What is a KEYSOP?

[Guest Ted Munice]

Whatis a KEYSOP? From what we know it seems to be a nonqualified deferred comp plan that invests in employer options contracts. What are the advantages, tax and otherwise, of doing this? Any info would be helpful.

[pjkoehler]

The term "KeySOP" is trade marked by the accounting firm of Deloitte & Touche. There are several different versions, but in general a KeySOP is an arrangement that allows executives to convert pre-tax compensation (like a bonus) in exchange for the option to purchase non-employer (publicly traded )securities, typically mutual funds at a discount. The difference between the option price and the fair market value of the securities (NAV in the case of mutual funds) on the date of grant is equal to the amount of the pretax compensation foregone by the executive.

One of the principal advantages of the KeySOP is that it is taxed under Code Section 83, not 451, as in the case of nonqualified deferred compensation. The executive is not taxable on the grant date. At exercise the difference between the fair market value of the shares minus the exercise price is taxable to the executive as ordinary income. The employer is required to impose FICA and income tax withholding at exercise. Appreciation in the shares after exercise is subject to capital gain treatment.

Usually, the KeySOP allows the executive to exercise and dispose of any number of option shares at any time, without regard to termination of employment. This allows the executive to obtain the equivalent of an in-service distribution without having to design the plan to maintain a substantial risk of forfeiture (to avoid constructive receipt problems) by imposing a "haircut" penalty. The employer is under no obligation to actually purchase the securities subject to the option contract, but to avoid negative accounting treatment, it will have to. The shares remain the general assets of the employer subject to the claims of creditors. They may be held in a Rabbi Trust to enhand the executives' benefit security. A KeySOP is not a deferred compensation plan for ERISA or Code purposes.

[This message has been edited by PJK (edited 06-08-2000).]

[IRC401]

WARNING: There are four basic variations of the KeySOP, depending on the exercise price:

1. Fixed exercise price

2. Indexed or increasing exercise price (The price starts at a fixed percentage of the exercise price at the date of grant and increases each year by either a fixed or variable interest rate.)

3. Floating exercise price (exercise price is a percentage of FMV at date of exercise.)

4. "Greater of" (greater of percentage at date of grant or date of exercise)

There is an issue whether the last two varieties are in fact options. The issue is whether you can get around the doctrine of constructive receipt by putting the word "option" on a sheet of paper and concluding that you have an option. The IRS should have authority under the section 83 regs to recharacterize the transaction as a deferred compensation arrangement.

Brisendine and Veal have an article in a recent edition of the Journal of Deferred Compensation that discusses discounted options. They skillfully discuss the first two varities and ignore the last two. It is the last two that Deloitte is selling.

IMHO the benefits of a KeySOP for an executive of a for-profit entity are marginal, and the risks are substantial. Tax-exempt enetities have a different situation because of 457(f), but they still need to understand what they are buying.

[Kirk Maldonado]

IRC401:

First, I want to say that I have never implemented one of these plans for a client, so I'm not a defender of those proprietary products.

Second, it seems to me that variations 3 and 4 should be defensible, by analogy to employee stock purchase plans under Section 423. Specifically, they allow the purchase price to be floating or the lesser of. If the lesser of is permissible, then the greater of should also be permissible.

On the other hand, there is the argument that those arrangements are permissible only because they are statutorily sanctioned (by Section 423). However, I don't necessarily agree with it.

[This message has been edited by Kirk Maldonado (edited 06-11-2000).]

[This message has been edited by Kirk Maldonado (edited 06-11-2000).]

[pjkoehler]

The different versions of the KeySop program are designed to recognize the financial impact on the employer of acquiring the underlying securities as a hedge against its obligations under the agreement.

1. Leveraged Plan: the excercise price remains a fixed percentage of the FMV at grant.

2. Partially Leveraged: The exercise price is the FMV at grant increased by the company's cost of capital.

3. Unleveraged: the exercise price is a percentage of the greater of the FMV at grant or exercise.

In the Leveraged and the Partially Leveraged KeySOP, the company must recognize the "leveraging" aspect of the plan as an additional expense. Leveraging in these 2 versions derives from the fact that the participant will potentially earn more than the option's underlying investment return on the amount that s/he deferred. The Unleveraged KeySOP, insures that the participant cannot obtain a rate of return greater than the option's underlying investment return on their deferral. In addition, the Partially Leveraged and the Unleveraged KeySOP allow the employer to share in some of the upside and recoup some of the costs of the program. While the use of a totally floating exercise price may be subject to IRS challenge as a form of deferred compensation, a reveiw of Tax Court cases reveals a general resistance to recasting transactions that have been carried out in the form of options. See Victorson v. Commissioner, 326 F.2d 264 (2d Cir. 1964) aff'g 21 TCM 1238 (1962).

The Partially leveraged KeySOP probably strikes a better balance between maintaining its economic substance as a bona fide option and not creating a potential for the participant to reap disproportionately large gains. The old "restricted stock option" rules specifically permitted "variable price options," where the option price was a percentage of the FMV of the stock at any time during a period of 6 months, which includes the time the option is exercised." Code Sec. 421(d)(7) and Reg. 1.421-1(d)(2)(ii)(a). I believe D&T will provide a Tax Opinion on any of these versions, but I'm not sure whether the level of authority for the basis of the opinion varies.

[This message has been edited by PJK (edited 06-12-2000).]

[Kirk Maldonado]

PJK:

Thanks for sharing that information with us. I'm sure a lot of use will be contacted by our clients about those techniques, and it's much better to have some idea about what's going on than being hit "cold."

[IRC401]

Kirk-

It is a classic form v. substance issue. The issue is whether a product is an option for purposes of section 83 solely on the basis of form.

Suppose an employer granted an employee a fixed price option to purchase 1500 units of a mutual fund (with a $1/sh price) for $1000. It looks like an option, but suppose I add that the fund is a money market fund. Can you really have an option (within the meaning of section 83) to purchase a cash equivalent? If not, then substance must have some role to play.

Variation 3 is the economic equivalent of offering an employee the right to take deferred comp equal to the value of 700 units of his favorite mutual fund at any time that he wants plus the opportunity to purchase (with his own after-tax dollars) 300 units of the same mutual fund at the price that the fund sponsor is selling the fund to the public. In variation 4 the employee has the opportunity to purchase the 300 units at a price that will almost certainly be the same as the public price but could in theory be higher.

The value of the option privilege (or Black-Scholes value)for variation 3 is zero. For variation 4 the Black-Scholes value is negative (although it is probably zero when rounded to the nearest dollar). Therefore, variations 3 and 4 simply do not and would not exist outside of a plan of deferred compensation. They have no substance as options; they merely look like options.

Check reg 1.83-3 and ask yourself whether the IRS reserved for itself the ability to recharacterize a transaction based on the facts and circumstances. Variations 3 and 4 are economically indistinquishable from construcitve receipt, and the IRS should either kill those variations or abandon the doctrine of constructive receipt.

[IRC401]

PJK-

I just spent 20 minutes typing a response to you, and aol logged me off for inactivity.

The short version is:

The development of D&T's variations had nothing to do with financial statements. People sold what I refer to variation 3 before it was reviewed by National Tax, and when objection (both internal and external) were raised National Tax created variation 4 rather than give back money. Variation 4 is virtually economically indistinquishable from variation 3, but it looks more like an option. You are selling camouflage.

The reason why versions 3 and 4 are so popular (if they work) is that they are economically indistinquishable form constructive receipt without the adverse tax consequences.

The 421 provisions you cite are obsolete, and because they are limits on floating exercise prices, I wonder if Congress regarded floating exercise prices as an abuse 60 years ago. See my question to Kirk re: the 83 regs.

The Victorson case could (and probably should) be read as nothing more than that a taxpayer is bound by his choice of a form for a transaction but the IRS is not so bound. If Victorson had gone the other way it would have opened the door to abuseive situations.

Deloitte is (or at least was) giving a "more likely than not" opinion on variation 4 (unleveraged), which means that it believes that there is a 49.99% chance of failure.

If you were a VP in a private company with $100,000+ of deferred comp would you want a traditional plan with 30+ years of IRS rulings behind it, or the "unleveraged" plan with a 49.99% chance of immediate taxation?

[pjkoehler]

IRC 401, the principal issue with discounted stock options is at what point does the discount become so great and the exercise price so small in relation thereto that applying applying the option rules of Sec. 83 is illogical. Your are certainly right to raise this issue. KeySOPs are not your grandfather's traditional deferred compensation plan. They are in fact a new form of compensatory option (an option to acquire employer property, rather than employer stock) that relies upon logical, yet untested interpretations of the Code and regulations, as were nonqualified deferred compensation plans once upon a time. There's a certain natural symmetry in the fact that the optionholder is taking a more aggressive tax filing position in order to potentially enjoy greater distribution flexibility, freedom from "top hat" plan restrictions and reduced estate tax exposure. There's no free lunch afterall.

It should be noted that the IRS has never taken the view that constructive receipt can occur AFTER the grant of an option due to increases in the value of the optioned property, even if the exercise price eventually becomes minimal. Accordingly, it may be argued that any constructive receipt theory would be applied only to options that were deeply discounted at their date of issue. I believe D&T typically recomends no more than a 25% discount from FMV at date of grant, which is certainly not aggressive.

You should also note that that Reg. Sec. 1.83-3(a)(2), in discussing the meaning of the term "option," makes no reference to the value of the option privilege, although Sec. 1.83-7(B)(3) which addresses the meaning of "readily ascertainable fair market value" does refer to the option privilege's value. Thus, it is not free from doubt that an option's value cannot be zero or negative.

Also, I don't agree that a "more probable than not" level of authority translates into a 49.99% chance that optionholders under a prudently drafted unleveraged" KeySOP would be subject to immediate taxation on a theory that it violates the substance over form doctrine and would be affirmed by appeal to the Tax Court. It merely means that there is insufficient published authority or other guidance that would allow D&T to indicate a greater likelihood of prevailing. The more conservative approach would be to adopt a leveraged or partially leveraged plan. But you cannot say in the abstract that all unleveraged KeySOPs expose the taxpayer to the same risk of immediate taxation, regardless of the difference in their terms. Obviously, taxpayers vary in the tolerance for risk, some will push the envelope, while others take a wait and see attitude.

[This message has been edited by PJK (edited 06-13-2000).]

[IRC401]

In my first message, I described four types of KeySOPs. In my opinion the first two kinds work. This message deals with the the last two kinds.

I disagree with your description of the issue. The issue is whether a financial instrument must have economic substance as an option in order to be an option for purposes of section 83. There is no authority that resolves this issue. In my opinion: (1)the IRS reserved for itself in the section 83 regs the ability to apply a substance requirement, and (2) as a matter of public policy they should apply such a requirement or abandon the doctrine of constructive receipt. Is it good public policy to let wealthy people get around the doctrine of construcitve receipt by disquising what is clearly constructive receipt with embellishments that have no economic substance?

If (and it is an if) an option must have economic substance, then the value of the option privilege must have a positive value. If the option privilege does not have a positive value, then the "option" would not make any economic sense outside of a plan of deferred compensation, and I think that it would be reasonable for the IRS to take the position that the product is, as a matter of economic reality (as opposed to form), a plan of deferred compensation.

In the case of my variation 3 (for which you have no name although Deloitte has sold it) the discount percentage is irrelevant (do the arithmetic), and therefore, it is easy for me to take the position that the product is not an option regardless of whether the discount is 1% or 99%.

Variation 4(which you call "unleveraged")

is variation 3 with a risk (probably very small) of economic loss. It appears that you are making some sort of "haircut" argument that the potential for a loss is enough to make this an "option".

I: (1) don't regard your position as being based on a logical interpretation of the regs (because I believe that you have assumed a solution to the biggest problem), (2)don't see how the KeySOP reduces estate tax exposure (have you checked with the estate tax specialists in National Tax), (3) agree with your "not free from doubt" statement (but my lack of clear authority does not mean that you have authority), and (4) think that the only kind of unleveraged KeySOP that would not subject the taxpayer to the "same risk of immediate taxation" is one that did not provide for a cashless exercise (and as far as I know D&T is not selling those).

[pjkoehler]

IRC 401, maybe we should take our debate offline, since this is probably no longer responsive to the initial question and you seem to be on a mission to disparage an admittedly aggressive, but far from impermissible (based on current guidance), compensatory option scheme. In your initial response to this thread you referred to an article, co-authored by Tom Brisendine, describing his comments as "skilfully" incongruous with the nationwide marketing efforts of D&T, about which you apparently believe you have intimate knowledge. You failed to mention that Brisendine is a former long-term senior staff member in the Office of the Chief Counsel of the IRS who dealth with these issues while in that role, which is a somewhat less than "skilfull" effort to deflect the additional weight his comments would ordinarily receive in contrast with someone who publishes under the moniker of an irrelevant Code Section.

You assert the absence of a public policy reason that would allow "wealthy people" to try to "get around the constructive receipt doctrine," as if the issue of whether the KeySOP violates the substance over form doctrine is free from doubt. While that is a rather novel perspective, if you make a living rendering tax advice in the private sector, I suspect it isn't emblazoned on your letterhead.

[IRC401]

Just to clarify the record:

- What I disparage is Deloitte's marketing of the idea. Deloitte is, in effect, using a bait and switch tactic. They discuss this idea as if it were a fixed price option and then sell the "unleveraged" variety without discussing any difference in risks.

Deloitte has been marketing this idea for over three years, and your statement is the first admission that I've seen that the idea is aggressive. At one point Deloitte was (and may still be) using literature that uses the quote "not being risky" to describe the idea. (The same literature has misleading statements about bankruptcy law, estate planning, and FICA taxes and omits any mention of issues related to state taxation of nonresidents.)

- As for Tom Brisendine, you missed the point of my comment. Brisendine is commenting on what Deloitte isn't selling. Therefore, I conclude that your firm is trying to hide something. (If you doubt the accuracy of my statements, please show the statistics regarding how the KeySOP sales break down by type.) Next time you talk to Tom, please feel free to discuss with him what he meant when he stated at an ALI-ABA program a couple of years ago that he was troubled by some of the discounted option products.

- I do make a living rendering tax advice in the private sector, and I make it a point to try to consider all relevant tax issues before I sell an idea (or when I'm reviewing someone else's idea). The issue of form versus substance is hardly a novel issue.