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GiftLaw Note: Taxpayer has accrued a right to three different types of unqualified deferred compensation. He has compensation that has been payable but has been deferred, non-statutory stock options that he may exercise and a right of his estate to receive an additional amount of nonqualified deferred compensation.

Under Sec. 83(a), deferred compensation is not currently taxable if it is "subject to a substantial risk of forfeiture." This deferred compensation apparently complies with that requirement. It is not vested and could be forfeited. Furthermore, since the nonstatutory stock options do not have ascertainable value under Reg. 1.83-7(b), these also will not cause recognition of ordinary income until date of exercise.

Taxpayer inquires as to whether or not the three different types of unqualified deferred compensation may be transferred through beneficiary designations to qualified exempt charities. The Service first notes that under Sec. 2055 of the Code, deferred compensation will be treated similarly to other assets transferred to qualified charities upon the death of the owner. Thus, the Sec. 2055(a) charitable deduction for estate tax purposes is permissible.

Furthermore, under Sec. 691(a), IRAs, qualified plans, installment notes, U.S. Savings Bonds, commercial annuities and unqualified deferred compensation are characterized as income in respect of a decedent (IRD). These items may be transferred to charity. Taxpayers are permitted to avoid both the estate tax and the income tax otherwise payable when these various IRD assets are transferred to charity. Thus, for any estate, it is very desirable for those with charitable intent to use a beneficiary designation, when possible, to make the transfer directly to a charity.

An ongoing concern of tax counsel is to be certain that the estate will not be subject to payment of income tax when the assets are transferred. For example, if an estate receives an IRD item and satisfies a pecuniary bequest to a charity with IRD, the estate will be required to pay the income tax on the IRD. Fortunately, in this circumstance, the Service determined that the Sec. 691(a) status of all three types of unqualified deferred compensation enables direct transfer to charity through a beneficiary designation.

While the IRD asset will produce income to the charity, the charitable trust will receive passive income that will not constitute unrelated business income to the trust. For example, see PLR9634019, in which IRD was transferred to a testamentary unitrust. Thus, for a transfer of IRD either to a charity or to a testamentary charitable trust, the charitable entity will, absent other reasons, not recognize and pay unrelated business income tax on the IRD.

Date: September 30, 1999

We received your letter dated, November 30, 1998, in which you request a ruling concerning the estate and income tax consequences under sections 2055, 691 and 83 of the Internal Revenue Code related to the Taxpayer's designation, in the event of the Taxpayer's death, of one or more charitable organizations as the beneficiaries of certain deferred compensation to which he is entitled and to Taxpayer's bequest at his death to one or more charitable organizations certain stock options which he owns. This letter is in response to your request.

The represented facts are as follows: Taxpayer has been employed by Corporation, since he founded Company in year 1. Taxpayer is currently Chairman of Corporation's Board of Directors.

During the course of Taxpayer's employment, he has elected to defer receipt of certain amounts to which he was entitled, consisting of (1) compensation that had been payable to Taxpayer but the receipt of which he elected to defer pursuant to Corporation's deferred compensation plan, (2) shares of Corporation stock that had been payable to Taxpayer as a result of his exercise of compensatory stock options granted to him by Corporation, the receipt of which he elected to defer pursuant to Corporation's deferred stock option plan. Furthermore, Taxpayer negotiated with Corporation for the Corporation to provide a death benefit to his estate or designated beneficiaries upon his death. Collectively, these three items are referred to as the deferred compensation.

Pursuant to Taxpayer's agreement with Corporation with respect to the deferred compensation, Taxpayer may designate any one or more beneficiaries within a certain class, which would include charitable organizations, to whom the deferred compensation would be payable in the event of his death.

Taxpayer intends to name as the designated beneficiaries of the deferred compensation one or more charitable organizations, each of which qualifies for tax-exempt status pursuant to section 501(a) as an organization described in section 501(c)(3).

During the course of his employment with the Corporation, Taxpayer also has been granted certain rights (options) to purchase shares of Corporation stock at specified option prices. No option price was less than the fair market value of the stock to which it applied on the date the option was granted.

It is represented that the options are the type of options commonly known as "nonstatutory options" because they do not meet the requirements for special income tax treatment under sections 421 through 424 ("statutory options"). It is further represented that at the time of their grant, the options did not have a readily ascertainable fair market value.

Pursuant to Taxpayer's agreement with Corporation under which the options were granted, in the event of his death, Taxpayer may transfer the options by will to any one or more beneficiaries within a certain class, which would include charitable organizations. Taxpayer intends to bequeath the options under his will to one or more of the charitable organizations.

Specifically, you request the following rulings:
  1. Taxpayer's estate will be eligible for a federal estate tax charitable deduction under section 2055(a) for the deferred compensation passing to the charitable organizations and for the value of the options passing to the charitable organizations.
  2. The deferred compensation to which the charitable organizations will become entitled following Taxpayer's death will be income in respect of a decedent under section 691 which will be included in the gross income of the charitable organizations in the year in which the charitable organizations receive such income.
  3. When, following Taxpayers death, the charitable organizations exercise the options which Taxpayer bequeaths to them under his Will, the charitable organizations will recognize income in respect of a decedent under section 691 which will be included in the gross income of the charitable organizations.

ISSUE 1: (Estate Tax Charitable Deduction)


Section 2055(a)(2) provides that for purposes of the tax imposed by section 2001, the value of the taxable estate shall be determined by deducting from the value of the gross estate the amount of all bequests, legacies, devises, or transfers to or for the use of any corporation organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes.

Based on facts submitted and representations made the deferred compensation and the value of the options will be includible in the Taxpayer's gross estate under section 2033 and 2039(a) of the Code. We also conclude that, assuming the charitable organizations are organizations described in section 501(c)(3) at the time of the Taxpayer's death, the Taxpayer's estate will be eligible for a federal estate tax deduction under section 2055(a) of the Code for the deferred compensation payable to the charitable organizations in accordance with Taxpayer's beneficiary designation and for the value of the options passing to the charitable organizations under Taxpayer's will.

ISSUES 2 & 3:


(Income in Respect of a Decedent)

Section 691(a)(1) provides that the amount of all items of gross income in respect of a decedent which are not properly includible in respect of the taxable period in which falls the date of the decedent's death or a prior period (including the amount of all items of gross income in respect of a prior decedent, if the right to receive such amount was acquired by reason of the death of the prior decedent or by bequest, devise, or inheritance from the prior decedent) shall be included in the gross income, for the taxable year when received, of: (A) the estate of the decedent, if the right to receive the amount is acquired by the decedent's estate from the decedent; (B) the person who, by reason of the death of the decedent, acquires the right to receive the amount, if the right to receive the amount is not acquired by the decedent's estate from the decedent; or (C) the person who acquires from the decedent the right to receive the amount by bequest, devise, or inheritance, if the amount is received after a distribution by the decedent's estate of such right.

Section 691(a)(2) of the Code provides that if a right, described in section 691(a)(1), to receive an amount is transferred by the estate of the decedent or a person who received such right by reason of the death of the decedent or by bequest, devise, or inheritance from the decedent, there shall be included in the gross income of the estate or such person, as the case may be, for the taxable period in which the transfer occurs, the fair market value of such right at the time of such transfer plus the amount by which any consideration for the transfer exceeds such fair market value. For purposes of section 691(a)(2), the term "transfer" includes sale, exchange, or other disposition, or the satisfaction of an installment obligation at other than face value, but does not include transmission at death to the estate of the decedent or a transfer to a person pursuant to the right of such person to receive such amount by reason of the death of the decedent or by bequest, devise, or inheritance from the decedent.

Section 691(a)(3) provides that the right, described in section 691(a)(1), to receive an amount shall be treated, in the hands of the estate of the decedent or any person who acquired such right by reason of the death of the decedent, or by bequest, devise, or inheritance from the decedent, as if it had been acquired by the estate or such person in the transaction in which the right to receive the income was originally derived and the amount includible in gross income under section 691(a)(1) or (2) shall be considered in the hands of the estate or such person to have the character which it would have had in the hands of the decedent if the decedent had lived and received such amount.

Section 1.691(a)-1(b) of the Income in Respect of Decedents Tax Regulations provides that the term "income in respect of a decedent" refers to those amounts to which a decedent was entitled as gross income but which were not properly includible in computing the decedent's taxable income for the taxable year ending with the date of the decedent's death or for a previous taxable year under the method of accounting employed by the decedent.

Section 83(a) of the Code provides that if, in connection with the performance of services, property is transferred to any person other than the person for whom the services are performed, the excess of -- (1) the fair market value of the property (determined without regard to any restriction other than a restriction which by its terms will never lapse) at the first time the rights of the person having the beneficial interest in the property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier, over (2) the amount, if any, paid for the property, will be included in the gross income of the person who performed the services in the first taxable year in which the rights of the person having the beneficial interest in the property are transferable or are not subject to a substantial risk of forfeiture, whichever is applicable. Under section 83(e)(3) of the Code, section 83 does not apply to the transfer of an option without a readily ascertainable fair market value.

Section 1.83-1(d) provides that if substantially nonvested property has been transferred in connection with the performance of services and the person who performed the services dies while the property is still substantially nonvested, any income realized on or after such death with respect to the property under this section is income in respect of a decedent to which the rules of section 691 apply. In such a case the income in respect of the property shall be taxable under section 691 (except to the extent not includible under section 101(b)) to the estate or beneficiary of the person who performed the services, in accordance with section 83 and the regulations thereunder.

Section 1.83-7(a) of the regulations provides, in part, that if there is granted to an employee or independent contractor (or beneficiary thereof) in connection with the performance of services, an option to which section 421 (relating generally to certain qualified and other options) does not apply, section 83(a) shall apply to the grant if the option has a readily ascertainable fair market value (determined in accordance with section 1.83-7(b)) at the time the option is granted. If section 83(a) does not apply to the grant of the option because it does not have a readily ascertainable fair market value at the time of the grant, sections 83(a) and 83(b) will apply at the time the option is exercised or otherwise disposed of, even though the fair market value of the option may have become readily ascertainable before such time. If the option is exercised, sections 83(a) and 83(b) apply to the transfer of property pursuant to the exercise, and the employee or independent contractor realizes compensation upon the transfer at the time and in the amount determined under section 83(a) or 83(b). If the option is sold or otherwise disposed of in an arm's length transaction, sections 83(a) and 83(b) apply to the transfer of money or other property received in the same manner as sections 83(a) and 83(b) would have applied to the transfer of property pursuant to the exercise of an option. See section 1.83-7(b) of the regulations for the test to be applied in determining whether an option has a readily ascertainable fair market value. However, section 1.83-7 is silent regarding the transfer of a nonstatutory option in a non-arm's length transaction.

Based on facts submitted and representations made, we conclude that if the charitable organizations are named as the designated beneficiaries of the deferred compensation, the proceeds from the deferred compensation that would have been items of gross income to Taxpayer if the proceeds had been distributed to Taxpayer before his death will be income in respect of a decedent to the charitable organizations under section 691(a)(1)(B) when distributed to the charitable organizations. The proceeds from the deferred compensation will not be income in respect of a decedent to Taxpayer's estate.

Based on facts submitted and representations made, we conclude that Taxpayer's bequest of the options to the charitable organizations is governed by the rule set forth in section 1.83-1(d). Therefore, we also conclude that any income realized by the charitable organizations after Taxpayer's death by exercise of the options is income in respect of a decedent to the charitable organizations under section 691(a)(11)(C). The income from the options will not be income in respect of a decedent to Taxpayer's estate.

Except as ruled above, we express or imply no opinion concerning the federal tax consequences of this transaction under the cited provisions or any other provision of the Code. In particular we express or imply no opinion regarding the value of any stock options.

This letter ruling is directed only to the taxpayer who requested it. Section 6110(k)(3) provides that it may not be used or cited as precedent.

Sincerely,
Christine E. Ellison Branch Chief, Branch 7
Office of the Assistant Chief Counsel
(Passthroughs and Special Industries)




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