Using Stock Warrants as Consideration

Editor: Howard Wagner, CPA

Tax Accounting

The tax treatment of compensatory stock options issued to employees in connection with the performance of services and lending transactions is long settled. What is less clear is the treatment of stock options issued in other commercial transactions. Recent Tax Court litigation involving Google Inc. and America Online Inc. (AOL) provides insight into how the IRS views these transactions.

Background

In May 2002, AOL entered into agreements with Google to make Google AOL’s exclusive supplier of paid and unpaid search services. Under the agreements, Google issued AOL a warrant for the right to purchase shares of Google’s series D preferred stock to induce AOL to select Google as its search provider. At the time of issuance, Google was a privately held company. In May 2004, AOL exercised the warrant at a cost of $21.6 million. Upon Google’s IPO in August 2004, the series D preferred stock was converted into Google common stock. Later that month AOL sold 2.35 million common shares for $195 million. During 2005, AOL sold the remaining 5 million shares for $940 million.

Google maintained that it issued the warrant in connection with the performance of services by AOL, and accordingly, it took the position that Sec. 83 governed the transaction. Google also asserted that the fair market value (FMV) of the warrant was not readily ascertainable at the date of grant in accordance with Regs. Sec. 1.83-7. Applying Sec. 83 treatment, Google claimed a tax deduction for $238 million in 2004, the year AOL exercised the option. The $238 million deduction represented the excess of the stock’s FMV over AOL’s exercise price.

Conversely, AOL took the position that Google provided the warrant as consideration to induce AOL to choose Google as its service provider rather than as compensation for services. Under this treatment, AOL should have recognized income of $37 million upon receipt of the warrant, which it asserted was the FMV of the warrant on the date of the grant. AOL did not report any income upon exercise of the option, recognizing income only when it ultimately sold the stock.

The IRS has raised the treatment of the warrant in audits of both AOL and Google, taking opposing positions in each instance. Each taxpayer has filed a petition with the Tax Court challenging the IRS notice of deficiency (Google, Inc., No. 014061-13 (petition filed 6/21/13); Time Warner Inc., No. 009927-13 (petition filed 5/6/13)). Determining whether Google issued the warrant to AOL in connection with the performance of services is paramount, as the tax rules provide for different treatment of warrants depending on whether they were issued in connection with the performance of services.

Warrants Issued in Connection With the Performance of Services

Sec. 83(a) provides that if property is transferred in connection with the performance of services, the excess of the FMV of the property over the amount the recipient paid for the property generally is taxable income to the service provider in the first tax year in which the property is transferrable or not subject to a substantial risk of forfeiture. Sec. 83(h) states that the issueris entitled to a deduction equal to the amount of the income the service provider realized in the tax year that includes the year end in which the service provider realized the income.

Regs. Sec. 1.83-7 provides the general rule for the taxation of stock options issued in connection with the performance of services. The regulation provides that Sec. 83(a) applies to the grant of a stock option only if the option has a readily ascertainable FMV on the grant date. If the option does not have a readily ascertainable FMV on the date of the grant, Sec. 83(a) provides that the service provider recognizes income, and the issuer of the option is permitted a deduction, when the option is exercised or disposed of, even though the option’s FMV may have become readily ascertainable before that time.

Regs. Sec. 1.83-7(b) acknowledges that options have a value at the time they are granted, but that value ordinarily is not readily ascertainable unless the option is actively traded on an established market. If the option is not actively traded on an established market, the option is not considered to have a readily ascertainable FMV when granted, unless all of the following conditions exist:

• The option is transferrable by the optionee;
• The option is exercisable immediately in full by the optionee;
• The option or the property subject to the option is not subject to any restriction or condition that has a significant effect on the FMV of the option; and
• The FMV of the option privilege is readily ascertainable, considering whether the value of the property subject to the option can be ascertained, the probability of any ascertainable value of the property increasing or decreasing, and the length of the period during which the option can be exercised.

Under these provisions, warrants issued by private companies in connection with the performance of services generally are not taxable at the time of grant under Sec. 83, unless the options are deemed to have a readily ascertainable value by meeting the requirements of Regs. Sec. 1.83-7(b). If the warrants do not have a readily ascertainable FMV as of the date of grant, the taxable event and corresponding deduction is deferred until the warrants are exercised, even if the warrants’ FMV becomes readily ascertainable before that time. For warrants issued in connection with the performance of services that do not have a readily ascertainable value at the time of grant, the service provider recognizes income, and the issuer receives the corresponding deduction (if allowed under Sec. 162), at the time of exercise. The amount of income recognized is the excess of the FMV of the property received upon exercise of the warrant over the amount the service provider paid for that property.

In Connection With the Performance of Services

For Sec. 83 to apply, the warrants must have been issued in connection with the performance of services. While no definition for the term “performance of services” or “services” exists in Sec. 83, Regs. Sec. 1.83-3(f) provides:

Property transferred to an employee or an independent contractor (or beneficiary thereof) in recognition of the performance of, or [the] refraining from performance of, services is considered transferred in connection with the performance of services within the meaning of section 83. The existence of other persons entitled to buy stock on the same terms and conditions as an employee, whether pursuant to a public or private offering may, however, indicate that in such circumstances a transfer to the employee is not in recognition of the performance of, or the refraining from performance of, services. The transfer of property is subject to section 83 whether such transfer is in respect of past, present, or future services.

The courts have ruled in Bagley, 85 T.C. 663 (1985), and Kowalski, 434 U.S. 77 (1977), that the determination of whether property is transferred in connection with the performance of services is based on the facts surrounding the transaction. In Bank of America, 680 F.2d 142 (Ct. Cl. 1982),the court held that the performance of services was not the predominant feature of the transaction and should be treated as ancillary to the transaction’s true motivation. In that case, Bank of America received acceptance and confirmation commissions that the court determined were for the substitution of its own credit for that of the foreign bank, and thus analogous to interest and not for any services provided. Over the years, this precedent has been applied to similar cases where the application of Sec. 83 has been in question.

Typically, courts have found that Sec. 83 applies to property transferred in connection with the performance of services when there is an identifiable employer-employee relationship, even in cases where the property is transferred at FMV (see Alves, 734 F.2d 478 (9th Cir. 1984)). In Centel Communications Co., 92 T.C. 612 (1989), the court found that the transfer of stock warrants in connection with personal guarantees of debt by shareholders was not subject to Sec. 83. The court held that the assumption of additional financial risk in their capacity as shareholders was the predominant feature that led to the issuance of stock warrants and, as a result, Sec. 83 did not apply to the transaction.

In Technical Advice Memorandum 9737001 the IRS determined that stock and options issued to cable operators by a television program producer to assure that the operators would devote cable channels to their programming were not issued in connection with the performance of services. In the analysis, the IRS concluded that the performance of services was not the predominant feature of the transaction, and thus Sec. 83 did not apply.

Taxpayers must look to the nature of the transaction to determine whether the property transferred was in connection with the performance of services and that the performance of those services was the predominant feature of the transaction, because no definition for the terms “services” and “performance of services” exists under Sec. 83, and the courts have determined the definitions are a question of fact.

Warrants Not Issued in Connection With the Performance of Services

Only warrants issued in connection with the performance of services are subject to Sec. 83 and the readily ascertainable valuation requirements of Regs. Sec. 1.83-7. If it is determined that Sec. 83 does not apply, warrants are taxable to the recipient on the date of the grant. Regs. Sec. 1.1001-1(a) provides, in part, that “the gain or loss realized from the conversion of property into cash, or from the exchange of property for other property differing materially either in kind or in extent is treated as income or as loss sustained. . . . The fair market value of property is a question of fact, but only in rare and extraordinary cases will property be considered to have no fair market value.” Under this regulation, it appears unlikely that a taxpayer could successfully argue that a warrant has no ascertainable FMV, since the additional requirements imposed by Regs. Sec. 1.83-7 do not apply. In a case involving warrants not issued in connection with the performance of services, Kimberlin,128 T.C. 163 (2007), the court ruled that the application of prudent valuation techniques was sufficient for establishing the FMV of the warrants at the date of the grant.

Conclusion

Analyzing the facts surrounding the issuance of warrants outside of the traditional lending or employer-employee relationship is vital, as the timing, amount, and character of the income and deduction vary depending on whether the issuance was in connection with the performance of services. To attempt to remove any ambiguity regarding the transaction’s proper tax treatment, taxpayers entering into these transactions should have written documentation agreed upon by all parties identifying whether the warrants are issued in connection with the performance of services. In the event that the parties agree that the issuance of warrants was not in connection with the performance of services, they should obtain a formal valuation and include it in the agreement. While it remains to be seen how the Tax Court will rule, the AOL and Google cases nonetheless provide taxpayers further insight on the application of Sec. 83 to the issuance of stock options in a commercial transaction.

EditorNotes

Howard Wagner is a director with Crowe Horwath LLP in Louisville, Ky.

For additional information about these items, contact Mr. Wagner at 502-420-4567 or howard.wagner@crowehorwath.com.

Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.