Exercise of Options Using Borrowed Funds

By Jim Maio, CPA, San Diego, CA

Editor: Kevin F. Reilly, J.D., CPA

Under Sec. 83(a), if property is transferred in connection with the performance of services, the employee who performed the services has gross income in an amount equal to the excess of the fair market value (FMV) of the property over the amount paid for the property. Sec. 83(a) also states that both the income event and the measurement of FMV of the property occur only when the property is first either transferable or not subject to a substantial risk of forfeiture. Under Regs. Sec. 1.83-3(a)(1), a transfer of property occurs when a person acquires a beneficial ownership interest in such property. When property is received in the form of a nonqualified stock option, Sec. 83(e)(3) requires that the option must have a readily ascertainable FMV to be taxed to the employee at grant.

In Racine , 7/3/07, the Seventh Circuit addressed the issue of when a transfer occurs for Sec. 83 purposes. The decision provides a cautionary tale for taxpayers who use nonrecourse debt to finance the exercise of their stock options.

Facts

Racine was employed by a large telecommunications company during the 2000 tax year. As part of her compensation package, she was granted nonstatutory employee stock options that were not actively traded on an established market. From March–July 2000, she exercised options to purchase 25,257 shares. The exercise price was $58,811, and the FMV of the shares at the time of exercise was $1,972,706. The company remitted about $625,000 in income tax withholding on her gain of over $1.9 million and demanded reimbursement from her before it would give her clear title to the shares. To finance the exercise price and the tax, Racine borrowed about $684,000 on margin from a market-maker broker.

Soon after the option exercise, the FMV of the stock began to plummet and the broker issued margin calls. In November 2000, Racine sold 18,291 shares at $15.61 per share, and in May 2001 she sold 1,836 shares at $20.41 per share.

On her 2000 return, Racine claimed a $368,000 refund, asserting that the shares were transferred to her when they were sold in November 2000 and May 2001 and not at exercise. The IRS granted the refund but demanded the money back after an audit. The Tax Court agreed with the Service and concluded that the refund was issued in error and that Racine should pay back more than $500,000.

Regs. Sec. 1.83-3(a)(2) provides that in a purchase transaction, if the amount paid for property is in whole or in substantial part indebtedness secured only by the acquired property (i.e., nonrecourse debt), the transaction may be viewed as the equivalent of the grant of an option. Thus, the regulations take the position that the acquisition of property with nonrecourse debt may not constitute a transfer of the property so acquired.

Seventh Circuit Decision

On appeal, Racine argued that buying stock with borrowed money is like replacing one option with another: As long as a broker supplies the capital, the taxpayer has nothing at risk and can walk away freely, allowing the broker to sell the collateral in the market to cover the loan.

In her argument, Racine reasoned that the nonrecourse nature of the debt (as provided in Regs. Sec. 1.83-3(a)(2)), combined with the fact that none of her capital was at risk (as provided in Regs. Sec. 1.83-3(a)(6)), make her transaction look like Regs. Sec. 1.83-3(a)(7), Example (2), in which a nonrecourse loan works like an option by allowing an em-ployee to capture any gain in the stock’s value without taking a risk of loss.

According to Racine, Congress intended to deny capital gains treatment to those who do not make any capital investment in their options; see Palahnuk, 70 Fed. Cl. 87, 92 (2006). Thus, Racine concluded that because she exercised her options using a loan from a market-maker broker, she had no capital at risk and therefore no transfer occurred until the market-maker broker sold the stock to satisfy the margin calls on her account.

The Seventh Circuit affirmed the decision of the Tax Court and held that a transfer occurs when a taxpayer exercises an option and acquires full legal and beneficial ownership of stock. The court determined that the margin loan in question was not a nonrecourse debt and that Racine bore the risk of loss. The court further disagreed with Racine’s analogy of her situation to that described in Regs. Sec. 1.83-3(a)(7), Example (2), which the court said dealt with whether the investor bears the risk that the price of the asset at issue will decline and not whether the risk is to the investor’s other assets. The court also indicated that the holder of a call option (unlike Racine but like the employee in Example (2)) cannot lose because he or she can walk away from the option if the price declines. In addition, the court noted that Sec. 465, which limits business expense deductions to amounts at risk, does not define transfer for purposes of Sec. 83.

The crux of the Seventh Circuit’s ruling was that Racine bore the risk of loss at all times and never made a serious attempt to reduce her financial exposure to the possibility that the stock could drop in price. The court commented that if Racine wanted to reduce her exposure she could have hedged with put options, sold the stock and invested in a diversified portfolio, or withdrawn the money from the stock market altogether.

Observations

This case highlights three courses of action an individual taxpayer should consider when deciding to exercise nonstatutory stock options that do not have a readily ascertainable FMV at the date of grant if the taxpayer does not have enough money to fund the exercise of the options.

The first consideration would be to create an arrangement under which the shares could be obtained and sold instantaneously and the proceeds from the sale could be used to finance the exercise price. In Racine’s case she held on to the shares after obtaining them and as such fell into a classic whipsaw when the price of the stock declined.

If such an arrangement is not possible, a second alternative would be to finance the exercise price with nonrecourse debt; the holder of property purchased with such debt generally has no risk that the property will decline in value unless (and until) he or she puts his or her own capital into the transaction. However, it is important to note that the test for transfer status when using nonrecourse debt becomes unclear as the borrower makes payments on the debt. As payments are made and the debt becomes smaller, the risk of decline in stock value is gradually shifted to the borrower, and he or she eventually takes on the role as true beneficial owner of the property.

Finally, if a taxpayer chooses to take Racine’s course of action and finance the exercise with a margin loan, the risk should be mitigated as soon as possible. Whether, as the court said, by hedging with put options or by withdrawing the money from the stock market altogether, the taxpayer should formulate and employ a strategy to lessen the exposure that would be created by a substantial decrease in the price of the stock.

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