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Compensation deduction from NQSO exercise.

The IRS, in Rev. Rul. 2003-98, provided guidance on which taxpayer, among several parties in a purchase or merger, can deduct employees' exercise of target nonqualified stock options (NQSOs). The ruling generally holds that the target can take the deduction in the situations described below.

Example 1: In year 1, X began employment with T Corp. and was granted NQSOs to purchase T's common stock. The NQSOs have no readily ascertainable fair market value (FMV) at grant and are not exercisable until January 1 of year 4. On November 15 of year 4, A Corp. acquired all of T's outstanding shares for cash, but did not make a Sec. 338(g) election. T thereafter conducts its business as A's wholly owned subsidiary. Both corporation are accrual-basis taxpayers with a tax year ending September 30.

On the acquisition date, X surrendered his TNQSOs to A for A NQSOs with no readily ascertainable FMV. On January 15 of year 5, while employed by T, X exercises his A NQSOs and receives substantially vested A stock.

Example 2: The Facts are the same as in Example 1, except that, on January 15 of year 5, under an agreement, A cancels the NQSOs for a payment (in cash or shares) to X.

Example 3: The facts are the same as in Example 1, except that, instead of exchanging T NQSOs for A shares on the acquisition date, the T NQSOs remain in effect. On January 15 of year 5, under an agreement, A cancels the T NQSOs and pays X (in cash or value-equivalent substantially vested A shares) the excess of the FMV of the stock subject to the NQSOs over their exercise price.

Example 4: The facts are the same as in Example 1, except that on November 4 of year 4, A and T merge under state law, with A as the survivor, in a merger that qualifies as a complete liquidation under Sec. 332.


Income: Under Sec. 83(a), when property is transferred to any person in connection with the performance of services, he or she must include in income (as compensation) the excess of the property's FMV over the amount (if any) paid for the property. FMV is determined when the transferee's rights to the property are either transferable or not subject to a substantial risk of forfeiture.

Sec. 83(e)(3) contains an exception for options; it provides that the transfer of an option is not includible in income if it has no readily ascertainable FMV at grant. Instead, income is generally recognized when the option is exercised or otherwise disposed of. Under Temp. Regs. Sec. 1.83-7T, however, this does not apply to sales or dispositions of NQSOs to a person related to the service provider that occur after July 1, 2003. For this purpose, a person is not related to a service provider if he or she is a service recipient as to the option or the option grantor.

In each of the above examples, because the T NQSOs had no readily ascertainable FMV when granted, X did not recognize income on account of the grant.

Deduction: Under Sec. 83(h) and Regs. Sec. 1.83-6 generally, a service recipient can take a Sec. 162 deduction for the amount included in the service provider's income, for the tax year in which or with which ends the service provider's tax year in which the amount is included in gross income. Kegs. Sec. 1.83-6(a)(3) contains an exception--if property transferred is substantially vested on transfer, the service recipient can take the deduction under its accounting method.

If a shareholder transfers property to an employee (or independent contractor) for services performed to the corporation, the transaction is a contribution by the shareholder of such property to the corporation's capital and, immediately thereafter, the corporation's transfer of such property to the employee or independent contractor. The transfer is deemed to be for services performed by the employee for die corporation, if either (1) the property is substantially nonvested at the time of transfer or (2) an amount is includible in the employee's gross income at that time.


In Examples 1, 2 and 4 above, the replacement of T NQSOs with A NQSOs does not cause X to recognize income under Sec. 83(a). In Examples 1 and 4, X recognizes income under Sec. 83(a) in year 5, the year in which the A NQSOs are exercised. In Examples 2 and 3, X also recognizes income under Sec. 83(a) in year 5, the tax year in which A canceled the substituted A NQSOs or cancelled the T NQSOs.

As to which party gets the deduction, Sec. 83(h) and Regs. Sec. 1.83-6 require that T recognize the expense in Examples 1-3. A's payment or transfer is treated as (1) A's capital contribution to T (and T is treated as purchasing the stock from A in the case of a stock transfer to X); and (2) T's payment of cash (or transfer of stock) to X.

In Example 4, because of the merger and liquidation under Sec. 332, A succeeds to and takes into account T's tax items under Sec. 381. Because A assumed T's obligation under A's NQSOs after the merger date, and because T would have otherwise been entitled to deduct the liability, A can deduct the item when paid or accrued as if it were T. Accordingly, A can deduct the income X included under Sec. 83(a).The amount is determined on January 15 of year 5, when the NQSOs are exercised. Because the stock is substantially vested when transferred, A can deduct the compensation included in X's income for the tax year ending September 30 of year 5.

FSA 200206003

In FSA 200206003, key officers of Target were granted NQSOs having no readily ascertainable FMV. The NQSO plan provided that in the event of a change in Target's control, all NQSOs would become exercisable and be cancelled and exchanged for cash. Target subsequently merged with an acquirer in a Sec. 368(a)(1)(A) transaction accounted for under the pooling-of-interest method. The NQSO plan was amended because Target's NQSO cashout provision would have violated the pooling-of-interest method. Instead, key officers would receive acquirer stock for their NQSOs. Under Securities and Exchange Commission rules, "affiliates" of either company could not sell stock acquired on account of the merger for a period of 30 days before the merger and until financial results covering at least 30 days of post-merger operations were published. On the day before the merger closing date, most of the affected employees made a Sec. 83(b) election For the acquirer shares to be received.

The Service reasoned that, because the shares could not be sold For a period, they were not substantially vested under Regs. Sec. 1.83-3(k) when transferred to the key employees. Because of this, the special timing rule under Regs. Sec. 1.83-3(k) (which would have given accrual-basis Target the deduction in its final year) did not apply. Instead, the general timing rule under Sec. 83(h) applied; the deductions attributable to the employees' Sec. 83(b) elections belonged to the acquirer.

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Title Annotation:nonqualified stock options
Publication:The Tax Adviser
Date:Nov 1, 2003
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