Friday, March 29, 2024
GiftLaw Pro
GiftLaw Note:
PRIVATE RULING 9737016

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 B under the 1993 Plan ("the Plan"), and that Option B was a nonstatutory option for substantially-vested Company shares. When granted, Option B 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 prices per share equalled the fair market value of a Company share.

When 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; 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 (or his legal representative or beneficiary) to pay the amount of the withholding taxes to Company.

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

Employee intends to irrevocably donate all or a portion of Option B directly to a designated charity (or charities) described in section 170(c) of the Code. Employee's transfer of Option B will be subject to a proposed Option Gift Agreement ("the proposed Agreement").

Under the proposed Agreement, Employee B will have the power to veto a charity's proposed exercise of Option B. However, if Employee dies prior to the exercise of Option B, the 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 of 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).

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

(1) Employee will not recognize income or gain upon the transfer of Option B to a Permitted Transferee.

(2) If Option B 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 B 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(d), we rule as follows:

Employee 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. These will not be deductible contributions under section 170, because Employee will retain an inter-vivos veto power over all proposed exercises of Option B. In this regard, see section 1.170A-1(e) of the regulations. However, if a charity exercises Option B while Employee is alive, Employee will be treated as having made a charitable contribution, within the meaning of section 170(c), to the charity. Employee will have made a completed gift of Option B to the charity at the time of exercise. See Revenue Ruling 79-249, 1979-2 C.B. 104. For these purposes, the value of Option B will be equal to the fair market value of the stock transferred (or issued) to the charity over the sum of the amount of the exercise price and the amount of withholding taxes paid by the charity (or on the charity's behalf).

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.

The amount of the deduction will not be subject to a reduction under section 170(e)(1) of the Code. On the exercise of Option B, Employee will recognize compensation income under section 83 (see above). Even though his income recognition is not from the transfer of contributed property, as in section 1.170A-4(e) of the regulations, the effect here is similar to the situation considered in that regulation. Here, Employee has income upon the exercise of Option B, so, in effect, Option B does not have an appreciated value at the time of the deductible section 170 contribution.

For purposes of applying the percentage limitations provided in section 170(b)(1), the contribution of Option B will not be a contribution of "capital gain property," as defined in section 170(b)(1)(C)(iv), because its sale would have resulted in compensation income rather than long-term capital gain. See section 1.183-1(b)(1) of the regulations. So long as the charity to which Option B is contributed is an organization described in section 170(b)(1)(A), the deduction will be subject to the limitations of that subparagraph and not to the limitations of sections 170(b)(1)(B), (C), or (D).

However, if the value of Option B is $250 or more at the time of contribution, then, in order to deduct the contribution under section 170(a), Employee will have to substantiate the contribution by a contemporaneous written acknowledgment by the donee charity which meets the requirements of section 170(f)(8)(B).

In response to requested ruling 4(a), 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 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.

The transfer of the Option B to a charity will not be a completed gift for gift tax purposes until the charity exercises that option because, until that time, Employee will retain the right to control the amount to be received by the charity through his power to determine the amount of the withholding tax and through his reservation of the right to veto exercises.

However, on the date that the charity exercises Option B, Employee will designate the withholding tax rate to be applied to the spread on exercise and will have approved the exercise. At that time, therefore, there will be a completed gift to the charity of a fixed and ascertainable percentage of Employee's entire interest in the spread on Option B. For gift tax purposes, at that time, Employee will have made a completed gift, and, provided that the charity is an organization described in section 2522(a) and the deduction is not disallowed under section 2522(c), the gift to the charity will be eligible for a charitable gift tax deduction under section 2522(a).

In response to requested rulings 5(a) 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 which 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.

To the extent that Option B has not been exercised by the charity before Employee's death, the value of Option B 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 B to the charity or charities.

Pursuant to sections 2035(d)(2) and 2036 (and/or section 2038), to the extent that Employee transfers a stock option to a charity and during the three-year period ending on the date of his date the option is exercised by the charity, the value that the option would have had on the date of his death will be includible in Employee's gross estate. Furthermore, assuming that 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 his 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 31 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)




© Copyright 1999-2024 Crescendo Interactive, Inc.