In early 2002, Congress enacted the Sarbanes-Oxley Act, P.L. 107-204 (SOX), in response to accounting scandals of public companies including Enron, Worldcom, Tyco, and others. This legislation had widespread impact on how companies conduct and report their business affairs. One of its provisions prohibited companies from making loans to their directors and/or executive officers (SOX §402(a)). This provision is rather broad and prohibits both direct and indirect loans and arranging or extending credit for directors and/or executive officers. SOX allowed existing loans to remain outstanding as long as no modifications were subsequently made.
In 2004, the IRS issued Rev. Rul. 2004-37, which addressed certain modifications of employee debt by the employer. Specifically, the ruling discussed modification of recourse debt used by an employee to satisfy the exercise price of a nonqualified stock option. The ruling concluded that subsequent modifications of this debt would result in compensation income to the employee rather than a nontaxable adjustment to the basis of the stock acquired in the exercise.
The effective date of the SOX prohibition on loans to directors and/or executive officers is July 30, 2002. The IRS issued Rev. Rul. 2004-37 over a year and a half later on February 25, 2004. The ruling could still apply to loans made to employees before July 30, 2002, which are available for adjustment under the statute, but what impact did the ruling actually have by the time it was issued? The authors have heard several tax professionals and one of the ruling’s co-authors, Jean Casey, suggest that the ruling is no longer relevant in light of the SOX prohibition.
Did SOX nullify Rev. Rul. 2004-37 before it was even issued? This item will discuss the prohibition on loans and loan modifications in SOX and the tax consequences of loan modifications in Rev. Rul. 2004-37. It will also show that the ruling is still relevant and discuss situations in which the ruling could affect taxpayers.
Sarbanes-Oxley Act of 2002The Sarbanes-Oxley Act made sweeping changes to the way businesses conduct and report their business activities. One of its provisions dealt with employers making loans to employees. SOX §402(a) provides that publicly traded companies cannot make personal loans to directors or executive officers (Securities Exchange Act of 1934 (1934 Act) §13(k)(1)). Specifically, the act provides that companies cannot extend or maintain credit, arrange for the extension of credit, or renew an extension of credit either directly or indirectly to any director or executive officer.
SOX does include exceptions, though they are very limited. First, any extension of credit that existed on the enactment date is not prohibited, subject to the act’s provisions, but material modifications to that debt on or after the enactment date are prohibited (1934 Act §13(k)(1)). The second type of loan that is outside this prohibition is an extension of credit by a securities firm to a director or executive officer that is made in the ordinary course of the company’s business if that loan is
- Of a type made available to the public, and
- Made on terms that are no more favorable to the director and/or executive officer than to the public.
The prohibitions extend to “issuers,” as defined in SOX. Essentially, issuers are publicly traded companies and others that issue securities required to be registered under the 1934 Act (SOX §2(a)(7); 1934 Act §3). Note that companies that are not traded publicly but that issue registered debt or other security instruments are included. Privately held companies that do not issue debt or other security instruments are not affected by this new prohibition.
The parties affected by the SOX loan prohibition are limited to the company’s directors and executive officers. “Directors” refers to members of a public company’s board of directors or its equivalent. While the §402 prohibition does not define the term “executive officer,” the prohibition was added to §13 of the 1934 Act, and therefore the definition set forth in SEC Rule 3b-7 should apply.
Rule 3b-7 defines an executive officer of an issuer as its president, any vice president in charge of a principal business unit, division, or function (such as sales, administration, or finance), any other officer who performs a policy-making function, or any other person who performs similar policymaking functions for the issuer. (Note that §16(a) of the 1934 Act contains similar rules for determining who is an officer required to meet reporting obligations set forth in the 1934 Act.) While the SOX prohibition focuses on directors and executive officers, who are the most likely to receive a loan from the company, it is possible that the company could make loans to individuals not included in this definition.
Taxation of Stock Options Addressed in Rev. Rul. 2004-37Rev. Rul. 2004-37 provides guidance for employers and employees who modify debt agreements for recourse debt that was originally used to satisfy the exercise price of a nonstatutory stock option. Specifically, the ruling gives an example of an employee who uses recourse debt to pay the exercise price when exercising a stock option. The debt is later reduced by the employer, and the ruling concludes that the employee has compensation income in the year of the reduction.
Tax Consequences of Recourse Debt ModificationsSignificant modifications defined: Under Sec. 61(a)(12), a reduction in the amount of the debt will result in discharge of indebtedness income to the debtor unless another provision characterizes the modification differently. Other modifications may also result in income. Regs. Sec. 1.1001-3 provides guidance for measuring the amount of the modification. Under Regs. Sec. 1.1001-3(b), a debt modification is an exchange (and therefore may result in income recognition) if the modification is significant.
A modification is defined very broadly to include <emany< />alteration of a legal right or obligation, whether written, oral, or simply indicated by the parties’ conduct (Regs. Sec. 1.1001-3(c)). This applies to additions or deletions of rights or obligations in whole or in part. This broad definition of modifications could include alterations such as extending the repayment period, removing an indemnification clause, or changing the priority of debt relative to other debt.
For the modification to be considered significant, it must be economically significant. Guidelines for making that determination are outlined in the regulations (Regs. Sec. 1.1001-3(e)). As the types of modifications vary, the specific tests also vary and are not discussed in detail here. If, however, the tests indicate that the modification is significant, an exchange of the unmodified debt (old debt) for the modified debt (new debt) has occurred, and the employee will have income equal to the excess of the value of the old debt over the value of the new debt.
If the modification is considered significant and the employee recognizes income, the employer will have a corresponding deduction. The deduction will be available in the same tax year in the year of the modification (Secs. 161 and 162).
Compensation income from the modification of recourse debt: Rev. Rul. 2004- 37 addresses when compensation must be recognized as a result of debt modification by presenting an example of an employee who previously issued a recourse note to his employer to exercise a nonstatutory stock option. In the scenario given, the employee and the employer subsequently agree to a reduction in the note’s principal amount. The revenue ruling indicates that as a result of the modification, the employee has compensation income in the amount of the reduction, and this income is subject to FICA, FUTA, and federal income tax withholding.
Rev. Rul. 2004-37 specifically states that compensation income recognition would also apply to other debt modifications. Examples of other modifications that could trigger income to the employee specifically mentioned in the ruling are reductions in the note’s interest rate or a change from recourse to nonrecourse debt. The revenue ruling does not give an exhaustive list of changes that would cause compensation income recognition but instead provides guidelines for determining whether the modification will result in income.
According to one of the ruling’s authors (during a phone conversation on February 28, 2005), the ruling was issued in response to multiple requests from field agents for guidance. It seems that taxpayers wanted to treat the debt modification as a purchase price adjustment, which would in turn adjust their basis in the stock acquired. This would result in deferring income recognition until the stock is sold and changing the character of the amount recognized from ordinary income to capital gain. This treatment also succeeds in removing the income from FICA, FUTA, and federal income tax withholding requirements.
The ruling discusses two possible treatments for this debt modification—compensation under Sec. 83 and purchase price adjustment under the Sec. 108 debt forgiveness rules—and explains the applicability of each section’s provision. The arguments contained in the ruling are explained below.
Sec. 83Even before Rev. Rul. 2004-37, it appears that if there was a significant debt modification the recognition of compensation was unavoidable. In general, Regs. Sec. 1.83-4(c) provides that if any debt treated as an amount paid as consideration for stock in an exercise under Sec. 83 is later cancelled, forgiven, or settled for less than the amount due, the amount not paid will be included in the employee’s gross income in the year in which the cancellation, forgiveness, or satisfaction occurs. This income will be considered compensation under Sec. 83, and the employer will be allowed a corresponding deduction under Sec. 162. Since the income is treated as compensation income to the employee, it will be subject to employment taxes and federal tax withholding.
In such situations, the employer can deduct as compensation expense the amount the employee must include as compensation income. In addition, the employer must withhold federal income taxes and FICA taxes on the income even though it was not paid in cash (Regs. Secs. 31.3121(a)-1(e), 31.3306(b)-1(e), and 31.3401(a)-1(a)(4)). The employer could withhold federal income taxes and FICA taxes from other cash earnings of the employee, the employee could remit them to the employer, or the employer could pay these “withholdings” on behalf of the employee and treat the payment as additional income to the employee.
Sec. 108Under Sec. 61, gross income includes income from cancellation of indebtedness. Sec. 108 provides an exception if the taxpayer is in bankruptcy or is insolvent. Essentially, the income that would have been recognized due to forgiveness of the debt is not recognized to the extent that the debtor is insolvent or if the debt is forgiven in bankruptcy.
An additional exception to the general rule of Sec. 61 is provided in Sec. 108(e)(5) for transactions between a purchaser and a borrower or between a seller and a lender. This subsection provides that if the debt being forgiven was originally part of the purchase price of property, the subsequent forgiveness of the debt is treated as a purchase price adjustment, e.g., a reduction of the basis of the property purchased. This additional exception applies to solvent debtors, and its treatment is limited to debt reductions that otherwise would be treated as income to the purchaser from the discharge of indebtedness within the meaning of Sec. 61(a)(12). However, debt discharge that is only a medium for some other form of payment, such as a salary, is treated as that form of payment rather than under the discharge of indebtedness rules (S. Rep’t No. 96-1035, n. 7, 96th Cong., 2d Sess. (1980), reprinted in 1980 U.S.C.C.A.N. 7017).
Does Rev. Rul. 2004-37 Still Matter?As discussed above, SOX forbids loans to directors and executive officers of publicly traded companies. Since private companies would not generally use stock options as a form of compensation, the ruling would appear to have little applicability after the enactment of SOX. This sentiment was even expressed by the ruling’s co-author during a phone conversation about the ruling. However, there are several situations in which the ruling is still relevant and could affect the tax treatment of loan modifications to debt owed by an employee to an employer.
Two recent studies of publicly held companies found that a significant number of executive loans existed both before and after the implementation of SOX (Hodgson, The Low-Carb Corporate Loan (The Corporate Library 2004), and Hodgson, My Big Fat Corporate Loan (The Corporate Library 2002)). Surprisingly, these studies indicate that loans to acquire property other than stock are more common than loans to acquire or retain stock. Stock loans were classified as stock retention, stock purchase, or stock option exercise.
The loans that were clearly indicated as property loans were both relocation loans, which included house purchases, and house purchases as a separate category. Other property loans may have been included in the categories described as “unspecified” or “other.” The number of loans in these two categories combined is approximately the same as the stockrelated loans. This category could include additional property loans.
If any of these property-related loans were for purchases made directly from the company, Rev. Rul. 2004-37 would still apply to prohibit treatment of debt modification under Sec. 108(e)(5) and would require that compensation income be recognized as a result of cancellation or forgiveness of the debt. The provisions of Sec. 108(e)(5) will not be applied when the debt discharge is only a medium for some other form of payment, such as a salary. In the instant case, the cancellation is treated as compensation income rather than under the discharge of indebtedness rules (S. Rep’t No. 96-1035, n. 7; Regs. Sec. 1.61-12(a)).
Based on the above, it is reasonable to assume that public companies continue to make loans to employees not covered by the SOX prohibition. Since the SOX prohibition applies only to directors and executive officers, other employees in the company could still be borrowing money from the company or financing purchases with the company. The guidance in the revenue ruling would also apply to any of these loans. In the event that the employee purchased property from the company and used debt to do so, the employee cannot use Sec. 108(e)(5) to reduce the basis of the property purchased rather than recognize compensation income when the terms or amount of the debt are modified.
Nonpublic companies are also likely to be making property-related loans. Many smaller companies are delisting their stock and “going private” in response to the SOX requirements (see Carroll, “Thinking Small: Adjusting Regulatory Burdens Incurred by Small Public Companies Seeking to Comply with the Sarbanes-Oxley Act,” 58 Ala. L. Rev. 443 (2006); Gibeaut, “Private Drive: New Twists in Sarbanes-Oxley May Compel More Smaller Companies to Exit the Market,” 91 A.B.A.J. 20 (January 2005)). The internal control documentation requirements are simply too costly and difficult for these smaller firms to comply with. Firms that have always been private are often family owned or closely held. Both types of privately held companies are probably as likely as publicly held companies were (before SOX) to make loans to executives and officers because they are not prohibited from doing so by SOX. In these companies, the loans would more likely be for outright purchases of stock rather than exercising stock options. The definition of officers and directors also leaves many other employees eligible to borrow money from the company for a number of purposes.
ConclusionLoans to employees other than executive officers are not prohibited by SOX. Both pubic and nonpublic companies continue to make loans to these employees. When modifications of recourse debt are granted to employees, the guidance provided in Rev. Rul. 2004-37 applies. Employers should be aware of the tax consequences associated with significant modification of debt owed to them by employees, including the requirement to collect tax on amounts deemed compensation, even if that compensation is in the form of something other than money. Rev. Rul. 2004-37 requires that an employee recognize compensation income upon the significant modification of the terms or amount of a loan from an employer. While the ruling specifically addressed recourse debt used by an employee as payment of the exercise price of an option, the provisions of the applicable Code sections can be applied to loans granted to employees for other purposes. The rules regarding the tax treatment of gains recognized by significant debt modification when employees are solvent are found in Secs. 61(a)(12) and 108(e)(5). However, these sections apply only where, but for the application of Sec. 108(e)(5), the income would be discharge of indebtedness income. When a modification to the principal amount of debt produces a significant change in the debt’s yield, or when there is an exchange of an unmodified note for a modified note, there may be tax consequences for both the employee and the employer (Regs. Sec. 1.1001-3(e)(1)). The amount of the debt that is not paid is includible in the employee’s taxable income and is deductible as compensation by the employer.
Kevin F. Reilly, J.D., CPA, is a member of PKF Witt Mares in Fairfax, VA.
Unless otherwise noted, contributors are members of or associated with PKF North American Network.
For additional information about these items, contact Mr. Reilly at (703) 385-8809 or firstname.lastname@example.org.