457(f) and mutual fund options

[Guest kkost]

Thanks for all the replies, however, I think most of the replies here are missing the point of the original question. I'm not sure that this is a section 83 issue. 457(f) accelerates recognition to employees of EOs who have vested deferred compensation - even though it takes the form of an unfunded unsecured promise to pay. The products on the market are based on the assumption that the carve out from 457(f) treatment for "that portion of any plan which consists of a transfer of property described in section 83" takes these arrangements out of 457(f). In other words, the only way that this works is if the program deals with a transfer of property under 83. However, section 83 does not apply to options that don't have a readily ascertainable value. So, it is possible that the Service will take the position that the carve out at 457(f)(2)© doesn't apply because of 83(e)(3). That is, because Section 83 does not apply to this sort of option, the regular 457(f) rules govern and if any plan sponsored by an EO provides for the deferral of compensation (and does not meet the requirements of 457(B)) the compensation will be taxed to the participant as he vests.

In other words, the participant may be forced to recognize an amount of ordinary income at grant, measured either by the intrinsic value at grant or the BS value (or some equivalent as the Service selected in Rev. Proc. 2002-13 for parachute payment calculations), just as he would if the EO had placed him in a traditional shadow 401(k) type arrangement in which his account balance would track investment performance in his 401(k) account or other selections. The Service doesn't have to rely on Section 83 - it can interpret the exception at 457(f)(2)© and find it inapplicable. Thereafter, it would only need to find a way to quantify the amount of compensation that the participant deferred under the plan. Answering the "how much" question is no mystery and the Service has already adopted valuation models for performing these calculations (see Rev. Proc. 2002-13).

The whole point here is that taxable employers don't need to come up with this type of program. If they felt concerned about treatment of discounted options under section 83, they would just accomplish the same thing by structuring an unfunded unsecured program that pays out in cash (rather than shares or units) with a value that floats with whatever benchmark the parties select. Moving away from an "option" removes any uncertainty - warranted or not - with the issue of readily ascertainable value under Section 83 for taxable employers and they can accomplish the same thing with a floating account balance payable in cash rather than actually distributing other property to participants.

Maybe the audit lottery is worth the gamble here; maybe the Service won't even challenge them if it stumbles onto these programs. On the other hand, Treasury has publicly stated that it will be spefically addressing these programs with regulations under 457 in the near future. To me, that suggests that (1) Tresury wants to make its opinion public in light of a perceived ambiguity or abuse and (2) it doesn't think that the analysis has anything to do with Section 83 (if it did, it would issue regs under 83, not 457).

[Guest Glen Armand]

First a bit of IRS history - The IRS looked at this same issue twice before and each time the effort was either kill by Treasury Council or abandoned internally at IRS for the lack of a definable basis. So the Treasury/IRS must believe that Section 83 plans have a basis in the statue and regs.

What has changed? No statutory or regs have been modified. How are they attacking them?

What we find the most interesting is the IRS’s own current view of this matter.

In several meetings with Sweetnam and staff during the last few months they admit that there is no basis for them taking a negative position on options grated under 83 and excluded from 457. Their whole argument is based on the following.

“The IRS does not believe Congress intended the statue to be used in this manner”

Not only by the IRS’s own admission are they without a defendable statutory basis but their “intention interruption” argument does not standup either.

Section 83 regulations that permit Not for Profits to use discount option plans were issued July 21, 1978. PL 95-600, the statute that enacted Code Section 457(f) - which included the exemption from that section of plans consisting of a transfer of property was enacted on November 5, 1978 - AFTER the Code Section 83 regulations were issued. So Congress was aware that such option transfers could have occurred when they drafted Code Section 457(f) - which included the section 83 exception from the outset. Moreover, the Code Section 457(f) regulations were issued on September 23, 1982, four years after the 83 regulations were issued. There was plenty of opportunity to address discount option plans as section 457(f) arrangements, but this was not done, suggesting that discounted options were not within the scope of section 457(f) and within the Section 83 exception.

In fact, why would Congress have included the regulation in 457 if there was not and active consideration by Congress to provide the exemption? The fact that the exemption for 83 is there clearly demonstrates the fact that Congress did intend for the Section 83 arrangements to be excluded from the limitations of 457.

In summary, Congress was plainly aware of the structure of Section 83 prior to the exemption being put in place - the IRS position that Congress did not intend a total exemption is without basis.

If there is no basis why is the IRS attacking 83 for tax exempts? After speaking with several former and current senior IRS staffers we can only conclude a overzealous sense of duty. It appears that the IRS knows that the position will not stand under review but is will to use the regs as a tool to curb the use of these plans in the interim by causing uncertainty.

[Guest kkost]

Glen, you obviously have a handle on the sequence of events but I think you have the purpose of 457(f) stated in reverse. 457(f) is an override that causes accelerated recognition - it captures deferred compensation and triggers faster recognition than the section 83 rules would. Vanilla deferred comp plans don't trigger tax under 83 until the benefits are actually or constructively received. Congress didn't like that rule for EOs and wrote a rule that causes accelerated recognition in certain circumstances - if the section 83 rules wouldn't trigger current recognition. If they intended a different result when the payout is made in gold bars or shares of Cisco rather than cash, they could have selected better language for the 457(f)(2)© carve-out. As it stands, it is subject to either interpretation. Not that the Service has a slam dunk but it certainly has a resonable argument in light of the ambiguous language of the statute.

[Guest Glen Armand]

Sorry if my previous post was not clear on the point I was trying to make.

In short - we think the Service has a very steep hill to climb in the argument that an option is not property under 83.

Seems to us that there is case law, which would contradict this point.

In the mean time, we plan to keep the lobbying and political pressure up – our goal to abort the IRS effort – reportedly they are feeling the pressure to remove from regs. We just got another senior Senator on board yesterday who has contracted Treasury on behalf on this matter.

Best - Glen

[Guest kkost]

Okay, I'm with you.

Assuming that the prior argument doesn't work. The other argument is found in Treas. Reg. Sec. 1.83(e) - which defines "property." That section provides "the term property includes real and personal property other than an unfunded and unsecured promise to pay money OR PROPERTY in the future." An option such as the ones that we have been considering is nothing more than an unfunded, unsecured promise to pay property in the future. Maybe that regulation will be invalidated if challenged - but if these types of options are not property, no transfer of property has occurred to trigger the 457(f)(2)© carve-out.

I'm just trying to see what people think they can hang their hat on if their clients are challenged with respect to one of these arrangements.

[mbozek]

This is pure speculation on my part but is the IRS anticipating that Congress will revise the rules and tax options with no readily ascertainable fmv under some of the reform proposals in Congress. I know that there is a proposed legislation to change the IRS rule that would tax stock options as wages for FICA purposes.

[pjkoehler]

kkost: One of the principal advantages of this strategy vis a vis traditional deferred compensation is the executive's access to the intrinsic value of the option property (most likely publicly traded mutual fund units). Assuming this works the executive can exercise at any time all or any portion of his vested options without regard to his employment status, i.e. in the vernacular of deferred comp s/he can obtain an in-service withdrawal without being subjected to a so-called "haircut" penalty (usually at least 10%) a necessary evil presumed to be required under traditional deferred comp to avoid application of the "constructive receipt" doctrine, assuming the deferred comp plan would allow in-service withdrawals at all.

The arguments in favor of this theory run like this:

Sections 83(e)(3) and (4) govern the tax treatment of options (other than statutory options) granted to employees in connection with the performance of services. Section 83(e)(3) states that section 83 does not apply to the transfer of an option without a readily ascertainable fair market value. Section 83(e)(4) states that Section 83 does not apply to the transfer of property pursuant to the exercise of an option with a readily ascertainable fair market value. The IRS has issued regulations interpreting sections 83(e)(3) and (4). Although the caption to these regulations refers specifically to nonqualified stock options, the reasoning behind the regulations should apply equally to options to buy other types of property. (The Tax Court and the IRS, for example, have applied these regulations to options to buy partnership units. See Schulman v. Commissioner, 93 T.C. 623 (1989); PLR 9801016.) It may be argued that the absence of any language in sections 83(e)(3) and (4) limiting the application of those sections to stock options supports this interpretation.

Under the regulations, if an option granted to an employee in connection with the performance of services has a readily ascertainable fair market value at the grant date, the employee has received property for section 83 purposes at the grant date -- and therefore has compensation income under section 83 on that date. Reg. section 1.83-7(a). An option that was taxable at grant because it had a readily ascertainable fair market value at grant is not subject to tax at exercise.

In contrast, if the option does not have a readily ascertainable fair market value at the time of grant, section 83(a) does not apply at the grant date. Rather, section 83(a) applies at the time the option is exercised or otherwise disposed of, even if the option's fair market value becomes readily ascertainable before that time. Reg. section 1.83-7(a). If the option is exercised, section 83(a) applies to the transfer of property pursuant to the exercise, and the employee realizes compensation on the transfer at the time and in the amount determined under section 83(a) or 83(B). Thus, if the property the employee receives pursuant to the exercise of the option is transferable or not subject to a substantial risk of forfeiture, the employee must recognize as income upon the exercise an amount equal to the difference between the exercise price and fair market value of the property.

[Guest Glen Armand]

The following is from an article that Tom Brisendine wrote that summarizes the arrugment best.

"The principal argument against removing options from the ambit of section 457 (f) relies on section 83(e), which states that section 83 “shall not apply to . . . the transfer of an option without a readily ascertainable fair market value”. The section 83 regulations, however, interpret that exclusion to mean only that sections 83(a) and (B) do not lead to any income inclusion at the point where such an option is issued. In fact, those regulations say a great deal about the tax consequences of options without a readily ascertainable fair market value, seemingly occupying the whole field of the taxation of compensatory options. The section 457 (f) exception refers broadly to “a transfer of property described in section 83”. The issuance of an option is unquestionably “a transfer of property”(1) , albeit one that does not normally result in current tax liability. And it is “described in section 83”, because that section tells us when and how it results in taxation.

It is also worth noting that, in closely parallel contexts, the Internal Revenue Code treats options as a nondeferred form of compensation. As already noted, options are not treated as deferred compensation under section 3121 (v) (2). Similarly, section 404 (a) (5), governing employers’ deductions with respect to any plan “deferring the receipt of compensation”, does not apply to deductions arising from the exercise of options. Instead, the employer is entitled to a deduction under section 83 (h).

(1) The regulations carefully point out that the grant of an option is not a transfer of the property subject to the option. [but] They do not suggest that an option is not “property” or that its issuance is not a transfer. Treas. regs., §1.83-3 (a) (2). By contract, the definition of “property” excludes “an unfunded and unsecured promise to pay money or property in the future”. Treas. regs., §1.83-3(e)."

[Guest Glen Armand]

MJB

We have been to the Hill several times on this issue including Ways and Means and Seante Finance members - No known efforts under way or consideration to tax options without a RAFMV.

Do NOT belive this is in play at this time.

[Guest kkost]

I understand how §83 works and I've read the article you cited.

The problem is that 1.83-3(e) says that unfunded unsecured promises to pay property in the future are not property. The options we have been addressing are nothing more than unfunded unsecured promises to pay property (the units or shares or whatever) in the future. Likewise, 1.83-7, which deals with options which have a readily ascertainable fair market value says that they are taxed at grant but does NOT state that they are property. So, no property is transferred until the exec cashes out under either scenario - stated another way, there is no transfer of property upon grant.

I think everyone agrees that if an EO lets an exec defer $50,000 this year in exchange for the right to receive the amount that sum would have grown to if invested in government bond fund x by the end of 2005, provided that the right is vested, he would be taxed currently. This is because the promise to deliver is not property under 1.83-3(e). Change that to a current deferral of $50,000 in exchange for the right to receive the value that $100,000 current investment in government bond fund x by the end of 2005 in exchange for an additional $50,000 payment (which may or may not be waived through a net exercise) and you still have an unfunded unsecured promise to pay money OR PROPERTY in the future. The promise is not property under 1.83-3(e). If the mere promise is not property, the carve out to 457(f) doesn't apply and Section 83 is completely irrelevant.

Does anyone have a cite to anything (other than opinion) which states otherwise? Maybe it is the fact that the amount is not paid in money that is the factor that everyone relies on here. In other words, money is not property under 1.83-3(e) so deferred comp paid in money would not trigger 457(f)(2)© and would be taxed when vested. Pay me in marketable securities instead, which I can convert to money the day that you pay me, and you trigger application of 457(f)(2)© - resulting in the deferral of tax until the amount is paid or made available - without regard to vesting. That's an argument but it seems like a stretch to me.

[mbozek]

Doesn't IRC 1234(a) define an option as property for capital gains? Section 1234(B)(2) defines property as including stock and securities, commodies and commodity futures.

[IRC401]

Sorry to change the topic somewhat, but PJK's response deserves a reply. The LoBue and Graney cases deal with fixed price options and therefore are not relevant. My criticism is of variable price options.

Technically, all four cases deal with fixed price options. The issue is whether the amount of the discount is so great as to make the arrangement not an option.

The Victorson case appears to take the position that anything that is called an option is an option (and if that is the correct interpretation the entire tax bar and all tax CPAs have been negligent for decades for missing a golden opportunity to ignore the doctrince of contructive receipt). The case could also be interpreted to mean that a taxpayer is bound by his choice of form, but the IRS is not (which produces a very different result).

You are probably already aware of the comment in the Veal and Brisendine article noted above that it would not be prudent to rely on the case.

I have no specific comment on the fourth case at the moment.

I should also note that the Veal and Brisendine article discusses fixed price options. They tiptoe around variable price options. If you think that that article supposrts variable price options, read it again very carefully.

I don't know what the IRS is up to. If the Service wants to kill 90%+ of the discounted options out there, it could do so with a revenue ruling invoking the doctrines that I listed above. It could also kill all of them by amending the 83 regs, which would take more time. If it goes at them using the 457(f) regs, it seem to me that once again the IRS has decided to do things the hard way with the least chance of success.

[mbozek]

IRC 401:I dont think any of the doctrines u cite could be used as precedent to tax options given the existing Section 83 regs and the statutory language of IRC 1234. In the post 1998 IRS reform act world, the IRS cannot act like King Canute and just issue revenue rulings to stop practices that it does not like- It needs substantial authority under the tax law which is lacking. The fact that a loophole or exception is being utilized by taxpayers to reduce their taxation under the applicable regulations is no reason to curb its application if there is no change in Law (e.g., it is perfectly legal for us companies to incorporate outside the US to avoid paying US income taxes). If you or any other person really believes that variable options are not property within the meaning of IRC 83/1234 then come up with the authority. Otherwise, u are like the Don Quixotes of the IRS tilting at the windmills of tax deferral.

Finally why won't the IRS position on 457 (f) wind up any differently than their waffling on split dollar life insurance?

[Guest kkost]

At the risk of beating a dead horse, again, my point is that 457(f) taxes vested deferred compensation of EO executives. It has nothing to do with Section 83, unless there has been a transfer of property. The 83 regs say that mere promises to pay property in the future themselves are not property. An option is a promise to pay property in the future. Although the regs do state that certain non qualified options will trigger current tax under 83, they do not reach the result by calling those options "property." Definitions of property in other sections are equally irrelevant - Treasury defined what "property" means for purposes of Section 83 in 1978 and that definition is still contained in 1.83-3(e). If there has been a transfer of property, 83 is triggered and income is recognized. If there has been a vested deferral of compensation without a corresponding transfer of property, income is recognized under 457(f).

If you offer a discounted option to an EO exec (either at a fixed or a variable price), you have enabled the deferral of compensation which does not work under 457(f). If the interest is vested, it is taxed currently. 83 and has nothing to do with it. 457(f) focuses on the deferral of compensation and accelerates taxation when 83 would permit deferral.

The point of the post was not to solicit opinions regarding policy - it was to see if anyone had any rationale, in light of the text of the current code and existing regulations, for the position that this works - again, we are only talking about non-govermental exempt organizations here - this is a Section 457 board. I have seen a legal memorandum used by one vendor in support if its product but it merely contains a mixture of the sort of policy/ personal opinion and off point arguments posted here, followed by a lengthy caveat essentially stating we don't know how this will turn out or if it works.

[mbozek]

Kost : Arent all security purchases a promise to pay money or property in the future, e.g., the purchase of stock is a promise to pay for the stock upon delivery of the shares in three business days after the trade? Isnt a life insurance policy with a cash value an unsecured promise to pay money in the future? Yet They are property under Section 83.

[Guest EAKarno]

YES! Options are property under Section 83.

The idea being marketed by the Big 5 and others, however, are options in name only. An option with a floating exercise price has an option privilege with zero value. Hence, it cannot truly be an option, and therefore it is not a transfer of property described in Section 83. Thus, it follows, it is subject to taxation under 457(f). Even if it weren't, it would be immediately taxable under Section 451 since there is no substantial limitation or restriction upon exercise.

As IRC401 keeps trying to impress upon all of you, it is a matter of substance over form -- which the Service is always free to invoke. If you put a saddle on a pig and call it a horse, it's still a pig. Likewise, if you take deferred comp, give it an exercise feature and call it an option, its still deferred comp.

Treasury and the Service are aware of this sham and are set shut it down for tax-exempts through the new 457 regs. If they try and do so with fixed exercise priced options I agree that they may be going against settled case law.

Floating exercise priced options (with or without a floor) deserve to be shut down both for taxable as well as tax exempt organizations.

[mbozek]

Even if you assume that all floating rate options are a sham I dont see anything in Section 83 or the 83 regs that allows the IRS to distinguish between taxation of options granted to taxpayers who work for a non profit instead of a profit making employer. Under the Computer Associates Case the IRS has no authority to distinguish between similarily situated taxpayers.

[Guest EAKarno]

If it's not an option, it's not property, and thus it's not covered by Section 83. Since floating exercise priced options are economically identical to deferred comp it would only make sense to tax them as such. Unfunded deferred comp is taxed under Section 451 for taxable entities and Section 457 for tax-exempts. Congress made that differentiation, not the Service.

[mbozek]

ERIC: Section 457 is merely a statutory form of constructive receipt for NP and st gov. for deferrals in excess of $11,000 or such higher amount permitted under 457 and is an extension of Sect 451. But if the essence of the tax deferral of options under Sect 457 is defined in the regs under IRC 83, the definition of an option used in NQ plans for both NP and profitmaking employers must be the same- An option for a employee in a profit making employer cannot include a floating rate exercise price but exclude a floating rate option in a 457 plan. It is not Section 457 but Sect 83 that drives the analysis since the definition of an option is the same for both types of plans. The IRS cant just decide that it wants to make tax different tax policy for NP under Sect 457 without a change in the law because the IRS needs substantial authority for applying the law.

[pjkoehler]

EAKarno: In what sense is the employer's obligation to transfer property contingent upon the the optionee's payment of the exercise price (however, formulated) "economically identical " to an obligation to pay money in the future, which is at most contingent on the employee's performance of future services. Designed to achieve the objectives of a deferred compensation arrangement and, therefore, similar, sure, but "identical." Give me a break. Form over substance is an attrative catch-all doctrine, which, like the step doctrine, the IRS uses judicially, i.e. selectively. If you're philosophically opposed to the idea you might find it persuasive, but it doesn't mean these options are devoid of any substance or lack the essential economic attributes of option contracts.

Take for example, the case of the insolvent optionee who is economically unable to tender the exercise price with respect to vested options before they expire. Is his position "economically identical" to the position of a participant in a NQDC plan? Firstly, the vested NQDC participant has an unfettered right to receive payment as of the distribution date first to occur under the plan. If the employer fails to perform, the participant can bring a collection action, become a judgment creditor, etc. Not so the insolvent optionee. Second, options expire. If the optionee doesn't exercise by the expiration date, he will permanently forfeit the option privilege. Not so the NQDC participant. His contract claim against the employer is subject only to the statute of limitations applicable to the collection action under state law. Even if you want to presume that all such plans provide for cashless exercises, the insolvent optionee has to pay the brokerage fees and interest charges associated with that transaction, which is clearly economic detriment to which the NQDC participant is not subject.

You are also completely forgetting about ERISA. That's right, even ERISA "top hat" plans (like 457(f) plans for EOs) are subject to ERISA's civil enforecment provisions. The participants have rights to disclosure of information and access to a developed claims procedure and all the other protections. Not so, the optionee. If the employer chooses to wrongfully breach the option agreement, the optionee has no standing to bring an action in federal courts, claim relief under the causes of action specifically created by ERISA or seek recovery of his attorney fees. He'll have to slug it out in state court at his own expense.

These aren't abstract distinctions with no economic impact. Your "form over substance" argument might well be adopted by the Service and ultimately affirmed by the Tax Court, but that doesn't mean two different things with similar economic objectives, are "identical."

[IRC401]

MBozek-

If the "option" is really NQDC, it is taxable to the employee of the for-profit entity under the doctrine of constructive receipt and to the employee of the non-profit under 457(f). That is the difference.

PJK-

1. Start looking more at the economics and less at the regs and case law. If the employer allows for a cashless exercise (which as far as I know they all do), the fees related to the exercise can be deducted from the proceeds. [PS: I have been told that E&Y doesn't even bother with the formalities of an option exercise.]

2. If an employer tells an employee that he can take his NQDC whenever he wants it at anytime during the next ten years, when is the employee taxed. When (and if) he takes it or as of the first day that he could take it???

3. ERISA is not voluntary. Regardless of whether the employer wants to make these "options" subject to ERISA, it has no say in the matter.

[pjkoehler]

IRC401: Not everything that has form has no substance. Compensatory stock options that do not have RAFMV are taxable at exercise regardless of when they vest under Code Sec. 83. An option agreement (with exercise price discounts that do not exceed 75%) impose material economic detriment to obtain the benefit, expiration deadlines and no ERISA protections. These distinguish it from an ERISA "top hat" plan.

If all the actuarial assumptions that are used to determine the value of a participant's account balance in a Cash Balance Plan are exactly realized, then it produces the same "economic" benefit as a Profit Sharing Plan that had similar cash flows and investment experience. Because that is possible, does that mean that a Cash Balance Plan and a Profit Sharing Plan are identical and that all other distinctions should be ignored for purposes of determining deduction limits, funding requirements, etc.?

Arguments can be made on both sides of this. If you're on a crusade to shoot these programs down, you can make a strong argument. In the post-Enron era, the IRS may have decided that time is right to pounce on these arrangements. But that doesn't mean the issue if free from doubt.

[mbozek]

It seems that there is an impasse here. Several people on this thread believe that the IRS has authority to decide what is and was is not an option and that the IRS can distinguish between options provided under nqdc plans of profiting making and n/p employers. Others do not believe the IRS has inherent authority under the edxisting law. My view that the IRS cannot enforce its position to tax floating rate options under IRC 83 and Reg. 1.83-7 without a change in law is based on the following cases: U.S. v Mead, 150 L.Ed. 2d 292; Matz v. Household International Plan, 2001WL 1027275. The IRS cannot selectively tax options of NP employees who participate in 457(f) plans under the rationale of Oshkosh Truck Corp v. Us 123 F3d 1477 and IBM v. US 343 F2d 914.

[Guest EAKarno]

MBozek -- The Service wouldn't need to tax floating price options under Section 83 since they aren't options to begin with. This would be a case of taxing based on substance over form which the Service absolutely has the right to invoke. As disguised deferred compensation, floating price options would be taxable under Section 451 and the constructive receipt doctrine because there is no substantial limitation or restriction on exercising the "so-called option." This would be the case whether the taxpayer worked for a taxable or tax-exempt entity.

[mbozek]

Are you conceeding that the IRS would tax floating rate options of both profit making and np emloyers? If so this would contradict statements that the IRS was looking to change the definition of options under 457(f) type plans. As has been pointed out previously the IRS cannot just waive the magic wand of substance over form to tax transactions it does not like- The purpose of my citations is put into perspective what the hurdles are for the IRS to change the rules. Also under IRC 7805(B) it would be very difficult for the IRS to tax any amount deferred before it announces a proposed change in the rules.