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Thursday, April 18, 2024
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GiftLaw Pro |
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GiftLaw Note:
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PRIVATE RULING 9737014
DATE: June 13, 1997
This is in reply to your letter of July 18, 1996, in which rulings are requested on behalf of Company regarding certain federal income tax consequences of the transactions described below.
The information submitted states that Employee A was granted Option A under the 1986 Plan, and Employee B was granted Option B under the 1993 Plan.1 In both cases, the Options were nonstatutory options for substantially-vested Company shares. When granted, the Options did not have a "readily ascertainable fair market value," as defined in section 1.83-7(b) of the Income Tax Regulations, and their exercise prices per share equalled the fair market value of a Company share.
When Option A or Option B is exercised, the exercise price must be paid in full to Company, using one or a combination of the following methods: (1) payment in cash; (2) delivery of Company stock already owned by Employee A or Employee B; or (3) simultaneous sale, through a broker, of a portion of the Company stock acquired on exercise (a cashless exercise). To ensure that all federal, state, local, and other taxes required to be withheld in connection with the exercise of an option are paid, Company may (1) reduce the number of otherwise deliverable shares by the number of shares equal in value to the amount of such taxes; (2) deduct the amount of such taxes from any other amount payable by Company to Employee A or Employee B (or their legal representatives or beneficiaries); or (3) require Employee A or Employee B (or their legal representatives or beneficiaries) to pay the amount of the withholding taxes to Company.
On Date X, the Plans and the Options were amended to permit donation of the Options to organizations described in section 170(c) of the Internal Revenue Code. To enable anonymous donations, the Plans allow transfer of the Options to intermediaries, who will exercise the Options solely for the benefit of the charities. Under the Plans, eligible organizations and intermediaries are referred to as "Permitted Transferees."
On Date Y, Employee A irrevocably transferred Option A to Intermediary. Intermediary has established a combined custody and brokerage account ("Asset Account") on behalf of Employee A, and Option A is being held in the Asset Account. Employee A is the sole "account holder" on the Asset Account, which was opened in a "code name" to protect Employee A's anonymity.
Option A is subject to the terms and conditions of a Gift Administration Agreement ("the Agreement"). Under the Agreement, Intermediary must exercise Option A on a specified date, which Employee A has reserved the right to change. Under the Agreement, Employee A retains the right to specify and subsequently change (until the exercise date) the maximum spread that may result from exercise of Option A and the amount of withholding taxes to be paid upon exercise.
Under the Agreement, upon the exercise of Option A, Intermediary must immediately sell the Company shares received and deposit the net proceeds of the sale (gross proceeds less the exercise prices, withholding taxes, and costs relating to the option's exercise and its transfer) into the Asset Account. In accordance with the Agreement, Employee A will contemporaneously identify one or more charities (described in section 170(c)(2) of the Code) to receive a contribution, and Intermediary will make a wire transfer from the Asset Account of the amounts specified for contribution to the charities. Intermediary will not commingle any other payment or contribution to the charity (or charities) in that wire transfer.
Under the Agreement, if Employee A dies prior to the full exercise of Option A, Intermediary must transfer what remains of Option A to a previously designated charity (or charities), and the charity may exercise Option A without regard to the criteria for permissible exercise dates. To the extent that Option A is not exercised before its expiration date, it will expire unexercised.
Intermediary, as the agent of Employee A, will receive from each charity a contemporaneous written acknowledgment stating that a specified amount was received by the charity on a specified date by a specified wire transfer from a specified asset account maintained by Intermediary. The acknowledgment will also state the other information required by section 170(f)(8) of the Code. Intermediary will promptly furnish the charity's acknowledgment to Employee A.
Intermediary will also furnish to Employee A statements detailing the activities in the Asset Account during each month that a contribution is made to a charity. These statements will include the amount, number, date, and recipient of any wire transfer to a charity.
Employee B intends to irrevocably donate all or a portion of Option B to a designated charity (or charities) described in section 170(c) of the Code. Employee B's transfer of Option B will be subject to a proposed Option Gift Agreement ("the proposed Agreement").
Under criteria specified in the proposed Agreement, Employee B will have the power to veto a charity's proposed exercise of Option B. However, if Employee B dies prior to the exercise of Option B, his veto power immediately terminates, and the charity may exercise Option B at its discretion and without regard to the criteria for permissible exercise dates. To the extent that Option B is not exercised before its expiration date, it will expire unexercised.
The exercise of Option B may be accomplished in two ways. As one alternative, the charity will pay the exercise prices and all applicable taxes to Company and will be issued shares in its own name. Otherwise, the exercise will be transacted through a broker, who will pay the exercise prices and all applicable taxes to Company, will be issued shares registered in the charity's name, and will sell (on the open market) such number of the optioned shares as will be sufficient to reimburse itself for the amounts it has expended and the expenses of the sale. At the charity's discretion, it will then receive either the remaining shares or the net proceeds of the sale of those shares. Under the proposed Agreement, the transaction form that the charity must provide to Company in order to exercise Option B must state the appropriate withholding tax percentage applied to the gain realized on the exercise by the charity.
Under section 83 of the Code, if, in connection with the performance of services, property is transferred to any person other than the service recipient, the excess of the fair market value of the property, on the first day that the rights to the property are either transferable or not subject to a substantial risk of forfeiture, over the amount paid for the property is included in the service provider's gross income for the first taxable year in which the rights to the property are either transferable or not subject to a substantial risk of forfeiture.
Stated differently, property is not taxable under section 83 until it is transferred to and substantially vested in the service provider (or beneficiary thereof). See section 1.83-1(a)(1) of the regulations. A "transfer" of property occurs when a person acquires a beneficial ownership interest in the property (disregarding any "lapse restriction," as defined in section 1.83-3(i)). See section 1.83-3(a)(1). Property is "substantially vested" when it is either transferable or not subject to a substantial risk of forfeiture. See section 1.83-3(b).
For purposes of section 83, the term "amount paid" refers to the value of any money or property paid for the transfer of property to which section 83 applies, but does not refer to any amount paid for the right to use such property or to receive the income therefrom. When section 83 applies to the transfer of property pursuant to the exercise of an option, the term "amount paid" refers to any amount paid for the grant of the option plus any amount paid as the exercise price of the option. See section 1.83-3(g).
Section 83(e)(3) provides that section 83(a) does not apply to the transfer of an option without a readily ascertainable fair market value. However, sections 83(a) and 83(b) do apply to such an option at the time that it is exercised, sold, or otherwise disposed of. If the option is exercised, sections 83(a) and 83(b) apply to the transfer of property pursuant to the exercise. 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 it would have applied to the transfer of property pursuant to an exercise of the option. See section 1.83-7(a) of the regulations.
Although neither the Code nor the regulations provides rules for taxing the disposition of an option described in section 83(e)(3) in a transaction that is not at arm's length, we have concluded that rules similar to those provided in section 1.83-1(c) of the regulations should apply in determining the tax consequences of such dispositions. Under that regulation, if substantially-nonvested property is disposed of in a transaction that is not at arm's length, the service provider realizes compensation income in an amount equal to the sum of any money and the fair market value of any substantially-vested property received in the disposition. However, such compensation income may not exceed the fair market value of the property disposed of (determined at the time of the disposition and without regard to any lapse restriction) reduced by the amount (if any) paid for that property. Additionally, section 83 continues to apply to the property disposed of, except that any amount previously included in gross income as a result of the disposition is treated as an amount paid for the property. Compare Weigl v. Comm'r., 84 T.C. 1192 (1985).
Under section 83(h), the service recipient is allowed a compensation expense deduction, under section 162 of the Code, in an amount equal to the amount included in the service provider's gross income under section 83(a). The deduction is allowed for the service recipient's taxable year in which or with which ends the service provider's taxable year in which the amount is included in gross income. However, no deduction is allowed under section 83(h) to the extent that the transfer of property constitutes a capital expenditure, an item of deferred expense, or an amount properly includible in the value of inventory items. See section 1.83-6(a)(4) of the regulations.
Section 1.83-6(a)(3) of the regulations provides an exception to the general timing rule for the deduction. In cases where the property transferred is substantially vested upon transfer, the deduction is allowed to the service recipient in accordance with the recipient's normal method of accounting.
Thus, in response to requested rulings (1), 2(a), 2(b), 2(c), 3(b) and 3(c), we rule as follows:
(1) Employee A did not recognize income or gain upon the transfer of Option A to Intermediary A, and Employee B will not recognize income or gain upon the transfer of Option B to a Permitted Transferee.
(2) If Option A or Option B is exercised while the optionee (Employee A or Employee B, as applicable) is living,
(a) the optionee will recognize compensation income equal to the excess of the fair market value of the optioned shares on the date of exercise over the exercise price of the option;
(b) the compensation income recognized by the optionee will constitute "wages," under section 3401 of the Code, that are subject to federal income tax withholding. See Revenue Ruling 67-257, 1967-2 C.B. 359; and
(c) Company will be entitled to a deduction, under its normal method of accounting, in an amount equal to the amount of compensation income recognized by the optionee.
(3) If Option A or Option B is exercised after the optionee dies,
(b) the compensation income attributable to such exercise will not constitute "wages" under section 3401 of the Code. See Revenue Ruling 86-109, 1986-2 C.B. 196; and
(c) Company will be entitled to a deduction, under its normal method of accounting, in an amount equal to the amount of compensation income recognized by the optionee.
Except as ruled above, no opinion is expressed as to the federal tax consequences of the transactions described above under any provision of the Internal Revenue Code. Additionally, this letter ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) of the Code provides that it may not be used or cited as precedent.
Sincerely yours,
ROBERT B. MISNER
Assistant Chief, Branch 4
Office of the Associate
Chief Counsel
(Employee Benefits and Exempt Organizations)
FOOTNOTE
1 Hereafter, the 1986 Plan and the 1993 Plan will sometimes be collectively referred to as "the Plans," and Option A and Option B will sometimes be collectively referred to as "the Options."
END OF FOOTNOTE
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