Is the exercise of a stock option reportable as compensation?
Taxpayer Says: The stock option was not transferred in connection with the performance of services. It’s not compensation and is not includable in income.
Internal Revenue Service Says: Either the stock option is compensation and includable on the individual income tax return of the taxpayer, or it is not compensation and is not deductible on the corporate tax return of the issuing company.
From Internal Revenue Code Section 83(a): When property is transferred in connection with the performance of past, present or future services, a taxpayer must include in gross income the excess of the property’s fair market value over the amount paid for the property.
From Internal Revenue Code Section 83(e)(3) and (4): In the case of options without a readily ascertainable fair market value, section 83 applies to the stock received upon exercise of the options rather than at the time of receipt.
From Federal Tax Regulation 1.83-7(b)(2)(i): If an option is not traded on an established market, the option’s value is not readily ascertainable when the option is non-transferable.
From Centel Commc’ns Co. v. Commissioner, 92 T.C. 612, 627 (1989), affd. 920 F.2d 1335 (7th Cir. 1990): Whether property was transferred in connection with the performance of services is a question of fact.
From MacNaughton v. United States, 888 F.2d 418, 421 (6th Cir. 1989); Alves v. Commissioner, 734 F.2d 478, 481-482 (9th Cir. 1984), affg. 79 T.C. 864 (1982): Property does not necessarily have to be transferred as “compensation” to trigger section 83.
From Alves v. Commissioner, 79 T.C. 864 (1982), affd. 734 F.2d 478 (9th Cir. 1984): The statute applies as long as there is some relationship between the services performed and the property transferred, even if additional reasons for the transfer (e.g., to give an employee a stake in the business) are present.
THE CAUSE OF THE DISPUTE
In general, when you receive property, such as stock, in exchange for services, you have income. The amount you include in income is calculated by subtracting the amount you paid (which could be zero) from the fair market value of the property you received.
The dispute in this case is whether stock was received in exchange for services.
The taxpayer was a shareholder in a family owned company. When he and his wife divorced, she claimed one-half of his shares in the company. He threatened to leave the company because of this reduction in his ownership interest. In addition to causing family strife, his leaving would have jeopardized the company’s ability to meet certain financing restrictions. To keep those events from happening, the company came up with a stock option plan.
Under the plan, the taxpayer transferred his shares to his ex-wife, subject to an option that would let him repurchase the shares for $16 million. After the transfer, the company bought the shares from the taxpayer’s ex-wife. The company added a provision to the option, giving the taxpayer the right to accept fewer shares instead of paying the $16 million.
The taxpayer exercised the revised option, paid no cash, and received the reduced number of shares. He did not include the value of the shares on his tax return, saying it was not compensation. His argument: The stock was not transferred to him in connection with the performance of services. The transfer was made to alleviate family stress and facilitate the divorce proceedings. Additionally, the option did not, in form, appear to have been granted in connection with the performance of services.
The company says the stock was transferred in connection with the taxpayer’s performance of services because the option was granted with the intention of securing his participation in day-to-day management. The taxpayer threatened to leave the company, which would have caused default of financing agreements. In addition, the option contained a provision that required written notification of a section 83(b) election. That election allows a person who performs services in connection with the transfer of property to elect to treat the property as compensation in the year it is received. If the stock transfer was not compensation, there would be no need to mention section 83(b).
The company treated the value of the shares as compensation to the taxpayer and took a tax deduction.
The IRS says this is a “whipsaw” situation because of the lopsided treatment – the taxpayer claimed no income and the company received a deduction. If exercising the option resulted in compensation, it’s reportable on the taxpayer’s return and deductible (within the limits of reasonable compensation) by the company. If the exercise of the option is not compensation, it’s not deductible to the company.
The IRS position on the taxpayer’s claim is that he received taxable income in the form of compensation from the exercise of the stock option, and he owes $13.7 million in tax.
(Editorial note: This case also includes a valuation issue and a reasonable compensation issue.)
WHAT WOULD YOU DECIDE?
Make your selection, then see “The Court’s Decision” below for a full explanation
THE COURT’S DECISION
HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.
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