SIGNIFICANT ISSUES RELATING TO STOCK-BASED COMPENSATION FOR EXECUTIVES Materials Submitted By: Scott P. Spector Fenwick & West LLP Palo Alto, California T his outline addresses topics relating to stock-based compensation for executives. The outline summarizes the more important tax principles that must be considered in order to provide the best possible tax results to executives (or other employees) and the employer. The outline also discusses the key securities law registration exemptions and registration techniques that may be employed to permit executives to receive freely-tradable securities and liquidity. Finally, the outline addresses the new financial accounting rules that will dictate the type of equity awards that will be favored by employers. INTERNAL REVENUE CODE
I. TRANSFERS OF PROPERTY TO SERVICE PROVIDERS A. General Rules Under 83 1. Section 83 governs the income tax treatment of the transfer of property in connection with the performance of services. It is the operative income tax provision in connection with the award and vesting of restricted stock, the exercise of nonqualified stock options, the issuance of shares under a stock purchase plan that does not satisfy 423 and the exercise of stock appreciation rights that are settled with shares of stock or other property. Note that Section 83 applies to any transfer in connection with the performance of services and it does not matter whether such services are performed by an employee, a consultant, a natural person or an entity. a. As a general rule, a service provider recognizes ordinary income on account of the transfer of property on the first date that the property is either transferable or no longer subject to a substantial risk of forfeiture. The ordinary income that is recognized is equal to the difference between the fair market value of the property at that time and any amount paid for the property. 83(a). (1) Section 83 can apply to the transfer of property even though the amount paid by the service provider is the property s fair market value. Alves v. Commissioner, 79 T.C. 864 (1982), aff d 734 F.2d 478 (9 th Cir. 1984). (2) Section 83 can apply to the transfer of property even though the service provider is not an employee of the transferor. Reg. 1.83-3(f). b. Notwithstanding the general rule, a service provider may elect to have his income tax consequences determined as of the date that the property is transferred. This is accomplished by filing an election under 83(b). The ordinary income that is recognized in that event is equal to the difference between the transfer-date fair market value of the property and the amount paid for the property. 83(b). A service provider may want to make the election if he paid fair market value for the property or if he expects that its value will appreciate substantially during the period that 83 otherwise would postpone the tax date. (1) The election is irrevocable and must be made within thirty days of the date that the property is transferred. Reg. 1.83-2(f) and Reg. 1.83-2(b). However, if the sale of the property and the election are both rescinded within the same tax year that the election was made, such a rescission will be permitted. PLR 9104039 (Oct. 31, 1999). (2) The thirty day period may not be extended. For this reason, it is imperative that the service provider keeps track of the purchase date. (3) The election must be filed with the IRS and a copy must be furnished to the transferor and included with the service provider s tax return. The required content of the election is set forth in Reg. 1.83-2(e). Filing by registered or certified mail with return receipt requested is the advisable way to prove filing.
(4) Note that there is a limitation on the amount of loss that may be claimed if the property is forfeited after the service provider has made an election under 83. Reg. 1.83-1. 2. The principles of 83 are often more easily understood if the two most important purposes of the section are kept in mind. a. One important purpose of 83 is to dictate when income is recognized on account of the transfer of property in connection with the performance of services. b. Section 83 also characterizes the recipient s income. It directs that income will be taxed as ordinary income during the period that the transaction remains compensatory. Income or loss will have a capital character after the compensatory transaction closes and the recipient is in the same position as a typical investor. 3. Section 83(b) elections are most often made when there is a very small amount of current tax to be paid and a low purchase price or risk relative to expected future gain. B. Transfer Requirement 1. Section 83 cannot apply until there is a transfer of property. A transfer occurs when the service provider acquires a beneficial interest in the property. Reg. 1.83-3(a)(1). (Nonpermanent vesting conditions, called lapse restrictions under the regulations, are ignored in determining whether beneficial ownership has been transferred.) Id. a. A service provider cannot take advantage of property s low fair market value in determining his income tax consequences if there has been no transfer. b. An election cannot be made under 83(b) unless there has been a transfer of property. Reg. 1.83-2(d). 2. Whether property has been transferred is determined under a facts and circumstances test. The regulations describe several factors that can bear on this question but the most important factor appears to be whether the service provider bears the economic risk that the property may decline in value. Reg. 1.83-3(a). a. A transfer may not have occurred if it appears that the service provider has merely been granted an option to acquire the property. A sale of property to a service provider in exchange for his nonrecourse note may be treated as the grant of an option rather than a transfer. Reg. 1.83-3(a)(7) Example 2. By contrast, where such note is recourse, a transfer will have occurred. The question often arises as to whether a note may be partially recourse. In part, the answer depends on whether the entire property will secure the payment of the entire note, such that a default on any portion of the note will cause all of the property to be at risk. b. A transfer may not have occurred if it is clear that the service provider will be required to resell the property to the transferor in all events, e.g., upon death or
termination of employment. Reg. 1.83-3(a)(7) Example 3. However, if the transferor is required to repurchase the property because the property has been forfeited (e.g., the services fail to be performed) such a forfeiture will generally not affect whether a transfer has been made. c. In a similar vein, the relationship between the property s fair market value and the amount that the service provider will forfeit upon surrender of the property can affect whether there has been a transfer. This is true even if it is not certain that the property must be surrendered at a future date. Here, too, a transfer is more likely to have occurred if the risk of loss has been shifted to the service provider. Stated another way, the likelihood that the purchase price will, in fact, be paid is a factor. For example, if a service provider pays for stock with a $20 nonrecourse note and the stock is worth $1,000, the likelihood that the note will be paid is high, and a transfer may well have occurred upon payment with such note. C. Definition of Property 1.83-3(e). 1. Section 83 can apply to the transfer of both real and personal property. Reg. 2. Money or an unsecured promise to pay money are not treated a property under 83. However, an interest in a fund, e.g., a trust, will be treated as property if the fund is set apart from the claims of the creditors of the transferor. An interest in a rabbi trust thus will not constitute property. Id. 3. The applicability of Section 83 to the transfer of a partnership interest, or an interest in a limited liability company (an LLC ) that is taxed as a partnership is unsettled. The better view appears to be that Section 83 applies to the transfer of a capital interest, but not to the transfer of a profits interest. a. Section 83 is broad enough to apply to the transfer of a capital interest in a partnership, and Proposed Treasury Regulations issued in 1971 under Section 721, which have been neither withdrawn nor finalized, provide that such income is taxable under Section 83. The Eighth Circuit Court of Appeals has noted that a capital interest appears to be property subject to Section 83. Campbell v. Commissioner, 943 F.2d 815, 820 (1991). b. Existing Treasury Regulations under Subchapter K offer a Section 83-like rule for the taxation of such interests. Under Treasury Regulations Section 1.721-1(b)(1), the receipt of a capital interest is ordinary income under Section 61 to the partner who has or will provide services for the interest. The amount of income is equal to the fair market value of the capital interest, either (i) at the time the interest is transferred for past services or (ii) at the time services are rendered, where the transfer is conditioned on the completion of future services by the transferee. c. Revenue Procedure 93-27, 1993- C.B. provides that the receipt of certain profits interests will not be a taxable event for the service provider or the partnership. The safe harbor in the Revenue Procedure is not dependent on whether Section 83 applies. Several courts have found that Section 83 does cover the transfer of a profits interest, but did not result in
income recognition in the particular case because the value of the interest was not readily determinable. d. It is also possible that the receipt of a profits interest by a partner would be treated as a nonrealization event because the interest does not fall within either of the two exceptions Sections 707(a) and 707(c) to the general rule that partner-to-partnership transactions will be taxed under the provisions of Subchapter K rather than as if they occurred between unrelated parties. Under this analysis, tax under Subchapter K would be imposed when the partnership realized actual profits that are included in the partner s distributive share. D. Forfeitability and Transferability 1. As noted above, 83 provides that the service provider s income tax consequences will be determined as of the date that the property is first either not subject to a substantial risk of forfeiture or is transferable. 2. Whether a substantial risk of forfeiture exists is determined based on the facts and circumstances. Reg. 1.83-3(c). A substantial risk of forfeiture is referred to as a lapse restriction. Reg. 1.83-3(i). a. A requirement that the service provider continue to provide services for a specified period or the property must be returned can be a substantial risk of forfeiture. Id. b. A requirement that an individual return the property if he fails to observe a covenant against competition can be a substantial risk of forfeiture depending upon, e.g., the individual s age and health, the availability of other employment, and the transferor s past practice regarding the enforcement of such covenants. Reg. 1.83-3(c)(2). However, where an individual must return the property only if he is discharged for committing a crime, a substantial risk of forfeiture will generally not exist. Id. c. A requirement that the property be returned in exchange for a payment equal to its fair market value is not a substantial risk of forfeiture. Reg. 1.83-3(c)(1). However, as noted above, if the payment is made only because it must be resold at original purchase price following a forfeiture, a transfer will be deemed to have occurred. 3. Property is transferable for purposes of 83 if the service provider can transfer any interest in the property (including a pledge or assignment) and the transferee receives the property without being subject to a substantial risk of forfeiture. Conversely, property is not transferable if the service provider s transferee may lose the property pursuant to a substantial risk of forfeiture. Reg. 1.83-3(d). E. Valuing Property 1. As noted above, a service provider recognizes ordinary income on account of the transfer of property equal to the difference between the property s fair market value and the amount paid by the service provider. Property is valued without regard to lapse restrictions but