Using options to compensate service providers at the formation of a new entity.

When a service provider is to be compensated with an equity interest in an entity, the use of an in-the-money call option may provide the best tax results.

If a shareholder contributes services for an equity interest in a new entity rather than cash or other property, Sec. 83 controls. The provider of services will recognize income equal to the excess of the fair market value (FMV) of the property received over any amount paid for the property. This determination is made at the earlier of the date that the rights to the property are transferable or are not subject to a substantial risk of forfeiture.

The use of stock options as property transferred to a service provider may provide numerous tax benefits. Under Regs. Secs. 1.83-3(a)(2) and 1.83-7(a), the transfer of an option that does not have a readily ascertainable FMV at the date of the grant will not be a transfer of property. Most nontraded stock options cannot be valued when granted. A call option is a contingent claim because the holder has the right, but not the obligation, to exercise the option. If the option is in-the-money (the FMV of the underlying assets exceeds the option's exercise price as of the date of grant), the holder can profit from appreciation in the underlying asset while limiting the capital at risk.

If properly structured, the advantages of this arrangement include:

* Allowing the service provider to control the year of income recognition. This may solve any liquidity problems that might arise from noncash compensation. * Assuring that other shareholders satisfy the control requirement under Sec. 368(c). If the option is not equivalent to the outstanding stock, the service provider will not be a factor in determining the control requirement under Sec. 351. * The use of options may favorably affect the timing of the deduction taken by the entity. Note: In Rev. Proc. 94-3, the IRS announced that it will not issue advance rulings or determination letters addressing when compensation is realized by a person who, in connection with the performance of services, is granted a nonstatutory stock option without a readily ascertainable FMV to purchase stock at a price less than its FMV on the date the option is granted.