Editor: Greg A. Fairbanks, J.D., LL.M.
Over the years, companies and their compensation advisers have developed creative ways to compensate executives for their services and align the executives’ interests with those of shareholders. To accomplish this, companies often grant stock options, restricted stock, and other forms of equity-based compensation to the executives.
In order to give an executive ownership in the company, some private companies have chosen to conduct a private offering that allows a select group of executives to purchase stock from the company. Because the executive will often not have enough cash on hand to pay the purchase price, the company will sometimes lend the purchase price to the executive.
The use of a loan and purchase agreement can dramatically change the income tax treatment of this stock acquisition. What is considered a simple stock acquisition with no income tax consequences can turn into a very complex situation that could give the executive and the company headaches. This item explores the possible tax treatment when an executive purchases employer stock with a loan from the employer.
ABC Company is a closely held private corporation. G has been the CEO of ABC for the past five years and has proven to be a valuable asset to the company. The shareholders of ABC have decided to allow G to purchase shares from the company for $500,000, which is the fair market value (FMV) of the shares. ABC plans to give G all the rights of ownership.
G does not have access to enough cash to pay for the stock, so ABC decides to allow G to purchase the stock in exchange for a note equal to $500,000. ABC has decided that: (1) the note should accrue interest at a market rate; (2) the stock should be collateral for the loan; and (3) the loan should be payable in full at the end of five years. ABC would like to understand the tax consequences if the loan is a nonrecourse loan (i.e., G has no personal liability) or a recourse loan (G has personal liability) and the tax treatment if ABC forgives a portion of the loan when it matures.
Why the Executive May Be Required to Recognize Compensation Income
First, ABC should understand that G may be required to recognize compensation income in this transaction. Sec. 83 governs the taxation of property, including stock, that is transferred to a service provider in connection with the performance of services. It provides that when the stock becomes vested, the service provider recognizes compensation income equal to the stock’s FMV, less any amount paid for the stock. G and ABC may not think Sec. 83 would apply to a stock sale because G paid full value for the stock. However, the IRS would most likely take the position that the stock is subject to Sec. 83 because it was transferred in connection with the performance of services. That is, G provides services to ABC, so the IRS is likely to take the position that any transfer of stock to G is in connection with the performance of services.
Regs. Sec. 1.83-3(f) provides that property transferred in recognition of past, present, or future services is transferred in connection with the performance of services. A factor that may indicate that the stock was not transferred in connection with the performance of services is that other persons were able to purchase the stock on similar terms and conditions. If G was the only person to whom ABC offered the opportunity to purchase stock, this indicates that ABC transferred the stock in connection with the performance of services.
The courts have also ruled on when stock is transferred in connection with the performance of services. In Alves, 734 F.2d 478 (9th Cir. 1984), the court ruled that employer stock purchased by an executive was subject to Sec. 83 even though the executive paid full price for the stock.
Based on the regulations and the courts’ rulings, it would appear that the stock purchased by G would be subject to Sec. 83 because the only reason he is able to purchase the stock is that he is an executive of ABC. It does not matter that G will pay FMV for the stock; the stock is still subject to Sec. 83.
A loan from ABC may be attractive to G because the terms of the loan will most likely be better than a loan he could obtain on the open market. In addition, the use of a nonrecourse loan may be attractive to G because it places no personal liability on him, although it still requires full payment of the purchase price of the stock. Instead of imposing a personal liability, the stock that G purchases is held as collateral on the nonrecourse loan. If G defaults on the loan, ABC’s only action against G is to demand that G return the stock, instead of targeting G’s personal assets for repayment of the loan.
Because the loan is nonrecourse, G can simply walk away from the stock and loan if the value of the stock decreases to a point where G believes it has less value than the payments due on the loan. For example, assume the value of the stock has declined to $300,000 when the nonrecourse loan matures. G would be required to pay $500,000 for stock that is worth only $300,000. G may therefore decide to default on the loan and allow ABC to take back the stock.
Because of this possibility, Regs. Sec. 1.83-3(a)(2) provides that if the amount paid for the transfer of stock is an indebtedness on which there is no personal liability to pay all or a substantial part of the indebtedness (i.e., a nonrecourse loan), the transaction may be treated as the grant of an option to purchase the stock. This regulation has a major impact on the tax treatment of G’s purchase. G may think he holds stock in ABC (and legally he does hold the stock), but he is treated for tax purposes as holding an option to purchase the stock. As discussed below, rather than the taxation event under Sec. 83 occurring on the date the employee acquires the stock, the taxation event will occur when the option is deemed exercised. As discussed later, this could result in unexpected compensation income for G.
Regs. Sec. 1.83-3(a)(2) does not state that the transaction will be treated as the grant of an option but rather provides that it may be treated as the grant of an option. The determination of whether an option has been granted is based on the substance of the transaction. Regs. Sec. 1.83-3(a)(2) provides three factors that should be considered:
- 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 be paid. As for the type of property involved,
G holds ABC stock with the same rights as the other shareholders, which include voting, dividend, and liquidation rights. In addition, unless ABC places forfeiture restrictions on the stock, G may transfer it. In Tuff, 469 F.3d 1249 (9th Cir. 2006), the court ruled that such characteristics of the property would indicate that an option does not exist. However, it is not clear how the court would have ruled if the taxpayer’s rights in the stock were restricted based on a vesting schedule.
If the risk that the property will decline in value has not been transferred, a factor is present that would indicate an option has been granted. G does not have any risk that the property will decline in value because if the value of the stock does decline, G can walk away from the stock and the loan without any personal obligation to pay for the stock or repay the loan. Therefore, this factor appears to indicate that ABC has granted an option.
The third factor is the likelihood that the purchase price will be paid. It is difficult to determine this at the time of the transaction. The IRS may argue that because G did not have the means to pay for the stock on the acquisition date, the likelihood of his having the means to repay the loan is low. Therefore, this factor may indicate that an option has been granted. However, G and ABC could make an argument that G would pay the purchase price from the stream of income that he will earn from ABC or other financial resources.
If it is determined that the transaction is treated as the granting of an option to purchase the stock, the tax treatment under Sec. 83 will differ greatly from the treatment if the transaction were considered an outright purchase of the stock. In the latter instance, the stock is subject to Sec. 83. However, because the stock was vested when G purchased it, the taxable event under Sec. 83 would occur on the purchase date. G would recognize income equal to the difference between the stock’s FMV and the amount paid for the stock. The stock’s FMV is $500,000, and the amount paid for the stock is $500,000 (the value of the note transferred to ABC). Therefore, G would recognize $0 compensation income.
Alternatively, if the transaction is treated as the grant of an option to purchase the stock, the taxation event under Sec. 83 will not occur until the option is deemed exercised. How the deemed exercise date is determined is unclear under the Sec. 83 regulations, and neither the IRS nor the courts have ruled on this matter. Regs. Sec. 1.83-3(a)(2) provides that the option treatment may apply when there is “no personal liability to pay all or a substantial part” of the loan. This may mean that once enough of the loan balance has been repaid, the option is deemed exercised.
However, given the lack of guidance, it is not possible to conclude what constitutes a “substantial part” of the loan. This represents an area of Sec. 83 that is open to interpretation. Some practitioners believe that repaying 50% of the loan is enough to have a deemed exercise, while others believe an amount substantially greater than 50% is needed to have a deemed exercise. Other practitioners believe that an amount substantially lower than 50% is sufficient.
Assume that G does not repay any portion of the loan until it matures in year
5. In that circumstance, it appears that he will be deemed to have exercised the option in year 5 when the loan is repaid. On that date, the stock will be considered transferred to G for tax purposes. Assume that the FMV of the stock in year 5 is $800,000. When G repays the $500,000 nonrecourse loan, he will be treated as having paid the $500,000 for the stock. G would be required to recognize $300,000 ($800,000 FMV of the stock less $500,000 amount paid) of compensation in year 5 under Sec. 83, which is a very unfavorable tax consequence.
Full Recourse Loan
The use of a full recourse note to purchase the stock would allow ABC to target G’s personal assets to obtain full repayment of the note if G were to default on the loan. This means that G would have a personal obligation to repay the loan. This differs from a nonrecourse loan because, as discussed above, ABC would be able to collect or retain only the stock that was held as collateral under the nonrecourse loan.
If ABC allows G to issue a full recourse note in exchange for the stock, the recourse loan is treated as an amount paid for the stock. Provided that the stock is vested when acquired by G (i.e., not subject to forfeiture restrictions) and the amount of the loan is equal to the FMV of the stock purchased, G will not recognize any compensation income with respect to the stock. Any modification of the loan, such as the forgiveness of all or a portion of the loan, may result in G’s recognizing compensation income, as discussed below.
Forgiving All or a Portion of the Loan
Assume that because of G’s continued efforts for the company, ABC decides in year 5 to forgive $200,000 of the loan. G would then be required to repay only $300,000. Regs. Sec. 1.83-4(c) describes the rules in the context of Sec. 83 when a loan is forgiven. It provides that if a loan that has been treated as an amount paid for stock is subsequently canceled, forgiven, or satisfied for an amount less than the amount of the loan, the amount that is not in fact paid is treated as compensation income to the employee in the tax year that the cancellation, forgiveness, or satisfaction occurs. The regulation does not distinguish between a nonrecourse loan and a recourse loan for this purpose. As discussed above, for purposes of Sec. 83, a loan is treated as an amount paid for the stock at different dates based on the type of loan and how the stock acquisition is treated under Sec. 83. Therefore, the income tax treatment under Sec. 83 will differ based on the treatment of the transaction.
First, consider a situation in which the loan is a nonrecourse loan and G’s acquisition of the stock is treated under Regs. Sec. 1.83-3(a)(2) as the grant of an option to purchase the stock. In G’s situation, the exercise of the option occurs in year 5 when he repays the loan, and that is when the loan repayment is treated as an amount paid for the stock. G repays $300,000 of the loan and ABC forgives $200,000 of the loan. G is treated as paying $300,000 for the stock. If the stock’s FMV is $800,000 in year 5, G will recognize $500,000 ($800,000 stock FMV less $300,000 amount paid) of compensation income in year 5 under Sec. 83.
Next, consider a situation in which G’s acquisition of the stock with a nonrecourse loan is treated as an outright purchase of the stock, rather than the grant of an option to purchase the stock. In year 1, the $500,000 loan is treated as an amount paid for the stock. Because the FMV of the stock on that day is $500,000, G does not recognize any compensation income. In year 5, when ABC forgives $200,000 of the nonrecourse loan, G will recognize $200,000 of compensation income because the full $500,000 was originally treated as an amount paid for the stock, but G was required to repay only $300,000 of the loan.
The tax treatment under Sec. 83 is the same for a recourse loan as described above for a nonrecourse loan that was treated as an amount paid for the stock when it was acquired in year 1. Any amount of the loan that ABC forgives in year 5, or any year prior to year 5, is compensation income to G in the year that the amount is forgiven.
Rules Are Applicable Only to Loans from the Employer
The rules discussed above for loans apply only if the employer provides the loan to the executive. If the executive receives a loan from a third party, such as a bank, and pays the cash from the loan to the employer for the stock, the taxation event under Sec. 83 will apply on the day the stock is transferred and the amount is paid for the stock, provided that the stock is vested. The courts (for example, the Ninth Circuit in Tuff ) have ruled on several occasions that the option treatment under Regs. Sec. 1.83-3(a)(2) applies only if the nonrecourse loan is from the employer.
The Sec. 83 rules for loans discussed above are often overlooked when a company allows an executive to purchase its stock with the proceeds of a loan from the company. It may be years later when a tax adviser reviews the transaction and raises the possibility of option treatment under Sec. 83. When option treatment applies, the executive will be required to recognize ordinary compensation income in the future if the stock has risen in value. This may come as a great surprise to the executive, who is expecting capital gain treatment on the appreciation in stock value. In order to avoid surprises, it is important for tax advisers to understand the rules and communicate them to their clients. Executives and their employers would surely rather understand the tax rules up front than be surprised years later.
Greg Fairbanks is a tax manager with Grant Thornton LLP in Washington, DC.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.For additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or firstname.lastname@example.org