Note: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.
The transactions described herein are designated as listed transactions pursuant to Notice 2003-47, 2003-2 C.B. 132. The notice concludes that (1) the transfer or sale of the stock options is not an arm's length sale for purposes of Treas. Reg. § 1.83-7, and (2) the receipt of the note or other deferred payment obligation from the related person results in immediate recognition of income. The result is that compensation income will be recognized by the individual at the time of the transfer or sale, with the potential for further compensation income at the time of exercise of the stock option by the family limited partnership, family trust or other related person.
In addition to Notice 2003-47, temporary regulations under I.R.C. § 83 issued concurrently with the notice provide that effective on or after July 2, 2003, the sale or other disposition of an option to a related person will not constitute an arm’s length transaction for purposes of Treas. Reg. § 1.83-7. The regulations also provide a definition of a related person that includes various family entities. Final regulations were issued on August 10, 2004, adopting the language of the temporary regulations without change. The final regulations apply only to transfers on or after July 2, 2003.
Generally, stock options are granted to individuals in blocks of shares with a specified exercise price, for example, $10 per share. The individual has a specified period of time to exercise the stock option. When the individual wishes to exercise the options, they notify the company and complete paperwork to affect the exercise. Assuming a fair market value of the stock at the time of exercise of $50, the individual would report income at exercise of $40 ($50 less the exercise price paid). This $40, often called the “spread”, is income under § 83(a) and is reported on the individual’s Form W-2. The employer is entitled to a corresponding deduction at that time under § 83(h). The income is subject to employment taxes in the year of exercise.
Similar treatment applies to restricted stock, which is stock that is not fully vested. Generally, restricted stock is included in income as the stock vests. Vesting of the stock often occurs on a graduated schedule.
However, for transactions described in Notice 2003-47, the arrangement is established in a manner to avoid the reporting of income at exercise of the options or vesting of the restricted stock. The primary issue is whether an individual can transfer or sell compensatory options to a related entity such as a family limited partnership and receive in exchange, from the partnership, a non-transferable, non-negotiable unsecured obligation calling for the purchase price to be paid in a 15 to 30 year balloon payment and defer compensation income and wages until the payment on the obligation is made.
The transaction involves three parties: an individual who holds nonstatutory stock options; the corporation that granted the stock options; and a related entity, such as a family limited partnership. The related entity purports to purchase the stock options from the i ndividual by giving the individual an unfunded, unsecured long-term balloon payment obligation equal to the fair market value of the stock options, typically determined through a valuation report supplied by the promoter. The related entity may then exercise the options but does not pay any cash to the individual (except perhaps interest on the obligation) until the balloon payment comes due.
The arrangement attempts to establish that the purpose of the partnership is to aggregate and diversify assets. Often the individual retains the vast majority of the ownership of the partnership (up to a 99% limited partnership interest), and/or may be general partner. The other partners typically include members of the individual’s family and may include a family trust. Generally, the related person is thinly capitalized by the individual’s initial contribution of their personal stock holdings.
This transaction typically involves the transfer or sale of stock options to a related person. However, variations may include the transfer of restricted stock instead of stock options or may include a combination of stock options and restricted stock. Other related persons may include a limited liability corporation or an individual’s foreign or a domestic trust. Usually, the person transferring the stock is an officer/employee. However, individuals have included non-employee directors.
The individual transfers the stock options or restricted stock to the related person in exchange for a deferred payment obligation. The deferred payment obligation may include a promissory note, contractual agreement or annuity. The parties to the deferred payment obligation are the related person and the individual. The deferred payment obligation is typically structured as an unsecured, nonnegotiable 15 to 30 year obligation, with a principal balloon payment due at the end of the term. Usually the obligation calls for the payment of periodic interest over the term of the obligation that is taken into income by the individual and would be reported on their Form 1040 in the year the interest is paid. The most common instruments utilized in this transaction are promissory notes and contractual or sales agreements. Annuities are also utilized, but usually in conjunction with a foreign trust and/or foreign corporation as the related person.
A Black-Scholes valuation or similar methodology is prepared by the promoter to determine the fair market value of the stock options at transfer. Typically, the fair market value of the options determined by the valuation equals the option spread (the difference between the fair market value of the stock option at exercise less the exercise price). The stated principal amount of the obligation is usually the same amount as the fair market value of the stock options determined by the valuation and the option spread. In some arrangements, these amounts may differ.
In the typical transaction, the transfer of the stock option, the exercise of the option occur within a very short period of time. Usually, this time frame is within 1 week or may all occur on the same day. Often, the option exercise and the sale of the aquired stock occur within a couple months of the original transfer of the stock option. When non-vested stock options or restricted stock is utilized, the sale of the stock by the related person can be delayed an extended period of time until the options or restricted stock vests.
Capital gain or loss may apply to the related person for the subsequent sale of stock, after exercise of options or vesting of restricted stock by the related person.
In some transactions, the corporation has claimed a deduction in the year of transfer of the stock options or restricted stock, and in other transactions no deduction was claimed. As part of the arrangement, many corporations agree to forgo the deduction until the payments are made on the obligation as compensation under the terms of the transaction.
At the time of transfer or sale of the stock options, a Form W-2 is not issued to the individual and income is not reported on the individual’s Form 1040. In addition, employment taxes a re not withheld by the employer. For non-employee directors, Form 1099 is not issued to report the income to the individual at transfer or exercise.
With respect to information reporting for the related person, Form 1099 has infrequently been issued by the corporation to the related person to report the transfer or sale.
Fees are paid to the promoters of the transaction and have been deducted by the party who has paid the fees or included in the basis of the related person for the sale of stock. In some instances, all parties to the transaction have paid and deducted or included in basis promoter fees including the corporation, related persons and individuals.
a. Form 1040: Assertion of gross income to the shareholder/officer when the stock option is exchanged for the note or other deferred payment obligation, instead of recognizing gross income and wages on the date the obligation is payable. In addition, assertion of additional gross income to the shareholder/officer when the family limited partnership exercises the stock option to the extent the fair market value of the stock on the date of exercise exceeds (1) the exercise price plus (2) the amount includible in the shareholder/officer’s income due to the receipt of the note or other deferred payment obligation.
b. Form 1120: Timing of the corporate deduction should be matched to income inclusion by the shareholder/officer. Generally, this will require actual inclusion of income by the shareholder/officer, or correct reporting of the amount on the Form W-2 provided to the shareholder/officer. See IRC § 83(h). In addition, § 162(m) may affect the deduction limitation.
c. Form 1065: Capital gain or loss to the related person or family partnership may apply upon subsequent sale of stock.
d. Form 941: Employment taxes apply to the individual’s income in the year the stock options are transferred and for any subsequent year where exercised. In most cases, employment taxes will primarily be the Medicare tax since the individual’s income is being addressed on Form 1040 and most individuals’ have exceeded the FICA wage base.
e. Promoter or legal fee expense from a qualified professional may not be incurred in the course of any trade or business and, thus, may not be an allowable deduction on Form 1120, 1065 or 1040. See IRC §162 and Treas. Reg. 1.162-1(a). Similarly, the fees may not be an allowable deduction for the family partnership. See IRC § 212.
f. Penalties, including the accuracy-related penalty under IRC § 6662; the return preparer penalty under § 6694; the promoter penalty under § 6700; the aiding and abetting penalty under § 6701 and the tax evasion penalty under § 7201 may be imposed.
g. The family limited partnership may not be a bona fide partnership or may be subject to recharacterization under Treas. Reg. 1.701-2.
How Do I Find This Issue?
Review SEC Form 10-K, Annual Report, including items 10, 11 and 12, to identify SEC 16b executives and Board of Directors and to identify executive compensation plans. The information in these sections may be cross-referenced to a later filed Form 14A, Definitive Proxy Statement. These forms may reveal stock options or restricted stock transferred to or held by shareholders, officers and Board of Directors in family limited partnerships or family trusts.
The disclosure is usually in the form of a footnote located below the table reporting the stock holdings of these individuals.
SEC Form 4, Statement of Changes in Beneficial Ownership, required to be filed by certain executives, may also report the transfer of stock options or restricted stock to a related person in footnotes and/or may indicate indirect ownership by the related person.
Form 4 may be available online at www.sec.gov under the company’s filings or under the individual shareholder/officer’s filing. If Form 4 is not available online, it should be requested from the company.
SEC Forms 10K, 14A and 4 may be located on the web site by utilizing the following techniques. From the home page, select “Search For Company Filings”. Then select “CIK Lookup” and enter the company name or for individuals the last name of the individual and start search. From the list provided, determine the appropriate entity or individual and copy the CIK Code. Go back 2 screens and select “Companies & Other Filers”. Enter the CIK for the company to locate all company SEC filings. For individuals, enter the CIK Code to locate Form 4.
Employment or consulting agreements may describe the transaction. The employment agreement may also be signed by the family limited partnership or trust as a party to the agreement.
Board of Director’s and Compensation Committee minutes may also reflect activities relating to the transaction. Review Board of Director’s and Compensation Committee minutes to identify activities relating to executive compensation, stock and stock option plans. Corporate payroll records may reflect the payment made to the related person instead of the individual. Where applicable, review merger and acquisition agreements that may include provisions relating to treatment of stock options for shareholder/officers and the Board of Directors.
The partnership return Form 1065, Schedule D, should report the disposition of the exercised options or sale of restricted stock after transfer from the corporation. Any capital gain or loss should also be reported. However, Schedule D may not properly reflect the details of the disposition, or may only reflect the net affect of the transfer or sale instead of details of the sales price and cost or other basis. The Schedule L balance sheet may also report the deferred payment obligation as a large liability for the family partnership and may report the stock options as assets.
The Schedule M-1 may reflect compensation expense for the shareholder/officer, that is deductible for tax but not for book purposes, that results from the differences in the fair market value of the stock less the option price at the date of exercise. If the transaction is not reported on Schedule M-1, the deduction may have been taken by the employer in wage or salary accounts.