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GiftLaw Note:
PRIVATE RULING 9737015

DATE: June 13, 1997

This is in reply to your letter of July 18, 1996, in which rulings are requested on behalf of Employee regarding certain federal tax consequences of the transactions described below.

The information submitted states that Employee was granted Option A under the 1986 Plan ("the Plan"), and that Option A was a nonstatutory option for substantially-vested Company shares. When granted, Option A did not have a "readily ascertainable fair market value," as defined in section 1.83-7(b) of the Income Tax Regulations, and its exercise price per share equalled the fair market value of a Company share.

When Option A 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; 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 (or his legal representative or beneficiary); or (3) require Employee A (or his legal representative or beneficiary) to pay the amount of the withholding taxes to Company.

On Date X, the Plan and Option A were amended to permit the donation of Option A to organizations described in section 170(c) of the Internal Revenue Code. To enable anonymous donations, the Plan allows transfer of Option A to an intermediary, who will exercise the Option A solely for the benefit of the charities. Under the Plan, eligible organizations and intermediaries are referred to as
"Permitted Transferees."

On Date Y, Employee irrevocably transferred Option A to Intermediary. Intermediary has established a combined custody and brokerage account ("Asset Account") on behalf of Employee, and Option A is being held in the Asset Account. Employee is the sole "account holder" on the Asset Account, which was opened in a "code name" to protect Employee's anonymity.

Option A is subject to the terms and conditions of a Gift Administration Agreement ("Agreement"). Under that Agreement, Intermediary must exercise Option A on a specified date, which Employee has reserved the right to change. Under that Agreement, Employee 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 exercise) into the Asset Account. In accordance with the Agreement, Employee 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 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, 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.

Intermediary will also furnish to Employee 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.

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).

Thus, in response to requested rulings (1), 2(a), 2(b), and 3(b), we rule as follows:

(1) Employee did not recognize income or gain upon the transfer of Option A to Intermediary.

(2) If Option A is exercised while Employee is living,

(a) Employee 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; and

(b) the compensation income recognized by Employee 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.

(3) If Option A is exercised after Employee 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.

In response to requested ruling 2(e), we rule as follows:

Although, on Date Y, Employee irrevocably transferred Option A to Intermediary with the proceeds to go to a charity (or charities) described in section 170(c)(2) of the Code, he also reserved rights that control whether, and the extent to which, Option A may be exercised. Thus, on Date Y, Employee did not make a contribution that was deductible under section 170. See section 1.170A-1(e) of the regulations.

If Option A is exercised while Employee is alive, Intermediary must sell the shares received and deposit the proceeds of the sale (net of any amounts needed to pay the exercise price, withholding taxes, and other costs relating to the transfer and exercise of the option) in the Asset Account. After Employee identifies a charity (or charities), described in section 170(c)(2), to receive a contribution, Intermediary will make a wire transfer from the Asset Account to each of those charities in the specified amount. At the time of such transfer(s), Employee A will be making a "charitable contribution," within the meaning of section 170(c), of money.

If the charities to which the funds are transferred are organizations described in section 170(b)(1)(A) of the Code, the limitation on the deductions will be governed by that section. The charity's contemporaneous written acknowledgment (identifying the number, amount, and date of the wire transfer and containing the other information required by section 170(f)(8)) that Employee will receive through Intermediary along with the statement of account from Intermediary (detailing the activity in the Asset Account) will substantiate the contribution for purposes of section 170(f)(8)(A).

In response to requested ruling 4(b), we rule as follows:

Section 2501(a) of the Code imposes a tax on the transfer of property by gift by any individual. Section 2501(a) applies whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible. See section 2511(a).

Section 25.2511-2(b) of the Gift Tax Regulations provides that a gift is complete as to any property or interest therein, of which the donor has so parted with dominion and control as to leave in him no power to change its disposition, whether for his own benefit or the benefit of another. The gift may be wholly incomplete if the property has been transferred and the donor has reserved any power over its disposition. Under section 25.2511-2(c), a gift also is incomplete if and to the extent that a reserved power gives the donor the power to name new beneficiaries or to change the interests of the beneficiaries as between themselves, unless the power is a fiduciary power limited by a fixed or ascertainable standard.

Section 2522(a) of the Code provides that, in computing taxable gifts for the calendar year, there is allowed as a deduction, in the case of a citizen or resident, the amount of all gifts made during such year to or for the use of: (1) the United States, any state, or any political subdivision thereof, or the District of Columbia for exclusively public purposes; (2) a corporation or trust organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes; (3) a fraternal society, order, or association, operating under the lodge system, but only if the gifts are to be used exclusively for religious, charitable, scientific, literary, or educational purposes, including the encouragement of art and the prevention of cruelty to children or animals; or (4) posts or organizations of war veterans, or auxiliary units or societies if the posts, organizations, units, or societies are organized in the United States or any of its possessions, and if no part of their net earnings inures to the benefit of any private shareholder or individual.

Accordingly, based upon the facts submitted and the representations made, Employee's transfer of Option A to Intermediary was an incomplete gift. Thus, that transfer was not subject to the federal gift tax. However, when Intermediary transfers the net proceeds resulting from the exercise of Option A and the sale of the stock to a charity (or charities), Employee will have made a completed gift. Provided that the charities are organizations described in section 2522(a) and that the deductions are not disallowed under section 2522(c), the contributions will be eligible for gift tax charitable deductions under section 2522(a).

In response to requested rulings 5(b) and 6, we rule as follows:

Section 2035(a) of the Code provides that the value of a decedent's gross estate generally includes the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer, by trust or otherwise, during the three-year period ending on the date of the decedent's death.

Section 2035(d)(1) provides that, except as provided in section 2035(d)(2), section 2035(a) shall not apply to the estate of a decedent dying after December 31, 1981.

Section 2035(d)(2) provides that section 2035(d)(1) shall not apply to a transfer of an interest in property that is included in the value of a gross estate under sections 2036, 2037, 2038, or 2042 or would have been included under any of those sections if such interest had been retained by the decedent.

Section 2036 of the Code provides that the value of the gross estate includes the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in the case of a bona fide sale for an adequate consideration in money or money's worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death -- (1) the possession or enjoyment of, or right to the income from, the property, or (2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.

Section 2038 of the Code provides that the value of the gross estate includes the value of all property to the extent of any interest therein of which the decedent has any time made a transfer (except in the case of a bona fide sale for an adequate and full consideration in money or money's worth), by trust or otherwise, where the enjoyment thereof was subject at his death to any change through the exercise of a power (in whatever capacity exercisable) by the decedent alone or by the decedent in conjunction with any other person (without regard to when or from what source the decedent acquired such power), to alter, amend, revoke, or terminate, or where any such power is relinquished during the three-year period ending on the date of the decedent's death.

Section 2055(a) of the Code provides that, for purposes of the estate tax, the value of the taxable estate is determined by deducting from the value of the gross estate the amount of all bequests, legacies, devises, or transfers: (1) to or for the use of the United States, any state, or any political subdivision thereof, or the District of Columbia for exclusively public purposes; (2) to or for the use of any corporation or trust organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes; (3) to a trustee or trustees, or a fraternal society, order, or association, operating under the lodge system, but only if the gifts are to be used by the trust or trustees or the fraternal society, order, or association, operating under the lodge system exclusively for religious, charitable, scientific, literary, or educational purposes, including the encouragement of art and the prevention of cruelty to children or animals; or (4) to or for the use of any veteran's organization incorporated by Act of Congress, or of its departments or local chapters or posts, no part of the net earnings of which inures to the benefit of any private shareholder or individual.

Accordingly, based upon the facts submitted and the representations made, to the extent that Option A has not been exercised by Intermediary before Employee's death, the value of Option A will be includible in Employee's gross estate under section 2036 and/or section 2038. Furthermore, if the charity or charities are organizations described in section 2055(a) and the deductions are not disallowed under section 2055(e), Employee's estate will be eligible for federal estate tax charitable deductions, under section 2055(a), for the transfer of Option A to the charity or charities.

Further, pursuant to sections 2035(d)(2) and 2036 (and/or section 2038), to the extent that Intermediary exercises an option for Employee and transfers the net proceeds to a charity during the three-year period ending on Employee's date of death, the value that Option A would have had on the date of his death will be includible in Employee's gross estate. If the charity is an organization described in section 2055(a) and the deduction is not disallowed under section 2055(e), Employee's estate will be eligible for a federal estate tax charitable deduction, under section 2055(a), for the amount included in the gross estate.

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)




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