Use of Corporate Partner Stock and Options to Compensate Service Partners -- Part 2 by: Sheldon I. Banoff As described in the first part of this article, 1 key executives of partnerships in which a corporation is a partner, and who receive ownership interests in and provide services to the partnership (rather than the corporation) ("service partners" 2 ) also may receive, as part of their compensation arrangements, restricted and unrestricted stock, nonqualified stock options (NQSOs), and stock appreciation rights (SARs) in the corporation. Among other benefits, use of corporate stock-based compensation can provide deductibility by the partnership without cash outlay, and without taxable gain being reported by any of the partners with respect to the stock. Relevant tax consequences to the service partner, the corporation, and other members with respect to such equity-based compensation include: The timing and amount of income recognition by the service partner. The service partner's ability to obtain favorable capital gains treatment on appreciation in value of the equity-based compensation. The timing and amount of the partnership's compensation deduction. The potential recognition of gain by the corporation (with respect to the stock or options used to compensate the service partner). The potential recognition of gain (or loss) by the other partners. The partners' various tax consequences with respect to equity-based compensation have not been fully resolved. As discussed in Part 1, uncertainty exists with respect to the timing of the partnership's deduction and the service partner's income recognition, depending upon whether Section 83 or 707(c) applies. Part 1 also identified three different approaches to dealing with the so-called "zero basis problem" that potentially arises upon the actual or deemed transfer of the corporation's stock (assumed to have zero basis) stock by the partnership to the service partner - the "zero basis/partnership gain recognition" approach, the "zero basis/no partnership gain recognition" approach, and the "cost basis/zero partnership gain recognition" approach. The analysis continues below, using six complex examples 3 involving transfers of the corporate partner's stock, NQSOs and SARs to the service partner. In all of the examples, individual X is the service partner of ABX, an accrual-method, calendar-year entity taxable as a partnership. ABX s equal partners are A Co., B, and X. ABX does not currently have surplus cash. X wishes to receive $100,000 of additional compensation (in connection with services rendered to ABX during 1998) on a net-aftertax basis, an will accept either cash or 1,000 shares of A Co. common stock (currently worth $100 per share). X s effective combined federal and state marginal rate is 50%. To meet X s objectives and to maintain parity among the partners, on 12/1/98 A Co. transfers 1,000 shares of stock and B and X each contribute $100,000 cash to ABX. 4 In Part 1, Examples 1 and 2 involved direct and indirect ( deemed and actual ) transfers of stock from the corporation to the service partner, and provided a framework for analyzing gain recognition as well as timing of the partnership s deduction and the Reprinted by Katten Muchin Zavis Rosenman with permission. "Journal of Taxation" January, 1999
service partner s income recognition. Example 3 involved a transfer to ABX of A Co. s stock in 1998 and pursuant to an arrangement made before X rendered any services a subsequent transfer of the stock to X on 12/1/99 (with no changes in the FMV of the stock during the interim). The example illustrated the uncertainty and the respective differences in tax consequences of determining whether Section 83 or 707(c) or both might apply to the partnership-to-service partner transfer. EXAMPLE 4: The facts are the same as in Example 3, except that on 12/1/99 the value of the 1,000 A Co. shares increases to $130,000. The increase in the value of A Co. stock while it is held by ABX from 12/1/98 to 12/1/99 complicates the tax analysis. As was true in the prior examples, neither A Co. nor ABX should recognize gain on A Co.'s 1998 transfer of its stock to ABX, pursuant to Section 721, regardless of which Code provision(s) govern the 1999 stock transfer by ABX to X. Nevertheless, the timing of deductibility by ABX and income recognition by X, as well as potential (additional) gain recognition by B and X on the 1999 stock transfer, will depend upon the determination of whether and to what extent Section 83 or Section 707(c) (or some combination thereof) will govern. Transfer governed by Section 83. X will recognize ordinary compensation income equal to the FMV of the A Co. stock (i.e., $130,000) upon its receipt on 12/1/99, if the ABX-to-X transfer is governed by Section 83. Section 83(h) will entitle ABX to a corresponding $130,000 deduction in 1999, in accordance with its normal method of accounting, in conformity with Sections 446 and 461. 5 Is gain also recognized by ABX on 12/1/99 on ABX's transfer of the A Co. stock to X, and, if so, how is it allocated? If the "zero basis/partnership gain recognition" approach applies, ABX would have a zero basis in the A Co. stock both on its receipt on 12/1/98 and barring any other transactions during the following 12 months also on 12/1/99; thus, ABX would recognize $130,000 of short-term capital gain on its transfer of the A Co. stock to X. Under this approach, on 12/1/99 A Co. would be allocated $110,000 of this gain, i.e., $100,000 of gain, pursuant to Section 704(c) (the precontribution or built-in gain as of 12/1/98), plus $10,000 of gain (i.e., one-third of the $30,000 postcontribution appreciation in the A Co. stock), pursuant to Section 704(b). B and X would each recognize $10,000 of gain as their shares of the post-contribution recognized gain. Fortunately for A Co., application of the aggregate approach as used in TAM 9822002 6 would effectively eliminate A Co.'s gain. As discussed in Part 1, application of the aggregate approach in this "zero basis/partnership gain recognition" scenario results in ABX recognizing gain (here, $130,000) on the transfer of the stock but, on allocation to A Co. of $110,000 of that gain, A Co. would not recognize gain by reason of Section 1032. 7 Not surprisingly, B and X generally will prefer that ABX successfully adopt the "zero basis/no partnership gain recognition" approach, consistent with holding 4 of Rev. Rul. 80-76, 1980-1 CB 15. As discussed in, Part 1, 8 under this approach even assuming that ABX is viewed as having a zero basis in the A Co. shares ABX would recognize no gain at the partnership level (and therefore none of its partners would recognize gain) "because Section 83 applies" to the transfer. In such case, B and X would not be allocated and would not recognize any gain on the $30,000 post-contribution appreciation, in contrast to the$10,000 short-term gain that B and X would recognize under the "zero basis/partnership gain recognition" approach. Unfortunately, the IRS may refuse to apply Rev. Rul. 80-76 to the facts in Example 4, 9 and therefore ABX may recognize gain on its transfer of assumed zero basis A Co. stock to X, at least for purposes of issuing a favorable letter ruling. As reported in THE JOURNAL, 10 the IRS, after a lengthy review of a letter ruling request, indicated its intention to issue -2-
an adverse ruling on the issue of gain recognition to a subsidiary corporation whose rabbi (grantor) trust used previously contributed parent stock to pay compensation. The author of that article, who had submitted the ruling request, reported that with respect to potential gain recognition by the subsidiary (employer), the Service's advance ruling position was that Rev. Rul. 80-76 applies only if the subsidiary is deemed to own the parent's stock under Reg. 1.83-6(d); the Ruling does not apply if the subsidiary actually owns the parent's stock (or pursuant to the grantor trust rules owns the parent's stock actually held by the subsidiary's rabbi trust). 11 The Service reportedly asserted that this result is consistent with and required by Rev. Rul. 74-503, 1794-2 CB 117. 12 To summarize then, although Ltr. Rul. 9822012 appears to extend application of at least some of the holdings in Rev. Rul. 80-76 to deemed transfers of a corporate partner's stock, the Service's reported negative ruling position on actual transfers to a subsidiary corporation's rabbi trust indicates that, at least for advance ruling purposes, the IRS would rule that if Section 83 governs ABX will recognize and the partners of ABX will be allocated taxable gain equal to the FMV of the A Co. stock on 12/1/99. Moreover, if Prop. Reg. 1.1032-3 were finalized as proposed, Rev. Rul. 80-76 apparently would be revoked as obsolete and ABX would not be protected by the Regulation from the zero basis problem in Example 4, because ABX would not be transferring the A Co. stock to X "immediately" after its receipt by ABX on 12/1/98. Although A Co. itself would be protected from gain recognition by Section 1032 (per TAM 9822002), B and X would each recognize as short-term capital gain their allocable shares of post-contribution gain ($10,000 each) in Example 4. Transfer governed by Section 707(c). Under Reg. 1.707-1(c), the timing of X's recognition of income is determined by the timing of ABX's deduction. Since ABX uses the accrual basis and X rendered her services to ABX in 1998, if Section 707(c) applies, ABX will accrue its compensation deduction with respect to the A Co. stock in 1998 and X will recognize income in 1998 of $100,000 the FMV of the stock on 12/1/98. The stock is not delivered until 12/1/99, however, when its FMV is $130,000. At delivery, ABX presumably can accrue an additional $30,000 deduction, because it is using appreciated stock (FMV$130,000) to pay its obligation (previously accrued at $100,000). Similarly, X presumably will report an additional $30,000 of compensation income in 1999 on receipt of the appreciated stock. 13 Consistent with the above analysis, and given the stock's assumed zero basis in ABX's hands, it appears that ABX does not recognize gain in 1998 (because ABX does not transfer the zero basis stock to X in 1998, but merely accrues the liability to X that year), but does recognize $130,000 of gain on 12/1/99 when it actually transfers the assumed zero basis stock. ABX's 1999 short-term capital gain of $130,000 would be allocated $110,000 to A Co. (i.e., A Co.'s Section 704(c) built-in gain of $100,000 plus one-third of the $30,000 post-contribution gain), while B and X would each be allocated $10,000 of such gain. Transfer governed by Sections 83 and 707(c). As illustrated above, the timing rules of Sections 83 and 707(c) conflict. Under the Section 83/707(c) reconciliation approach, 14 the Section 707(c) rules in relevant part would apply to cause ABX's year of accruing of deductions ($100,000 in 1998 and $30,000 in 1999) to control the timing of X's income recognition. When would ABX recognize the $130,000 gain relating to the transfer of A Co. stock? Under the Section 83/707(c) reconciliation approach, Section 83 would govern for all purposes other than timing of ABX's compensation deduction and X's income inclusion (which are expressly described in Reg. 1.707-1(c)). Under Reg. 1.83-6(b), ABX would apparently recognize such gain (i.e., $130,000) -3-
when it transfers the A Co. stock to X i.e., 12/1/99. This would result in a mismatching of that gain with ABX's accrued deduction (i.e., $100,000 in 1998 and $30,000 in 1999). A better reading of Section 83 is that the timing of the transferor's gain recognition should occur at the same time that the service provider recognizes ordinary income (compare Reg. 1.83-6(b)). Under this reading, ABX would recognize $100,000 of gain in 1998 and $30,000 in 1999, and thereby better match ABX's compensation deductions in those years. EXAMPLE 5: The facts are the same as in Example 4, except on 12/1/99 the value of the 1,000 A Co. shares has decreased to $70,000. ABX again will accrue a $200,000 compensation deduction in 1998 and X will report that amount into income in 1998, as required by Reg. 1.707-1(c), in all events. The timing of compensation deductions by ABX and income inclusion by X is the same as described in Example 4, except if Section 707(c) governs. The decrease in value of A Co. stock while it is owned by ABX from 12/1/98 to 12/1/99 further complicates the analysis. Transfer governed by Section 83. Pursuant to Section 83(a), X will recognize ordinary compensation income on 12/1/99 of $70,000, i.e., the then-current FMV of the A Co. stock. ABX will be entitled to a corresponding $70,000 deduction in 1999 with respect to the stock, pursuant to Section 83(h). In Example 5, the value of the 1,000 shares of A Co. stock decreased $30,000 while the shares were actually held by ABX. Does ABX recognize gain or loss on 12/1/99 on its transfer of the A Co. stock to X, and if so, how is it allocated? If the "zero basis/partnership gain recognition" approach applies, ABX would have a zero basis in the A Co. stock on its receipt on 12/1/98 and barring any other transactions during the next 12 months also on 12/1/99. Thus, ABX would recognize $70,000 of short-term capital gain in 1999 on its transfer of the A Co. stock to X. If, as one would anticipate, the aggregate approach used in TAM 9822002 is applicable in Example 5, the results would be as follows: The Section 704(c) traditional method, A Co. will be allocated gain of $70,000 (i.e., the $100,000 built-in gain in the A Co. stock as of 12/1/98, but subject to the ceiling rule 15 ). Pursuant to Section 1082, however, A Co. will not recognize any of the $70,000 gain allocated to it, while obtaining its $90,000 compensation deduction (one-third of the $270,000 paid to X) over two years (1998-99). Neither B nor X will recognize gain or loss (it all having been allocated to A Co. under Section 704(c)), but each will obtain a $90,000 deduction over two years (1998-99). Under the Section 704(c) remedial method, 16 A Co. will be allocated $90,000 of shortterm capital gain and B and X will each be allocated a $10,000 short-term capital loss A Co., however, will not recognize any of the $90,000 gain allocated to it, again thanks to Section 1032, while B and X will each recognize a $10,000 short-term capital loss and a $90,000 deduction. If the "zero basis/no partnership gain recognition" approach (consistent with holding 4 of Rev. Rul. 80-76 and Ltr. Rul. 9822012) applies, then, even assuming that ABX is viewed as having a zero -4-
basis in the A Co. shares, ABX would recognize no gain at the partnership level (and therefore neither A Co., B nor X would recognize gain or loss) "because Section 83 applies" to the transfer. In that event, B and X would not recognize their respective shares of the $30,000 post-contribution depreciation in value of the A Co. stock, (i.e., the aforementioned $10,000 loss that B and X would each recognize under the "zero basis/partnership gain recognition" approach) if ABX's partnership agreement had required the Section 704(c) remedial allocation method. This could cause A Co. on the one hand and B and X, on the other, to have conflicting positions, in the unlikely event (contrary to TAM 9822002) that the entity approach to partnership taxation applied: B and X would favor the "zero basis/partnership gain recognition" approach in conjunction with a Section 704(c) remedial allocation, while A Co. would strongly prefer the "zero basis/no partnership gain recognition" approach. Conversely, A Co. presumably would have no conflict (i.e., would be neutral) if the aggregate approach of TAM 9822002 applied to protect A Co. while the "zero basis/partnership gain recognition" approach gives B and X each a $10,000 loss under the Section 704(c) remedial method. 2. Transfers governed by Section 707(c). Under Reg. 1.707-1(c) ABX's compensation deduction with respect to the A Co. stock is accrued on 12/1/98, presumably in the amount of $100,000, when the FMV of the A Co. stock is $100,000. Thus, A Co., B and X each would be allocated $100,000 of ABX's $300,000 compensation deduction under Reg. 1.707-1(c). On 12/1/99, ABX delivers 1,000 shares of stock with an FMV of $70,000 in full satisfaction of its stock obligation to X. Does ABX recognize $30,000 of ordinary income (the difference between its accrued liability of $100,000 and the stock's FMV of $70,000) on 12/1/99, and, if so, what is the character of this income? It arguably is not cancellation of indebtedness income, not as there was no true "debt" for $100,000 but merely ABX's obligation to deliver 1,000 shares of stock (regardless of the shares' then-current FMV). On the other hand, ABX's 1998 accrual for tax purposes of a $100,000 liability with respect to the obligation to deliver stock created a "tax basis balance sheet" liability on ABX's tax books. This apparently requires a 1999 reversal of the compensation deduction that was overaccrued in 1998, with the result being a $30,000 increase in ABX's ordinary income in 1999, although it is not clear whether this would occur under the tax benefit rule or some other doctrine. The author is unaware of any authority directly on point. Similar issues arise with respect to X, who was required to report $100,000 of compensation income with respect to the A Co. stock in 1998, pursuant to Reg. 1.707-1(c), when ABX accrued the expense. X may have a $30,000 loss in 1999 where she receives only $70,000 worth of A Co. stock. If so, is her loss an ordinary (under the tax benefit rule or some other doctrine) Her recognition of such a loss presumably reduces her basis in the A Co. stock to $70,000. Alternatively, X may not recognize a loss in 1999 when the stock is delivered, but instead may obtain some tax benefit upon her ultimate sale of the stock (when X's "unreduced" $100,000 basis in the A Co. shares results in $30,000 less capital gain or $30,000 more capital loss. Again, the answers are unclear, but the IRS probably would contend that ABX recognizes $30,000 of ordinary income in 1999 (consistent with X's anticipated ordinary deduction claim of $30,000 in 1999, as described above). If the "zero basis/partnership gain recognition" approach applies, ABX will recognize gain on the transfer of the shares on 12/1/99 equal to the difference in value of the A Co. stock transferred (i.e., $70,000 FMV) and ABX's basis (assumed to be zero) in the A Co. stock. If the Section 704(c) traditional method applies, under the terms of the partnership agreement, A Co. will be allocated all $70,000 of short-term capital gain in 1999, while B and X will recognize no gain or loss (due to Section -5-
704(c)'s ceiling rule), as discussed earlier. If instead the Section 704(c) remedial method is used, A Co. will be allocated $90,000 of gain while B and X each are allocated $10,000 of loss in 1999. (If the aggregate approach of TAM 9822002 applies, A Co. again will be protected from recognition of gain by Section 1032.) Transfers governed by Sections 83 and 707(c). Under the proposed Section 83/707(c) reconciliation approach, ABX's deduction of $100,000 and X's income recognition of $100,000 would occur in 1998 with respect to ABX's obligation to deliver A Co. stock to X in 1999 (per Reg. 1.707-1(c)) and ABX's gain recognition on transfer of the A Co. stock would be governed by Section 83. As discussed in Example 4, the better reading of Section 83 for this purpose would be to recognize the transferor's gain at the same time the transferor obtains the compensation deduction. Therefore, ABX arguably should recognize $100,000 of gain on 12/1/98 (as in Example 4 in such scenario), all of which would be allocated to A Co. pursuant to Section 704(c). Query whether ABX recognizes $30,000 of ordinary income on 12/1/99, when ABX delivers the A Co. stock (whose FMV then is only $70,000), in full satisfaction of its obligation to X. It is unclear whether the tax benefit would support this result. If ABX does recognize such income in 1999, the question then would be whether the income would be allocated among the partners equally under Section 704(b). Similarly, since X was required (pursuant to Reg. 1.707-1(c)) to report $100,000 of compensation income in 1998 when ABX accrued the expense. Does X report a $30,000 loss in 1999 on receiving the A Co. stock then having an FMV of $70,000, or does X retain her $100,000 basis in the A Co. stock and only obtain a tax benefit upon her sale of the stock (via $30,000 less capital gain or $30,000 more capital loss)? Again, the answers are uncertain. DELAY IN STOCK VESTING Other complications arise if the service partner is not immediately vested in the corporate partner's stock transferred in return for the services rendered to the partnership. EXAMPLE 6: The facts are the same as in Example 1, i.e., A Co. will transfer its stock directly to X (rather than to ABX) on 12/1/98, except that the shares are unvested (i.e., the stock is subject to a substantial risk of forfeiture by X) until 12/1/99, when X will have finished rendering her services. X does not wish to accelerate recognition of income to 1998 (by making a Section 83(b) election), since she will not own the stock outright until 12/1/99. X completes performance of services to ABX on 12/1/99, when the A Co. shares vest. On 12/1/99, when those shares have an FMV of $120,000, ABX pays the $200,000 cash compensation to X. Transfer governed by Section 83. If only Section 83 applies, then pursuant to that section, the transaction should be characterized as a deemed transfer by A Co. of its stock to ABX on 12/1/99, when the stock vests, and a deemed transfer by ABX of the A Co. stock to X on that date. 17 Under that characterization, neither A Co. nor ABX would recognize gain or loss on the deemed transfer of A Co.'s stock to ABX, pursuant to Section 721. By operation of Section 83, X would recognize $120,000 of ordinary compensation income on 12/1/99 when the A Co. shares vest. Pursuant to Section 83(h), ABX would obtain a 1999 compensation deduction of $120,000. Again, issues exist as to (1) whether ABX would recognize gain or loss on its deemed transfer of the A Co. stock to X, and if so, (2) what consequences follow to ABX's partners?! Under the "zero basis/partnership gain recognition" approach, on 12/1/99 ABX would have a zero basis in the A Co. stock under Section 723 on its deemed contribution to -6-
ABX, and thus at the partnership level ABX would recognize a short-term capital gain of $120,000 on 12/1/99. At least the first $100,000 of gain should be allocated to A Co. under Section 704(c) and, pursuant to the aggregate approach approved in TAM 9822002, A Co. will be protected by Section 1032 from recognizing that gain. (The remaining $20,000 of gain will be allocable under Section 704(b); to the extent it is allocable in part to A Co., the latter will also be protected by Section 1032. 18 ) -7-
# EXHIBIT 1 Summary of IRS's Anticipated Positions on Illustrative Stock Transfers All examples assume $200,000 cash is contributed by B and X to ABX on 12/1/98 and paid by ABX to X in the year that X receives the A Co. stock Example number Type of transfer 1 Date of transfer from A Co. to ABX Date of transfer from ABX to X Value of A Co. stock, 12/1/98 Value of A Co. stock, 12/1/99 Section 704(c) allocation method 1 Deemed 12/1/98 12/1/98 $100,000 n/a Traditional or remedial 2 Actual 12/1/98 12/1/98 $100,000 n/a Traditional or remedial 3 Actual 12/1/98 12/1/99 $100,000 $100,000 Traditional or remedial 4 Actual 12/1/98 12/1/99 $100,000 $130,000 Traditional or remedial 5 Actual 12/1/98 12/1/99 $100,000 $70,000 Traditional 5 Actual 12/1/98 12/1/99 $100,000 $70,000 Remedial 6 Deemed 12/1/98 12/1/98 6 $100,000 $120,000 Traditional or remedial 7 Deemed 12/1/98 12/1/98 7 $100,000 $120,000 Traditional or remedial 1 "Actual" means stock actually transferred from A Co. to ABX and ABX to X; "deemed" means stock actually transferred from A Co. directly to X. 2 Per Rev. Rul. 80-76, 1980-1 CB 15, holding 4; cf. Ltr. Rul. 9822012; Prop. Reg. 1.1032-3. Even if gain or loss is recognized, A Co. is protected from recognition of gain by TAM 9822002 and Section 1032. 3 Assumes the zero basis rule of Rev. Rul. 74-503, 1974-2 CB 117, will be applied and holding 4 of Rev. Rul. 80-76 will not be applied to "actual" transfers. 4 If instead the "deemed cash purchase" approach of Prop. Reg. 1.1032-3 is applicable, ABX will not recognize gain or loss. 5 Per TAM 9822002 and Section 1032. 6 Shares are transferred 12/1/98 from A Co. to X, but are subject to risk of forfeiture until 12/1/99, when they vest. X wishes to defer income recognition until vesting. 7 Shares are transferred 12/1/98 from A Co. to X, but are subject to risk of forfeiture until 12/1/99. X wishes to accelerate income recognition to 12/1/98 and maximize potential LTCG on post-12/1/98 appreciation. Consequences to ABX Consequences to A Co. Consequences to B Consequences to X -8-
No gain or loss recognized 2 ; $300,000 deduction in 1998 No gain or loss recognized; $100,000 deduction in 1998 No gain or loss recognized; $100,000 deduction in 1998 No gain or loss recognized; $300,000 compensation income in 1998; $100,000 deduction in 1998; X has a $100,000 basis in the A Co. stock $100,000 STCG in 1998 3, 4, $300,000 deduction in 1998 $100,000 STCG in 1998 (not recognized) 5 ; $100,000 deduction in 1998 No gain or loss recognized; $100,000 deduction in 1998 No gain or loss recognized; $300,000 compensation income in 1998; $100,000 deduction in 1998; X has a $100,000 basis in the A Co. stock $100,000 STCG in 1999 3 ; If Section 83 governs, #200,000 deduction in 1999; If Section 707(c) governs $300,000 deduction in 1998 $100,000 STCG in 1999 (not recognized) 5 ; If Section 83 governs, $66,667 deduction in 1998 and $33,333 deduction in 1999; If Section 707(c) governs, $100,000 deduction in 1998 No gain or loss recognized; If Section 83 governs, $66,667 deduction in 1998 and $33,333 deduction in 1999; If Section 707(c) governs $100,000 deduction in 1998 No gain or loss recognized; If Section 83 governs, $200,000 compensation income and $66,667 deduction in 1998, $100,000 compensation income and $33,333 deduction in 1999; If Section 707(c) governs, $300,000 compensation income and $100,000 deduction in 1998; X has $100,000 basis in the A Co. stock $130,000 STCG in 1999 3 ; If Section 83 governs, $200,000 deduction in 1998 and $130,000 deduction in 1999 If Section 707(c) governs, $300,000 deduction in 1998 and $30,000 deduction in 1999 $110,000 STCG in 1999 (not recognized) 5 ; If Section 83 governs, $66,667 deduction in 1998 and $43,333 deduction in 1999; If Section 707(c) governs, $100,000 deduction in 1998 and $10,000 deduction in 1999 $10,000 STCG recognized in 1999; If Section 83 governs, $66,667 deduction in 1998 and $43,333 deduction in 1999; If Section 707(c) governs, $100,000 deduction in 1998 and $10,000 deduction in 1999 $10,000 STCG recognized in 1999; If Section 83 governs, $200,000 compensation income and $66,667 deduction in 1998, $130,000 compensation income and $43,333 deduction in 1999; If Section 707(c) governs, $300,000 compensation income and $100,000 deduction in 1998, $30,000 compensation income and $10,000 deduction in 1999; X has a $130,000 basis in the A Co. stock $70,000 STCG in 1999 3 ; If Section 83 governs, $200,000 deduction in 1998 and $70,000 deduction in 1999; If Section 707(c) governs, $300,000 deduction in 1998 and $30,000 ordinary income in 1999 $70,000 STCG in 1999 (not recognized) 5 ; If Section 83 governs, $66,667 deduction in 1998 and $23,333 deduction in 1999; If Section 707(c) governs, $100,000 deduction in 1998 and $10,000 ordinary income in 1999 No gain or loss recognized; If Section 83 governs, $66,667 deduction in 1998 and $23,333 deduction in 1999; If Section 707(c) governs, $100,000 deduction in 1998 and $10,000 ordinary income in 1999 No gain or loss recognized; If Section 83 governs, $200,000 compensation income, $66,667 deduction in 1998, $70,000 compensation income, $23,333 deduction in 1999; If Section 707(c) governs, $300,000 compensation income, $100,000 deduction in 1998, $30,000 ordinary loss, $10,000 ordinary income in 1999; X has a $70,000 basis in the A Co. stock $70,000 STCG in 1999 3 ; If Section 83 governs, $200,000 deduction in 1998 and $70,000 deduction in 1999; If Section 707(c) governs, $300,000 deduction in 1998 and $30,000 ordinary income in 1999 $90,000 STCG in 1999 (not recognized) 5 ; If Section 83 governs, $66,667 deduction in 1998 and $23,333 deduction in 1999; If Section 707(c) governs, $100,000 deduction in 1998 and $10,000 ordinary income in 1999 $10,000 STCL recognized in 1999; If Section 83 governs, $66,667 deduction in 1998 and $23,333 deduction in 1999; If Section 707(c) governs, $100,000 deduction in 1998 and $10,000 ordinary income in 1999 $10,000 STCL recognized in 1999; If Section 83 governs, $200,000 compensation income, $66,667 deduction in 1998, $70,000 compensation income, $23,333 deduction in 1999; If Section 707(c) governs, $300,000 compensation, $100,000 deduction in 1998, $30,000 ordinary loss and $10,000 ordinary income in 1999; X has a $70,000 basis in the A Co. stock $120,000 STCG in 1999 3, 4, $320,000 deduction in 1999 $106,667 STCG in 1999 (not recognized) 5 ; $120,000(?) deduction in 1999 $6,667 STCG recognized in 1999; $100,000(?) deduction in 1999 $6,667 STCG recognized in 1999; $320,000 compensation income $100,000(?) deduction in 1999; X has a $120,000 basis in the A Co. stock If Section 83 governs, $100,000 STCG in 1998 3, 4, $100,000 deduction in 1998, and $200,000 deduction in 1999; If Section 707(c) governs, $120,000 STCG in 1999, $320,000 deduction in 1999 If Section 83 governs, $100,000 STCG in 1998 (not recognized) 5, $33,333 deduction in 1998, $66,667 deduction in 1999; If Section 707(c) governs, $106,667 STCG in 1999 (not recognized) 5, $106,667 deduction in 1999 If Section 83 governs, no gain or loss recognized; $33,333 deduction in 1998, $66,667 deduction in 1999; If Section 707(c) governs, $6,667 STCG recognized in 1999, $106,667 deduction in 1999 If Section 83 governs, no gain or loss recognized; $100,000 compensation income, $33,333 deduction in 1998, $200,000 compensation income, $66,667 deduction in 1999; X has a $100,000 basis in the A Co. stock; If Section 707(c) governs, $6,667 STCG recognized in 1999, $106,667 deduction in 1999; X has a $120,000 basis in the A Co. stock! Alternatively, under the "zero basis/no partnership gain recognition" approach, if (as one would anticipate) holding 4 of Rev. Rul. 80-76 applies to this deemed transfer, ABX would recognize no gain at the partnership level "because Section 83 applies." The $20,000 increase in the value of A Co. stock between 12/1/98 and 12/1/99 will not result in recognition of taxable gain to A Co., B, or X (regardless of whether Section 1032 or Rev. Rul. 80-76 applies) but will result in a larger tax deduction for the partners of ABX. 19-9-
If Prop. Reg. 1.1032-3 is finalized as proposed, Rev. Rul. 80-76 apparently will be revoked as obsolete, but the results to A Co., B, and X would be the same, i.e., no recognition of gain. Proposed Reg. 1.1032-3(e), Example 4, involves a transfer functionally equivalent to our Example 6, i.e., a transfer by a parent corporation (P) of its stock subject to a substantial risk of forfeiture to compensate the employee of its subsidiary (S) for services, with no Section 83(b) election being made by the employee. Prop. Reg. 1.1032-3(e) holds that no gain or loss is recognized on the deemed disposition of P stock by S when the stock vests; P is deemed to have contributed cash to S equal to the FMV of the P stock on the date it vests, and S is treated as purchasing P's stock from P for that same amount on the date of vesting. Applying this deemed cash purchase approach to our Example 6 would result in ABX having a tax basis of $120,000 in the A Co. stock when it vests on 12/1/99; no recognition of gain or loss on its deemed transfer to X on that date; and a deduction by ABX of $120,000 20 as would occur under the other two approaches described above. Transfer governed by Section 707(c). If only Section 707(c) applies, ABX should report its deduction pursuant to its method of accounting, i.e., the accrual method. All events must occur for an expense to properly accrue; until the forfeiture restriction lapses, the A Co. stock may not be retained by X, and therefore the accrual arguably would be premature prior to 12/1/99. 21 On that date, ABX should report its compensation deduction at the stock's then-current value ($120,000) and X should report the equivalent income, pursuant to Reg. 1.707-1(c). ABX should recognize short-term capital gain of $120,000 on 12/1/99, equal to the difference between the A Co. stock's FMV and its assumed zero basis in ABX's hands on that date. To the extent such gain is allocable to A Co., Section 1032 should protect that partner from recognition. To the extent a portion of such gain is allocable to B and X under Section 704(b), those partners will report taxable gain. 22 Transfers governed by Sections 83 and 707(c). If both Sections 83 and 707(c) apply, the timing conflict as to compensation deductibility by ABX and income recognition by X (discussed above) arises again. Under the facts in Example 6, however, this conflict is more apparent than real regardless of which Code provision governs; ABX's deduction will accrue as of 12/1/99 and X will report compensation income on that date. A difference can occur as to gain recognition by ABX and its partners, depending upon which provision governs. If Section 707(c) governs, $120,000 of gain is recognized by ABX. If Section 83 governs and Rev. Rul. 80-76 or the deemed cash purchase approach of Prop. Reg. 1.1032-3 applies, ABX and its partners will not recognize a gain. Under the proposed Section 83/707(c) reconciliation approach, Section 83 governs for purposes other than timing of deduction, income, and gain recognition; here the amount of gain is at issue. Thus, Section 83 would govern, and B and X (who are not protected by Section 1032, unlike A Co.) would benefit from gain nonrecognition in that event, but their allocable share of ABX's compensation deduction likely would be limited to $100,000 each under Section 704(b). 23 EXAMPLE 7: The facts are the same as in Example 6, except that X believes the value of the A Co. stock will increase substantially between the date the shares are transferred (i.e., 12/1/98) and the date the risk of forfeiture lapses and the shares vest (i.e., 12/1/99). X wishes to recognize her compensation income on 12/1/98 (when the A Co. stock is worth $100,000, disregarding the risk of forfeiture). -10-
Transfer governed by Section 83. If only Section 83 applies, X can make a Section 83(b) election to accelerate recognition of $100,000 of compensation income to 12/1/98. ABX will obtain a corresponding tax deduction of $100,000 at that time pursuant to Section 83(h). Under the "zero basis/partnership gain recognition" approach, if the aggregate theory used in TAM 9822002 applies ABX will recognize $100,000 of gain as of the date of the election; that gain will be allocable solely to A Co. under Section 704(c) and not reported in A Co.'s taxable income pursuant to Section 1032. If either the "zero basis/partnership no gain recognition approach" applies pursuant to holding 4 of Rev. Rul. 80-76 or the "cost basis/no gain recognition" approach applies pursuant to the deemed cash purchase rationale of Prop. Reg. 1.1032-3, there also will be nonrecognition of gain for partners A Co., B, and X. 24 Transfer governed by Section 707(c). If only Section 707(c) applies, X cannot make a Section 83(b) election to accelerate recognition of income. For reasons described in Example 6, ABX will not be able to accrue a compensation deduction until the forfeiture restriction lapses on 12/1/99, and pursuant to Reg. 1.707-1(c) X reports compensation income when ABX reports its deduction. On 12/1/99, when the substantial risk of forfeiture terminates, ABX will accrue its compensation deduction of $120,000 under the 'all events' test, and X will report income of $120,000. If the "zero basis/partnership gain recognition" applies, ABX presumably will recognize $120,000 of capital gain on 12/1/99; A Co.'s allocable share of that gain will not be reported as income pursuant to Section 1032 (per TAM 9802002), while B and X would recognize a portion of the additional $20,000 capital gain and the corresponding compensation expense deduction. Transfer governed by Sections 83 and 707(c). If both Sections 83 and 707(c) apply, reconciliation of the conflicting principles of the two provisions is difficult. Under Section 83(h), the service recipient's deduction is allowed only when the service provider reports the transferred property as income, pursuant to the timing rules of Sections 83(a) and (b). Under Reg. 1.707-1(c), the service provider takes the property into income when the service recipient can first claim the deduction under its method of accounting. To give equal effect to Sections 83 and 707(c) appears impossible, given these divergent timing rules. Even the proposed Section 83/707(c) reconciliation approach produces an odd result. Under that approach Section 707(c) would govern as to timing of ABX's deduction and X's income recognition, while Section 83 would be given effect for all other purposes, with the following results: 1. X should be allowed to make a Section 83(b) election with respect to the A Co. stock she receives effective 12/1/98, thereby establishing the amount of X's recognition of income (and ABX's deduction) to be $100,000. 2. X would not report the income until accrual-method partnership ABX accrues the expense, per Reg. 1.707-1(c); this would defer the income inclusion and deduction until 12/1/99, when X completed rendering her services. Thus, ABX and X, respectively, would report the aforementioned $100,000 of deduction and income at that time. On 12/1/99, however, the A Co. stock is worth $120,000, and if deference were given to Section 707(c) as to the amount (not just the timing) of income recognition, X would have to report $120,000 of income in 1999 (despite her Section 83(b) election in 1998, when the stock's FMV was $100,000). Consistent with her Section 83(b) election X will be treated as the owner of the A Co. stock effective 12/1/98 as though ABX had transferred the stock on that date. Under such a deemed "unrestricted" transfer of stock, query whether ABX could accrue the expense under the all-events test as of 12/1/98, thereby justifying X's recognition of income under Reg. 1.707-1(c) as of the same date. -11-
If Section 83 controls the timing of deduction where a Section 83(b) election has been made, then on 12/1/98 X would recognize income and ABX would obtain a deduction of $100,000, pursuant to Section 83(h). Under the Section 83/707(c) reconciliation approach, the partnership arguably should not recognize gain pursuant to Section 83 (either under Rev. Rul. 80-76 or the deemed cash purchase rationale of Prop. Reg. 1.1032-3) with respect to ABX's transfer of stock to X; thus, A Co., B, and X not would recognize any taxable gain with respect to the difference between the stock's FMV and its basis. USING CORPORATE PARTNER'S NQSOS The analysis changes further if options to purchase the corporate partner's stock, rather than the stock itself, are the subject of the incentive plan. EXAMPLE 8: The facts are the same as in Example 1, i.e., X renders her services in 1998, except A Co. transfers NQSOs (either directly to X or first to ABX, which immediately transfers the options to X). The NQSOs are nontransferable and do not have a readily ascertainable FMV. The options are first exercisable on 12/1/99 by X's payment of $50,000 cash to A Co. At issuance on 12/1/98, the options are in the money, i.e., worth $100,000. On 12/1/99, when the options still have a value of $100,000 and the A Co. stock is worth $150,000, X exercises the options and pays the $50,000 exercise price to A Co. ABX transfers $200,000 cash compensation to X on 12/1/99. Transfer governed by Section 83. If only Section 83 applies, on 12/1/99 X will recognize ordinary compensation income of $100,000 with respect to the NQSOs and ABX will be entitled to a corresponding $100,000 deduction, pursuant to holding 4 of Rev. Rul. 80-76. 25 Under Reg. 1.83-7(a), NQSOs are not taken into income until the options are exercised, which occurs here on 12/1/99, when their FMV is $100,000. ABX would obtain a comparable $100,000 deduction on 12/1/99 pursuant to Section 83(h). The partners of ABX should not recognize gain on either the issuance or X's exercise of the options. If A Co. is deemed to contribute the NQSOs to ABX (under principles akin to Reg. 1.83-6(d)), ABX arguably should not recognize gain on the transactions if the rationale of either holding 4 of Rev. Rul. 80-76 or the deemed cash purchase approach of Prop. Reg. 1.1032-3 applies. Moreover, even if A Co. is deemed to contribute its stock to ABX (and ABX is the deemed transferor to X) under principles akin to Reg. 1.83-6(d), ABX arguably should not recognize gain pursuant to the previously discussed rationales of Rev. Rul. 80-76 and Prop. Reg. 1.1032-3. Transfer governed by Section 707(c). If only Section 707(c) applies, the taxation of the option grant and exercise is subject to substantial uncertainty. Neither Section 707(c) nor Reg. 1.707-1(c) provide guidance, and the author is unaware of any cases, rulings, or other authority on point. Under Reg. 1.707-1(c), accrual-method ABX presumably will obtain a deduction in 1998 when X renders her services, and X will report the NQSOs as income in that same year. 26 Transfer governed by Sections 83 and 707(c). If both Sections 83 and 707(c) apply, the appropriate tax treatment arguably would be to apply Reg. 1.83-7 and tax ABX and X pursuant to such rules, because Section 707(c) gives no guidance as to the timing of deductibility of options that are granted but not currently exercised. Nonetheless, the conflicting principles of Sections 83 and 707(c) described earlier appear to remain irreconcilable. Under Reg. 1.83-7(a), the service recipient's deduction effectively is allowed only when the option is exercised. Under Section 707(c), for accrual-method -12-
partnerships like ABX a deduction arguably should be allowed when the option vests, and all events of liability become fixed and determinable, not at the later exercise date. That the option's value is not readily ascertainable would not preclude the accrual of a deduction based on a reasonable guesstimate of value (perhaps with readjustment when the option is ultimately exercised); perhaps the FMV of X's services would be an alternative valuation method for this purpose. If X exercises her options and A Co. delivers the stock to X on receiving X's $50,000 payment, A Co. will not recognize gain pursuant to Section 1032. Under the proposed Section 83/707(c) reconciliation approach, Section 83 should govern the computation of gain recognized when an option described under Reg. 1.83-7 is exercised. ABX should recognize no gain on such exercise for the reasons described earlier. Finally, even if neither Rev. Rul. 80-76 nor the deemed cash purchase rationale would apply to protect ABX from recognition of gain, A Co. should not recognize gain on the facts in Example 6 based on the aggregate theory of TAM 9822002. The full amount of the built-in gain ($100,000) 27 on any deemed transfer by A Co. of its stock to ABX (i.e., as of 12/1/99, the date X exercises her NQSOs) would be allocable to A Co. under Section 704(c). USING CORPORATE PARTNER'S SARS The last permutation is the use of stock appreciation rights instead of stock or stock options. EXAMPLE 9: The facts are the same as in Example 1, except that on 12/1/98 A Co. awards SARs to selected partners and employees of ABX. Each recipient has a five-year right to participate in the appreciation in value of A Co.'s stock. The recipient will have the right to exercise the SAR and receive cash any time after one year. If the recipient exercises the SAR, either ABX or A Co. will pay the recipient cash equal to the increase in value of the A Co. stock. All SARs are contingent on continuing employment (or, with respect to service partners, rendering services in one's capacity as a partner). The goal of the SAR plan is to encourage positive contribution and loyalty by participation in A Co.'s profitability. On 12/1/98, X receives an SAR award and on 12/1/99 she exercises the SAR, receiving $100,000. Technically, Section 83 does not apply to SARs pursuant to Reg. 1.83-3(e), a transfer of "property" (requisite for applicability of Section 83) does not include money or an unfunded and unsecured promise to pay money or property in the future. Section 707(c) would govern such an arrangement, and since the services were performed by X during 1998 ABX presumably would accrue the expense and X would report the compensation income in 1998, pursuant to Reg. 1.707-1(c). 28 The actual $100,000 payment to X in 1999, on exercise of her SAR, presumably will require X to recognize additional income or loss, to the extent the payment differs from the amount X took into income in 1998. ABX presumably will have a corresponding income or deduction adjustment in 1999. ABX should not recognize gain or income on A Co.'s actual or deemed contribution of cash to ABX in 1999 to fund its obligation to X. 29 CONCLUSION Compensating service partners with a corporate partner's stock, NQSOs, and SARs results in tax consequences to the service partner, the corporation, and in some instances the other members of the partnership. Examples 1 and 2, contained in Part 1 of this article, involved the transfer of the corporate partner's stock to the service partner for services she previously rendered to the partnership and illustrated the tax advantages of using such compensation: deductibility by the partnership (subject to capitalization) without cash outlay, and no taxable gain being reported by any of the partners in using -13-
the (assumed to have zero basis). Example 3 involved a transfer to the partnership of the corporation's stock with no change in the FMV of the stock before its subsequent transfer to the service partner and introduced uncertainty as to the timing of the partnership's deduction and the service partner's income recognition that arises because of the doubts as to whether Section 707(c), 83, or both govern the transaction. Examples 4 and 5 further illustrate that the partners other than the corporate partner may recognize taxable gain or loss due to changes in the FMV of the corporation's stock while it is held by the partnership, prior to transfer to the service partner. The method selected by the partnership to deal with built-in gain under Section 704(c) (i.e., traditional or remedial) can affect the partners' respective allocations of such gain or loss. Example 6 illustrates the difference in allocations of compensation deductions and income recognition among ABX's partners that can arise with respect to unvested stock issued to the service partner, depending on whether Section 83, 707(c), or both, govern. Example 7 illustrates the uncertainty as to the availability of a Section 83(b) election by a service partner in a transaction that seems to fit within both Sections 707(c) and 83, and the differing tax consequences to all the partners that turn on that question. Example 8, involving the issuance of the corporate partner's NQSOs, highlights the tension between Sections 83 and 707(c), in that compensatory stock options are generally thought to be in the exclusive domain of Section 83, and if the latter does not apply, great uncertainty results as to timing and amount of the partnership's deduction and the service partner's income recognition. Example 9, involving SARs based on the corporate partner's profitability, is outside the realm of Section 83 and is governed by Section 707(c), with predictable results. The Service's recent pronouncements in TAM 9822002 and Ltr. Rul. 9822012 should provide nonrecognition of gain treatment for corporate partners who directly or indirectly (i.e., via a preliminary transfer of stock to their partnerships) transfer their stock or NQSOs to service partners. If the stock is transferred first to the partnership, where after it increases in value, and subsequently is distributed to the service partner, the partners other than the corporation will recognize capital gain, as those partners are beyond the protection given the corporate partner by Section 1032. If a larger compensation or other deduction is simultaneously generated, due to the increased value of the corporate stock, the remaining partners will be no worse off, and may be better off if the appreciation generates long-term capital gains and corresponding ordinary (compensation) deductions. Under the Service's previously reported negative ruling position with respect to actual transfers of stock to a subsidiary, however, the IRS may take the position at least for advance ruling purposes that (notwithstanding Ltr. Rul. 9822012) Rev. Rul. 80-76 does not eliminate partnership-level gain recognition with respect to actual stock transfers to the partnership. If it does not, the remaining partners may recognize gain (and possibly loss) in certain situations. In that event, it generally will be preferable for the corporate partner or member to transfer its shares directly to the service partner (either by a direct issuance of stock or upon exercise of NQSOs that had been issued to the partner). As discussed in this article, if the "deemed cash purchase" rationale contained in Prop. Reg. 1.1032-3 were extended to transfers of stock by corporate partners to employees and service partners of their partnerships, there would be no gain recognition by the partnership with respect to use of a corporate partner's stock and stock options in some situations. If, holding 4 of Rev. Rul. 80-76 is effectively revoked as obsolete as anticipated as part of the adoption of Prop. Reg. 1.1032-3 then issuance of stock (or options) on a delayed basis may result in undesirable gain recognition for the remaining partners who would not be protected by Section 1032. -14-