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457(f) and mutual fund options


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Guest kkost

Does anyone have any comments on the validity of products being currently marketed through which vendors contend that granting vested options NP execs to acquire mutual fund shares escape the 457(f) rules? I know that Treasury intends to address this issue soon with new 457 regulations. Any comments in the interim?

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We looked at this a few years ago, and it appeared that from a strict reading of the existing applicable statute and regulations, this probably worked for nongovernmental tax-exempt organizations if properly structured. However, the IRS obviously has concerns about such arrangement, so I would not be surprised to see changes or interpretations that would disallow them, at least for the future. The question then becomes how economically feasible it is to adopt an arrangement now that the organization may not be able to continue for very long in the future.

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The opinions of my postings are my own and do not necessarily represent my law firm's position, strategies, or opinions. The contents of my postings are offered for informational purposes only and should not be construed as legal advice. A visit to this board or an exchange of information through this board does not create an attorney-client relationship. You should consult directly with an attorney for individual advice regarding your particular situation. I am not your lawyer under any circumstances.

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Guest kkost

Thanks, Carol. My read was that to the extent that they are vested, they are either taxable under 457 or under 83 (if they have a readily ascertainable FMV). I assume this is what Sweetnam's staff will say when they roll out the new guidance - so I agree with you. I just thought I would see if anyone knew the basis for the contrary argument.

For non-governmental, non-church arrangements, I would also think (contrary to the vendor's assertions) that they would be ERISA pension plans because it is doubtful that any executive would exercise his/her options before terminating employment. The "surrounding circumstances" langauge of 3(2)(A) would seem to capture this sort of arrangement.

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The argument that the vendors are making is that these options do not have a "readily ascertainable fair market value" so long as they cannot be traded on an established market. There is language in the regulations which supports this view, which is why we think they work under existing regulations. But, as you say, that regulatory language may well be modified.

Employee benefits legal resource site

The opinions of my postings are my own and do not necessarily represent my law firm's position, strategies, or opinions. The contents of my postings are offered for informational purposes only and should not be construed as legal advice. A visit to this board or an exchange of information through this board does not create an attorney-client relationship. You should consult directly with an attorney for individual advice regarding your particular situation. I am not your lawyer under any circumstances.

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There is related discussion on this topic on the NQDC message board.

The major issue with most discounted option products is whether they are in fact options for purposes of section 83. If the value of the option privilege (the "Black-Scholes" value) is zero or negative (which is usually the case), the "option" has no economic substance. [Does putting the word "option" on a sheet of paper and telling someone that he has the "option" to take his deferred comp. when he wants to, create an option? The product could not exist but for the tax benefits.]

If you believe that form governs over substance, the products work. If you believe that there needs to be some substance, be careful.

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IRC 401:I am not an options whiz but i thought that it is not unusual for some options to have 0 value for BS purposes at some point in time before expiration and increase in value. Also at expiration of the option is not the value 0? I thought that reason the readily ascertainable FMV did not apply to options that were subject to restictions on tranferability (e.g., security issued under option that could be only sold back to issuer upon termination of employment), forfeitability, etc is that there is no way to determine the FMV of such options on a national stock exchange (CBOE, etc.) on the date of grant because options traded on an exchange do not contain such restrictions.

mjb

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I was referring to the BS value at the date of grant.

Suppose that an employee is given an option to purchase shares of ABC mutual fund, which to make the arithmetic easy, is selling for $1 per share.

If he is given an option to buy 10,000 shares for $5000, that is a classic option, which is worth the $5000 discount plus the value of the opportunity for appreciation on 10,000 shares.

Suppose instead that he is given an "option" to buy 10,000 shares for the price of 5000 shares. The price of his option floats with the price of the shares so that the employee is always able to get 10,000 shares for the price of 5000. The value of the option on the date of grant is the value of 5000 shares. The value of the option privilege or the BS value is $0.

How is that "option" economically distinquishable from an unfunded promise to pay 5000 shares on the date of exercise? [Hint: It isn't.] If an employee were given an "option" to take 5000 shares of ABC fund, wouldn't he be taxable under the doctrine of constructive receipt as of the first day that he could exercise (and maybe faster under 457(f))?

Therefore, the issue becomes whether if you take something that is taxable under the doctrine of constructive receipt (or 457(f)) and put a wrapper or disquise around it that has no economic substance, are you suddenly able to fall under the section 83 rules?

In practice, D&T, E&Y, and (I assume)KPMG are selling slightly different variations. Suppose that the exercise price is the greater of $5000 or 50% of the value of 10,000 shares. If the price of the fund increases, the option price is the price of 5000 shares and the product becomes identical to the dubious "option" described above. If the price of ABC fund drops, the price of the "option" is fixed at $5000, which means that once you remove the discount at grant from the calculation, the employer is granting an "option" at a higher price than the employee could get by calling the ABC Fund and buying directly. Such an "option" couldn't (and doesn't) exist outside of the world of deferred compensation.

As for the option (section 83) regs, I thought that they predated Black Scholes and Merton's work and that they were designed to delay the taxation of options in order to avoid valuation fights back in the days when no one knew how to value options.

Keep in mind that the discounted options that I have been discussing aren't designed to be options. They are deferred compensation plans that are disguised as options in order to get favorable tax treatment.

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The issue of deeply discounted options is one of the reasons I added the weasel words, "if properly structured," to my original post. To the extent that the option exercise price is too low, I would agree that what you have is not really an option. At the time we looked at the issue, it appeared that 20% of value was a minimum.

At the same time, an option has a value under Black-Scholes even if the exercise price at issue is exactly the same as the value at issue. This is because there is some calculable value to being able to wait x period of time (with no possibility of the losses you might experience if you actually owned the stock) and buy it only if the exercise price on the date the stock is purchased is less than the value on that date. Thus, it is at least in theory possible to structure an option plan in which the options are not discounted at all, have a value under Black-Scholes, but are treated as having no ascertainable value under the regulations. Such a plan would appear to work under the current regulations. Of course, as IRC 401 points out, the regulations predate Black-Scholes, and may well be modified in the near future.

Employee benefits legal resource site

The opinions of my postings are my own and do not necessarily represent my law firm's position, strategies, or opinions. The contents of my postings are offered for informational purposes only and should not be construed as legal advice. A visit to this board or an exchange of information through this board does not create an attorney-client relationship. You should consult directly with an attorney for individual advice regarding your particular situation. I am not your lawyer under any circumstances.

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Guest Tom Geer

Let me add some analysis under 83.

The essence of 83 is that when property is "transferred" in connection with the performance of services, the recipient is taxed and the transferor gets a deduction (not relevant here).

Stock options are one instance of determining whether or not there has been a transfer, and the standard there is "readily ascertainable fair market value", which has historically been intended and understood to mean the existence of a market for that specific option (which never in fact occurs). Whether option vaulation models vitiate this treament has been the topic of discussion, but I doubt the IRS is in the mood to gut an entire compensation device historically seen as reasonable and as in fact economically aligning executives with shareholders.

Here, it's a ggood idea to look at the Reg. on the term "transfer, which is 1.83-3(a). There are several ways the IRS can use the content of that Reg. to go after these arrangements. My personal favorite is 1.83-3(a)(5), which I generally call the "of course the idiot's going to exercise" rule, and which seems pretty clearly to apply where there is no floor price or where the floor price is immaterial. My second favorite is 1.83-3(a)(6), which provides that a transfer has occurred if the employee bears the risk of decline in value. Finally, 1.83-3(a)(2), which specifically deals with options( which these arrangements are in form) lists as one of the standards "the likelihood that the purchase price will, in fact, be paid," which is usually, and intentionally, a forgone conclusion in these arrangements.

Anyway, these arrangements are based on a pretty technical analysis of 83, which the IRS can zing pretty much any time it feels like by issuing a Revenue Ruling. Since there is no specific authority now saying the arrangements work, there would be no problem with retroactivity in such a ruling.

Given that, however, if the parties understand the risks they are taking the fact that major accounting firms are supporting the concept probably gets you out from fraud issues, and also probably shifts some of the downside risks to the accountants. So, in the right circumstances, with actually sophisticated consumers, trying it may make sense.

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IRC401: while you have brought up some excellent economic reasons why the options should not be deferred , the only basis for taxation is the language of the reg 1.83-7(B)(2) which clearly allows options that are not traded on an established exchange to avoid taxation at date of grant if there are restrictions on the transfer and/or the option is not immediately excercisable in full by the optionee because such restrictions are not placed on investors who purchase the options on an established exchange. No one said the tax code is fair and it cuts both ways at times.

Perhaps the correct question is why do such idiot rules exist to restict vested deferred compensation for employees of non profit orgainizations to $11,000 but not profit making employers? Prior to 1986 there were no restictions on deferrals of compensation by employees of non profit organizations. Congress as a matter of "tax policy" decided to limit deferred compensation of non profit organziations to the amounts set for government workers under IRC 457 to raise revenue because a deferral of compensation by an employee of a np did not result in a corresponding increase in taxable income by the employer. Does that make economic sense? Similar games are played by profit making corporations to avoid the $1,000,000 limitation on deductible compensation. (Also what about split dollar life insurance which is an alternative to deferred compensation-- don't the same economic issues arise?) In estate planning one of the time honored tools which has been approved by the courts is to transfer marketable assets to a family limited partnership and give the family members an interest in the FLP. Since the FLP interest has limited market value (because it cannot be transferred, there is no established market and is a minority interest) the value of the interest can be reduced by 25-40% of the fmv of the underlying assets for gift tax purposes. Tax advisors live a bizarre world that Congress has created and we deal must with it as it exists in the best interests of our clients.

mjb

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Guest Tom Geer

The underlying reason for 457 is the lack of any tension between the employer's need for a tax deduction and the employee's need for deferral. Without that constraint, the IRS is out of pocket with an EO deferred compensation plan in much the same way it is out of pocket in a qualified plan context, while with a taxable employer's NQDCP at least somebody is paying taxes so there's presumptively a business reason for the arrangement.

As to split dollar, you may want to go to the ACLI web site for current controversies.

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MBozek-

You and Carol missed the point of my comments. If what is being sold is in fact an option, it works. My argument is that the product is not an option (within the meaning of section 83).

There is a Black Scholes value if the option has a fixed price. What is being sold has a variable price.

What is the Black Scholes value of an "option" to purchase 100 shares of the Vanguard S&P 500 fund for the price that Vanguard will sell the fund to anyone who wants to buy it? The answer is zero. Is giving someone the "option" to buy a readily available product at the full retail price really an option within the meaning of section 83?

If an employer gives an employee the "option" to take his NQDC in form of 5000 shares in a Vanguard fund whenever he wants them, is the employee taxable when he "exercises" or when he has constructive receipt? IMHO, when he has contructive receipt.

If an employer gives an employee the "option" to buy 5000 shares of a Vanguard fund at the full retail price (determined as of the date of sale), has the employer granted an "option" within the meaning of section 83?

Now combine the two. The employee is given an "option" to buy 10000 shares (instead of 5000 shares) for a price equal to 5000 shares on the date of exercise (not grant). The value of the discount is the value of 5000 shares. The Black Scholes value is zero because the employee's exercise price fluctuates. All that the employer has done is put a wrapper with no economic significance around NQDC that would otherwise be taxable under the doctrine of constructive receipt. [Note: The options allow for cashless exercise. Therefore, when the employee "exercises" all he does is take his NQDC equal to the value of 5000 Vanguard shares when he wants them.]

If this product is in fact an option, then people have found a way for wealthy taxpayers to avoid the doctrine of contructive receipt purely by the form of the transaction. I don't think that it works.

NOTE: If the employer had granted the employee an option to purchase 10,000 shares for a fixed price equal to the price of 5000 shares on the date of grant, there would be a real option. The problem with fixed price options is that either the employer or employee has to absorb the Black Scholes value. The advantage of floating price options is that there is no messy Black Scholes value to deal with. When you design a tax product with no economic substance, how often does it work ?

PS: 1. Most of the actual products being sold have more smoke and mirrors than described above, but no more economic substance.

2. If you believe that form governs, how about an option to purchase shares of a money market fund? (Bank CDs?) Is an option to take cash, really an option? If no, then there have to be some applicable rules not in the 83 regs.

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IRC 401

I think you and I are actually agreeing here. All I said was that if the arrangement was properly structured (e.g., fixed price, option price not less than 20% of the FMV of the stock on the date of the grant of the option, etc.), I think it works. I would agree with you that many of the current variants of the mutual fund option plan are much more aggressive than that, and thus would not be considered "properly structured" within the meaning of my first comment.

Employee benefits legal resource site

The opinions of my postings are my own and do not necessarily represent my law firm's position, strategies, or opinions. The contents of my postings are offered for informational purposes only and should not be construed as legal advice. A visit to this board or an exchange of information through this board does not create an attorney-client relationship. You should consult directly with an attorney for individual advice regarding your particular situation. I am not your lawyer under any circumstances.

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Tom: Your observation on lack of tax tension on the employers need for a tax deduction versus the employees desire for a deferral as the rationale for limiting deferrals by nonprofit employers would be a correct analysis if the 457 limits were extended to profit making employers who had no taxable income in a tax year (Enron, Global Crossings??) since there is no business reason for an employer with tax losses to limit deferred compensation. You should check the Web sites of consumer and tax organizations to see that most large corporations pay little or no income taxes so there is no incentive to limit deferred compensation under the tax tension rationale.

IRC401/Carol/Tom: Maybe I dont get what u are saying about what consitutes an option but Reg. 1. 83-3(a)(2) states that a grant of an option to purchase property does not consititute a transfer of property. Reg. 1.83-3(e) defines property very broadly to include real and personal property other than money. An option includes the right to purchase any property. There is nothing in the definitions that requires that an option under the section 83 regs meet a bs fixed price definition to be an option. Since there is no such requirement in the regs the IRS cannot impose such requirement on options issued to employees. Period. The IRS does not have the authority to impose such a definiton where none exists under the law or regulations.

Further, under Reg. 1.83-7(B)(2) an option not actively traded on

an established market does not have a readily ascertainable fmv when granted unless the taxpayer can show that all of the following exist:

1. the option is transferable by the optionee

2. the option is exercisable immediatlely in full by the optionee

3. the option is not subject to any restriction or condition which has a significant effect on the FMV of the option and

4. the fmv is readily ascertainable under reg. 1.83-7(B)(3).

As i understand the above rule there is no readily ascertainable fmv if any of the 4 elements are absent and the options issued under the 457 plans alway make sure that at least one element is missing. Also note the fact that the burden is on the taxpayer (not the IRS) to prove the there is a ra fmv. How can the IRS imsose a fmv on the taxypayer who declines to do so? The products may be smoke and mirrors but they are smoke and mirrors which meet the requirements of section 83 for no readily ascertainable fmv. The economic substance of an option is not controlling since it is not part of the IRC 83 regulations.

I think that u should remember that the 1998 IRS reform act imposed a level playing field on administration of the tax laws by the IRS. In additon, case law involving UPS, Computer Associates and other taxpayers has restricted the ability of the IRS to ignore the literal language of regulations or impose disparate treatment on simularily situated taxpayers.

mjb

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Guest Tom Geer

Your refernce to 1.83-3(a)(2) is generally correct, and clearly where there is an option tha analysis moves over to 1.83-7. However, the fiollowing is also part of 1.83-3(a)(2):

"The determination of the substance of the transaction shall be based upon all the facts and circumstances. The factors to be taken into account include the type of property involved, the extent to which the risk that the property will decline in value has been transferred, and the likelihood that the purchase price will, in fact, be paid. See also Sec. .83-4© for the treatment of forgiveness of indebtedness that has constituted an amount paid."

This is explicit authorization for the IRS to use its general authoriy to look at the reality of the situation in deciding whether or not there is, in fact, an option present. I can extend your analysis to the grant of a lease on corporate headquarters with a value of $10,000,000, with the lessee paying all expenses, taxes, etc., for $1.00 per year with an option to but at $1.00. This is clearly a sale.

I admit that this is a reductio ad absurdum argument, but at some point the manipulation of the Regs has to be recognized as absurd.

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I would also like to add that the basis for taxing employees with discounted options is the doctrine of constructive receipt, which is a judicial doctrine.

All that it takes for the taxpayers to lose is for the courts to hold that a taxpayer can't get around the doctrine of constructive receipt by papering over an otherwise taxable event with a transaction that has no economic significance. To me that is not such a far fetched outcome. (Of course, whether the IRS will ever get around to bringing an enforcement action is a different matter.)

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Tom/IRC401: while both of your arguments have merit in theory, there are many reasons why it will be difficult to tax the deferrals of options under 457(f) plans without a change in the law:

First: as noted, options deferral is based upon the facts and circumstances of each case but this presents a problem to the IRS which will prevent the issuance of any uniform rules and allow taxyapers to distinguish their situations from the rules.

Second: deferred compensation is only reviewed through audits which will require the IRS to review plans on a case by case basis to determine if there have been violations. Needless to say employers will be represented by skilled counsel.

Third: The IRS has lost a number of constructive receipt cases in the last few years in the courts who do not accept the smell test

arguments raised by the IRS.

Fourth: My understanding is that all of the agreements have at least one fail safe provison in them to prevent meeting the requirements for readily ascertainable fmv, e.g., lack of tranferability, under the regs.

Fifth: According to a BNA tax management note from last year, any recharacterization of options under a 457(f) plan by the IRS would be suspect unless it is also extended to profit making employers since the IRS does not have the authority to distinguish between similarily situated taxpayers.

mjb

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  • 2 weeks later...
Guest slt

I am being told that there is a recent IRS notice or announcement discussing deeply discounted options and that it may involve options issued by t-e organizations to acquire mutual funds. I have not been able to find a thing. Does anyone know of any such IRS notice or announcement? Thanks.

-Shaun

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  • 4 weeks later...
Guest Glen Armand

Nothing out yet - however in meeting with Ways and Means members we understand that IRS is to put comments in the Preamble of the regs.

The position they are taking is that options are not property under 83 and as such the language in 457 regarding the exemption of "transfer of property" does not apply.

We think the IRS position is without a defendable basis.

Several members of Ways and Means and Senate Finance have expressed concerns over IRS’s planned position on this. We hope a little more pressure and IRS may withdraw this completely.

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Guest Glen Armand

Only Tax Exempts (at this time) as the regs they are using is 457. We have not heard of any plans by the IRS on addressing Taxable employer plans.

We have several Senators and House members on board fighting this - if you have any clients who want to support killing the pending reg have them call me and we can put them in touch with the House or Senate offices that having been supporting the efforts to kill the pending regulation.

Also see www.savesection83.com as a resource site.

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According to information that I cited in my prior post there does not appear to be any authority for the IRS to distinguish in taxation under IRC 83 between similarily situated taxpayers based upon employment by profit making or np employers. Is this correct? If so then wouldn't the IRS regs be struck down by the courts as arbitrary and capricious?

mjb

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I just want to make my position clear. The reason why most discounted options should be immediately taxable upon grant (or vesting) has nothing to do with section 83.

The options fail under the sham transaction, economic substance, and substance over form doctrines. If anyone has an opinion letter explaing why an option with a floating exercise price survives these doctrines, I would love to see it. NOTE: I didn't state that you couldn't design an option that survives under these doctrines; I'm merely stating that most so-called discounted options don't survive when scrutinized.

If Congress is going to allow these "options" to survive, it should repeal the doctrine of construcitve receipt because there is no good policy reason why certain people, by going through some paperwork with no economic substance should be able to get around the doctrine.

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IRC401, the case law that supports the contrary point of view includes the following

Commissioner v. LoBue, 351 U.S. 243 (1956), an employee was granted options to buy shares of employer stock at a price that equaled only 25 percent of the shares' fair market value as of the grant date. The Court concluded that the taxable amount was equal to the spread between the exercise price and the fair market value of the underlying shares on the exercise date -- the same treatment accorded at that time to nondiscount options.

Victorson v. Commissioner, 326 F.2d 264 (2d Cir. 1964), aff'g T.C. Memo 1962-231, Victorson received the right to buy shares of Glamur Products stock, contingent on his firm's successful completion of the underwriting of Glamur Products stock. The exercise price was $.001 a share -- a 99.8 percent discount from the $.50 public offering price. Citing LoBue, the court held that Victorson had to include the spread in income in the year of exercise.

Simmons v. Commissioner , T.C. Memo 1964-237, the Tax Court held that a taxpayer who was entitled to buy, for $.001 a share, stock worth $1 a share, was taxable in the year of purchase and not on the grant date. Citing LoBue, the court stated that if an option has no readily ascertainable fair market value and is not assignable, then receipt of the option did not give rise to income. The fact that the exercise price was nominal did not affect the court's decision.

Graney v. United States b, 258 F. Supp. 383 (DC W.Va., 1966) an executive was granted an option to buy company stock at $25 a share. Both the executive and the employer treated the stock as having a fair market value of $75 a share, and the executive agreed to sell the stock back to the employer at $190 a share. The court found that the agreement was an option and not a sale. Thus, the executive recognized income in the year of exercise regardless of the discounted option price.

LoBue, Victorson, Simmons, and Graney were decided before section 83 came into existence. However, LoBue established the basic principles used in the section 83 regulations for taxing nonstatutory compensatory options: Such options are classifed as either-- options with a readily ascertainable fair market value at grant or options without a readily ascertainable fair market value at grant -- with tax resulting at grant only with respect to the former.

Phil Koehler

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