therefore received no income when the stock was transferred to him. Judge Cohen in Cramer flatly says that the Alves holding bears no relationship to the Cramer facts, where the taxpayers attempted to report a fair market value of zero on receipt of their options, not stock. The issue, Judge Cohen states, is simply whether the options had a readily ascertainable fair market value when they were transferred.

The Cramer opinion is quite long and quite detailed, and is worth a read. Thanks again to M&A Tax Report subscriber, Ken Kail, for pointing it out.

One More Thing...

The May 2001 issue included one more point (this one on accounting treatment), that certainly needs clarification. Our gratitude to subscriber, John Ireland, Tax Director of DynCorp, for pointing out these issues.

If a company follows APB 25 (and has not adopted FAS 123), when a nonqualified option is exercised, there is no charge to earnings, as long as the NSO was a "market value" option at the date of grant. Thus, if the grant price equaled the fair market value at the date of grant, there is no charge to earnings. The only book entry made is that paid in capital is credited, and federal income tax receivable is debited to reflect the permanent tax benefit to the company (which does not affect earnings).

John Ireland was kind enough to also suggest that in the "accounting treatment change" note on page 7 of the May issue (part of the article entitled "Treatment of Options in M&A Deals," which commences on page 5), we could have pointed out that if there is an "Interpretation 44" event causing the books to recognize compensation expense, there is no corresponding tax deduction (or W-2 income). However, the tax effect is debited to paid-in capital and credited to federal income tax payable for the permanently lost tax deduction.

Correction and Clarification, Vol. 9, No. 11, M&A Tax Report (June 2001), p. 8.