The following article is reprinted from The M&A Tax Report, Vol. 12, No. 1, August 2003, Panel Publishers, New York, NY.


By Robert W. Wood

It wasn't too long ago that stock options were in the news primarily for their treatment for financial statement purposes. Should there be a charge to earnings, and if so, when? Stock options have also been in the news for AMT problems. Given the bust, as well as a more general stock market decline, many recipients of incentive stock options found themselves (quite painfully) caught by the AMT preference on ISOs.

Now, yet another stock option flap has hit the press, this time involving the Service's continuing tax shelter crackdown. This particular shelter came in several variations, but was essentially a tax shelter marketed by accounting firms to executives to defer tax on their options. See McKinnon and Bryan-Low, "IRS Targets Shelter for Stock Options," Wall Street Journal, July 2, 2003, p. A3.

Treasury Strikes Back

In July, the IRS issued Notice 2003-47, 2003-30 I.R.B. 1. The transaction the Service has targeted involves the grantee of nonstatutory compensatory stock options. The idea is that the recipient of options turns around and transfers the option to a related person. That transferee may be a family member or an entity in which the individual (or members of his family) hold a substantial interest. Partnerships are often used.

At the time this transfer is made, the related person will pay an amount that is purportedly equal to the fair market value of the option. This payment is generally in the form of a long-term unsecured and negotiable note, calling for a balloon payment of the purchase price at the end of the note term. Since the term is often very long (like 30 years!), the idea is to defer taxes as long as possible. In some of these deals the forms of payment include other deferred payment obligations, cash or combinations of these, but the long-term unsecured balloon note seems to be the most common. The related party making this purchase is often a thinly capitalized entity with no operating business. The terms of the note often fail to reflect the risk of nonpayment.

The promoters of this kind of arrangement argue that the options should be treated as sold or otherwise disposed of in an arms' length transaction. Under Regulation Section 1.83-7, that means that the individual does not recognize compensation income when the related person exercises the options. Furthermore, if the related person pays for the option with a note or other deferred payment obligation, the promoters argue that the individual does not recognize compensation income for the purchase price until the related party actually pays the amounts due under the note or the other deferred payment obligation.

End Game

Not surprisingly, the Service indicates it is challenging the transaction. The list of the grounds for challenges is not long, but includes a couple of heavy hitters. First, the Service agrees that where an option does not have a readily ascertainable fair market value at the time of grant, a triggering event can be a sale between unrelated parties at arms' length. Of course, that is not what these deals are.

Indeed, the Service says that the transactions at which Notice 2003-47 is directed "rarely, if ever, reflect terms that would be agreed to between unrelated parties dealing at arms' length." The notice also takes issue with the treatment of the deferred payment obligation. The Service casts a wide net, stating that in any case in which the transaction includes the disposition of an option without a readily ascertainable fair market value at the time of grant, and the individual receives a deferred payment obligation, the IRS will challenge any deferral of income with respect to that deferred payment obligation. This challenge applies, incidentally, regardless of whether the transaction is treated as arms' length or not for purposes of Reg. §1.83-7.

The consequence is pretty significant. The IRS will argue that the recipient of the option recognizes income to the extent that the amount of the deferred payment obligation transferred to the option recipient, plus any cash or other property received by the individual, exceeds the amount (if any) that the option recipient paid for the option.


There is also something in the notice about mismatching. Under Section 83(h), the payor (the issuer of the options) can claim a tax deduction for the compensation attributable to the transfer of the option only when the person who performed the services includes that amount in income. The Service wants to insure that there is no mismatching of income and deductions between the parties.

Finally, the Service notes that there are other bases on which the Service could challenge the types of transactions referred to above. Here, the Service threw in a kind of laundry list - a kind of "just in case we need it" litany of black marks. They include:

Proposed Regulations

To target this perceived abuse, the Service has taken a closer look at the regulations under Section 83, the Service has issued final regulations. The regulations provide that a sale or other disposition of a nonstatutory stock option to a related person will not be treated as a transaction that closes the application of Section 83 with respect to that option. One of the key issues, of course, is what constitutes a "related person." Here, the Service casts a wide net, generally using a 20% standard rather than a 50% standard within the context of Section 267 and Section 707. Although I am glossing over some of the complexity and detail here, just think of this as a heightened sense of targeted relationships.

Is anyone still planning on making huge gains on stock options? (The answer is surely yes, though not to the degree that it was just a few years ago.) Wouldn't it be great if you could defer all of your tax on gains from stock options beyond the exercise date? Wouldn't it be great if you could convert the triggering tax event for nonqualified options until disposition (sort of like a hybrid between nonqualified options and incentive stock options)? The answer to all these things is surely yes, which is why the Service has addressed this problem, perhaps later than it should have.

Executive Option? Not So Fast..., Vol. 12, No. 1, The M&A Tax Report (August 2003), p. 1.