457(f) and mutual fund options

[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?

[Carol V. Calhoun]

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.

[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.

[Carol V. Calhoun]

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.

[IRC401]

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.

[Kirk Maldonado]

IRC401:

Why do you say that the options have little or no value under the BS (pun intended) valuation methodology?

[mbozek]

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.

[IRC401]

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.

[Carol V. Calhoun]

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.

[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.

[mbozek]

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.

[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.

[IRC401]

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.

[Carol V. Calhoun]

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.

[mbozek]

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.

[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.

[IRC401]

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.)

[mbozek]

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.

[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

[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.

[mbozek]

Is this IRS policy limited to 457 plans or will it apply to nonqualifed DC Plans of profit making employers under IRC 83?

[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.

[mbozek]

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?

[IRC401]

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.

[pjkoehler]

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.

[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.