457(f) and mutual fund options

[Guest EAKarno]

MBozek -- Rumor has it that the new 457 Regs. will tax the initial spread under ALL discounted options as deferred compensation for tax-exempt employees. For fixed price options, I agree that this seems contrary to the Supreme Court's LoBue decision and might be difficult to support. On the other hand, Sections 83 and 457 didn't exist at the time of LoBue. Because 457(f) is a statutory provision that goes far beyond mere constructive receipt, it could be argued that Congress' enactment of 457 trumps any constructive receipt based holdings preceding it (at least with respect to tax-exempts). And remember, Congress, not the Service, created the distinction for deferred compensation between taxable and tax exempt entities.

[Guest kkost]

Along the lines of what I was trying to convey a few months back on this board, IRS released proposed regs (1.457-11) with which it intends to prospectively shut down the 457(f) option arrangements for exempt organizations. Assuming that they become final without substantial changes, the regulations will operate as the statutes read - 457(f) will trigger recognition of income deferred at the EARLIER of (1) the time that it would be taxed under Section 83 or (2) the time that it vests.

Once again, there is no statute, regulation or IRS interpretation that anyone has pointed to which states that options are "property" for purposes of section 83. As a result, the drafters probably got this right based on the text of the existing statutes and potentially (I wouldn't count on protection for discounted options) extended a free pass to those who have already granted options based on a strained reading of those provisions.

[mbozek]

KKost: According to BNA tax mgt portfolio # 383-3rd, Nonstatutory Stock Optons, Page A-14 col 1, an option constitutes personal property within the meaning of Reg 1.83-3e. Also there are cases, such as Cramer v. Comm, 101 TC 225, affd 64 F3d 1406 and Pagel v. Comm. 905 F2d 1190, in which the taxation of options under IRC 83 were the subject of review and no suggestion was made that options were not property under IRC 83. In Pagel a restricted nonpublicaly traded option to acquire stock was held to have no rafm value under Reg 1.83-7((B)(2).

[Guest kkost]

mbozec - TMPs contain an author's opinion and the cases you cited don't address the issue. My comment was:

"There is no statute, regulation or IRS interpretation that anyone has pointed to which states that options are "property" for purposes of section 83."

It appears that your approach is to ignore existing regulations and make your own determination as to whether you agree with IRS on a given point. If you believe you are right and it is wrong, you ignore the regulations. Good luck with that method when advising clients.

[pjkoehler]

mbozek: Prop. Reg. 1.457-11© provides that a transfer of property to which section 83 applies, will not be taxable under 457(f) (and its stringent definition of "substantial risk of forfeiture") if the date on which the condition lapses occurs on or after the transfer, otherwise 457(f) does apply. Prop. Reg. 1.457-12 further provides that Prop. Reg. 1.457-11© "does not apply with respect to an option without readily ascertainable fair market value (within the meaning of section 83(e)(3) that was granted before [May 8, 2002]." Under a fair reading of this language, the proposed regs appear to be contrary to the tax filing position many tax-empts have taken in the past, i.e. that their mutual fund option programs are taxable under section 83, and not 457(f), at least regarding grants made after May 8, 2002.

[mbozek]

KKost: If you knew how to do tax research you would have found Rev. Rul. 72-296 (options granted to employees to buy shares of a REIT are section 83 property) and Mitchell, TC memo 1990-617 (stock warrants are stock options governed by section 83). Both cases are cited in CCH tax service under IRC 83.

[Guest EAKarno]

Options are clearly property. The Supreme Court no less has ruled as such. But who cares?! The proposed regs. will tax the issuance of a discounted option based upon its intrinsic value once the right to the underlying property is vested. Upon exercise, any further gain will be taxed as well. At least that's how we read it and clearly what Treasury and the Service intended.

[Guest kkost]

Mbozek - If you would actually read the authorities underlying the dozens of random citations that you paste into your messages, you would do yourself (and the rest of us) a favor. Mitchell was a situation involving an exchange of warrants (not property) for stock (property) which resulted in recognition of income to the service provider because property (stock) was actually transferred. Rev. Rul. 72-296 is a Section 856 ruling regarding REIT status - not a Section 83 ruling. More importantly, if you look, you will notice that the regulations under Section 83 were promulgated six years AFTER the ruling was released - rendering it meaningless since "property" for purposes of Section 83 is defined in the regulations.

[mbozek]

Not so fast-- there are major issues regarding IRS authority to make this distinction in the absence of any legislative intent. See US v. Mead Corp, 121 SCt 2164 ( 2001). Also there is the issue of whether the IRS position is properly an interpretation under IRC 457 or under IRC 83-- If it is related to 83 then there cannot be any distinction between similarily situated taxpayers. This will be played out as DC Kabuki theatre-- just like the split dollar proposed regs.

[mbozek]

The Mitchell court expressly recited that warrants are options under Sect 83 which is what you had asked for. Aslo The fact that rev. rul. 72-296 was not revoked by the IRS after the regs were issued is confirmation that it is consistent with the the regs. Fact is you do not have any citation that options are not property under IRC 83.

[Guest kkost]

EAKarno: I agree with you that options are property in the common sense of the word. Money is property in the common sense of the word as well yet it not "property" for purposes of Section 83:

"For purposes of section 83 and the regulations thereunder, the term "property" includes real and personal property other than either money or an unfunded and unsecured promise to pay money or property in the future." Treas. Reg. § 1.83-3(e).

An option is an unfunded, unsecured promise to pay property (stock or mutual fund options) in the future. I raised the point in response to a series of posts about how IRS has no authority to accelerate income recognition on those options. There were also a series discussing why the Service did not have the authority to treat exempt organizations differently than taxable entities (notwithstanding a statute that was drafted to accomplish this).

The point was that this is one solid basis for the Service's conclusion. Becuase the options are not property, §475(f)(2)© does not apply and if vested, the deferrals do not achieve the intended goal of postponing recognition.

[Guest kkost]

(1) I asked for authority that options (aka warrants) are "property" on multiple occasions - not that options = warrants.

(2) The Service does not typically revoke Revenue Rulings when they have been superseded by regulations.

These forums are here to share information. People post looking for authoritative answers - they are not looking for a debate with you or anyone else.

[pjkoehler]

mjbozek: Calm down. Take a deep breath. Now, close your eyes and concentrate...concentrate...concentrate.....

[cue the voiceover]: The issue addressed in the recently proposed 457 regs is NOT whether or not a mutual fund option without readily ascertainable fair market value is "property." It's whether or not the grant of such an option is a "transfer of property" to which section 83 applies. So all those ancient revenue rulings that you completely misunderstand and misrepresent are meaningless as guidance.

Code Sec. 457(f)(3) teaches us that a deferred comp plan includes any agreement or arrangement. Sec. 457(a) says that compensation paid by the plan will be includible in gross income in the year in which the there is no "subtantial risk of forfeiture" EXCEPT as to "that portion of any plan which consists of a transfer of property described in section 83." Sec. 457(f)(2)©. Then, section 83 governs the tax treatment.

Prop. Reg. Sec. 1.457(f)-11© says that "a transfer of property described in section 83 means a transfer of property to which section 83 applies" BUT that section 457(f) applies if the lapse of the condition occurs before there is a transfer of property to which section 83 applies. Most of us know the grant of such an option is not a transfer of property to which section 83 applies. Prop. Reg. Sec. 1.457(f)-12 says that this treatment does NOT APPLY to such an option that was granted [before publication of the proposed reg]. Leaving one with the logical impression that it DOES APPLY to such options granted afterward. Did you notice that grandfather language and how it doesn't conflict with the tax filing position you advocate on grants prior to the effective date?

[Guest EAKarno]

I can't believe I'm doing this because it has nothing to do with the taxable outcome, however, I think it's important to clarify the point.

Options are indeed property taxed under Section 83. An option with a readily ascertainable FMV is taxed under Section 83 at grant. One without one is taxed under Section 83 at exercise.

Beyond the logisistic difficulties involved in valuing the arrangement, the rationale for taxing an option without an ascertainable FMV at exercise is related to Section 451 constructive receipt principals -- the lost opportunity for appreciation without capital investment is a substantial restriction upon exercising. See Revenue Ruling 80-300 (yes I realize that the ruling deals with a SAR but the economics are identical to an option with no readily ascertainable FMV). Ordinary rules of constructive receipt, however, do not apply to situations governed by Section 457.

Under the 457(f) regs., the transfer of a discounted option will be taxed twice, once under Section 457(f) and once under Section 83. The spread will be taxed at grant because the optionee's rights to the underlying property are not subject to any substantial risk of forfeiture. Upon exercise, the option itself is taxed under Section 83 based upon the bargain element realized less the optionee's tax basis obtained by the previous taxation under 457(f).

[pjkoehler]

EAKarno: Your statement that "the transfer of a discounted option will be taxed twice" is not quite right. Do you mean the grant of the option or the transfer of the property? Under the proposed reg the intrinsic value of an option without a readily ascertainable fair market value will be includible in ordinary income in the taxable year in which the substantial risk of forfeiture lapses as defined in section 457(f)(3) (i.e. is vested). Of course, since these discounted options are vested when granted, that means the intrinsic value is includible in the year of grant. The grantee therefore has tax basis equal to the amount included in income under 457(f). In the year of exercise, the amount includible in gross income is the excess, if any, of the FMV on the date of exercise over the taxpayer's basis. So, there has been no double taxation on the transfer. The taxpayer certainly shouldn't get a free ride on the spread from the date of grant to the date of exercise.

[Guest EAKarno]

I didn't say there would be double taxation nor did I in any way imply that there would! I simply said that the whole arrangement would be subject to tax on two occassions -- once upon grant and once again upon exercise. I made it clear that the 2nd tax upon exercise would take into account and give credit for the tax paid previously upon grant of the option.

[Guest kkost]

EAKarno: You're right, it doesn't matter if the proposed § 457 regs are finalized in proposed form but you are missing the property issue. Before the prop regs were released, people on this board and elsewhere had a problem with the language of § 457(f)(2)© and thought it would preclude what the Service has done with the proposed regulations. In any event, that section states:

" . . . that portion of any plan which consists of a transfer of property described in section 83." Note that this does not say a transfer of property which causes income recognition under § 83 - it just says a transfer which is DESCRIBED in § 83.

You say that all options are "property" for purposes of 83 notwithstanding the clear contrary language used in § 1.83-3 and § 1.83-7 - specifically calling them something other than property. If you are correct and all options are "property" for purposes of 83, there would be no basis for the new regulations since an option would be granted under "that portion of a plan which consists of a transfer of property described in Section 83" and would not trigger current recognition under § 457(f)(1)(A). Instead, the normal § 83 rules would apply and recognition would not be accelerated.

If you read the regs carefully, they say (1) options are not "property" for purposes of § 83 and (2) that if they have a RAFMV, they will be taxed on grant - without saying that they are property. Although they could have addressed this issue in a better way, whoever drafted those regs stated that options are not property; the stuff that you get on exercise is property. Again, read § 1.83-3(e):

"Property. For purposes of section 83 and the regulations thereunder, the term "property" includes real and personal property OTHER THAN either money or an unfunded and unsecured promise to pay money or property in the future. The term also includes a beneficial interest in assets (including money) which are transferred or set aside from the claims of creditors of the transferor, for example, in a trust or escrow account. "

Clearly, the drafter is saying that options (unsecured promises to pay property in the future) are not "property" for purposes of Section 83. Property for that purpose includes a funded promise to pay money or property in the future but does not include the grant of an option which is merely an unfunded promise to deliver mutual fund shares in the future.

For other Code sections, options are property. For example in the Rev. Rul. released today relating to the interaction between 1041 and 83, the Service calls them property for Section 1041 purposes. However, just as a "gift" for income tax purposes may not be a "gift" for estate tax purposes, "property" under 83 is not the same as property under other sections of the Code or in common application.

I think we are all saying the same thing - the grant of an option is a transfer of value and a deferral of compensation. The issue of whether it meets the § 83 definition of property is only relevant as a statutory basis for the new proposed regulations.

[pjkoehler]

EAKarno: Sorry to be taking your comments literally, but compare these two comments of yours:

Originally posted by EAKarno

I didn't say there would be double taxation nor did I in any way imply that there would!

.

and

[T]he transfer of a discounted option will be taxed twice, once under Section 457(f) and once under Section 83.

What did you mean by the "transfer of a discounted option." That's what my previous question. I assume you either meant (1)the grant of the option, which, because it doesn't have readily ascertainable fair market value means it isn't includible under section 83 (but because it's vested, under the proposed regs it is includible under 457(f)) or (2) the transfer of the underlying property to which section 83 does apply. But in neither case, is there income with respect to a single event (grant or transfer on exercise) that "will be taxed twice." I gather we're all in agreement about that.

[Guest kkost]

pjkoehler:

I think he means that the value of the vested option is taxed under 457(f)(1)(A) at grant. Upon exercise (after the value of the underlying property has presumably appreciated), the excess of the value of the property received over the amount he paid plus the income he already recognized would be taxed as a transfer of "property" (the stock or units) for services under Section 83.

I think his point was that the full value is taxed in two stages - not that it gets taxed twice.

[pjkoehler]

kkost: Thanks for the interpretation. Using terms like "transfer" and "option" imprecisely in a discussion regarding sec. 83 can lead to considerable confusion. It should help all the readers of this thread.

[Guest kkost]

FYI - the draftsman of the -11 regulation was at the ABA Tax Section Meeting in DC last friday and addressed a standing room only crowd. He made it clear that the intent was to tax options in two stages as described above. He also stated that although valuation was not addressed in the regulation, intrinsic value is not the proper measure of the deferral amount and that there is value to be recognized when fair market value options are granted. He also stated that the fact that the May 8 date was used to prevent application of the proposed regs to option programs does not mean that IRS is giving them a free pass. He suggested that abusive programs (such as floating exercise price programs) entered into before May 8 may still be challenged.

[pjkoehler]

kkost: Interesting, so according to the speaker options w/o RAFMV granted pre-5/8/02 are not grandfathered as to the employer's application of section 83 treatment. Is it your impression from these informal comments that options (fixed or floating) granted pre-5/8/02 will be subject to a more flexible "reasonable, good faith interpretation" standard because of the absence of official guidance?

[Guest kkost]

I'm not sure what you mean by your post but the gist of the comments was that the new reg states what the law has always been but non-abusive programs (whatever those are) will be grandfathered with respect to pre May 8, 2002 grants. All post May 8, 2002 grants would likely be taxed when vested - even if they are granted at fair market value.

[IRC401]

Many of the discounted option programs allow the employee to pick and change the underlying investment on which the option is granted.

Anyone have an opinion whether changing from an option on Mutual Fund A to Mutual Fund B would be a grant of a new option, taking the option out of the grandfathering rule (assuming that anti-abuse rules don't kill the option first)?

[Guest kkost]

That was suggested at the meeting and the unofficial answer was that anything short of a material modification would not be problematic. No specific examples were given but the general idea was that if the holder possessed rights (such as the right to switch underlying securities) on May 8, he could continue to exercise them without loss of reliance on the grandfather provision. Similarly, if the program was actually modified in a non-material manner after May 8, it might not cause the loss of reliance on the grandfather rule.

[Guest EAKarno]

Speaking strictly of legitimate options with fixed exercise prices --It seems to me that if the Service were to impose any tax at grant (or upon subsequent vesting) on any thing beyond the intrinsic value, then there ought not to be a subsequent tax upon exercise. Taxing the value of the option privilege, in addition to taxing the spread, seems like taxation of the full economic value of the option to me. To tax it again upon exercise would truly be double taxation rather than just taxation done in two phases.

As for options with floating exercise prices, I anticipate that they will eventually be taxed simply as deferred compensation (for both taxable and tax exempts) without any grandfathering whatsoever.

[Guest kkost]

EAKarno: I understand what you are saying but the concept is that the value of the vested option granted is the amount of the deferred compensation which must be recognized in the year that it becomes vested under 457(f). Later, when there is an actual transfer of property in exchange for services (upon exercise), the value of the property received less the amount of income previously recognized under 457(f) is the ordinary income recognized under §83 in the year of transfer. In the year that the property is transferred, you get a full credit for the amount of income previously recognized so there is no double taxation. This is the same result that would occur if the promise was to make a future payment of money instead of stock or units - amounts would be taxed when deferred if vested. When amounts are later made available, they are taxed to the extent that the full amount was not previously recognized by the participant. As a result, there is no "double" tax - it is just that there are two recognition events to accelerate recognition of a portion of the whole compensatory amount.

[Guest kkost]

Sorry - I should have said offset rather than "credit" in the prior post.

[Alf]

Can someone help me with two questions about the proposed regulations?

1) What is taxed at vesting for discounted options? The spread only or does value have to be given to the option element under bs?

2) Do the regulations apply to employee deferrals only or employer money only?

[Guest kkost]

Both employee and employer deferrals are taxed when vested.

Regarding valuation, in response to a question like yours, the comments from the draftsman at the ABA Tax meeting in May indicated that the spread is not a valid measure of value and that something along the lines of BS is (in their minds) a more appropriate measure of the true value.