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Stock warrants and options: compensation or investment sweetener?

Many start-up companies issue stock warrants or options under one of two scenarios: (1) to induce potential investors to purchase stock in an offering or (2) as compensation for executives, directors or other service providers. When these situations are distinct, the tax treatment is very straightforward.

Tax Ramifications

If a warrant is investment-related, the stock takes a basis equal to the warrant's exercise price, plus any value attributable to the warrant on the initial offering. There is no taxable income to the warrant holder on exercise. The holding period for the stock begins on exercise. Any gain on the ultimate disposition of the stock is capital gain (short-term or long-term, depending on how long the stock was held).

If the warrant is compensatory and does not have a readily ascertainable fair market value, it is not taxable on grant or issue. Instead, taxability is deferred under Sec. 83 until the warrant is exercised. On exercise, the difference between the exercise price and the stock's value is taxed as compensation (i.e., ordinary income).

Shareholders/Service Providers

A dilemma exists when warrants are issued to shareholders who are also service providers. Often, the warrant agreement stipulates service requirements, vesting or other service-related parameters; however, the number of warrants issued is tied to the number of shares purchased. The number of warrants issued does not necessarily have any direct relationship to the role of the service provider/investor or the services to be provided. In this regard, the tax law is unclear. In addition, it does not provide any practical means for bifurcating the compensation-related feature of a warrant from its investment-related function.

Sec. 83 covers the treatment of property received in connection with the performance of services. Sec. 83(a) requites the service provider to include in taxable income the excess of the value of the property received over the amount paid for it. In addition, Kegs. Sec. 1.83-3(f) indicates that property transferred to an employee or independent contractor in recognition of the performance of services is considered "transferred in connection with the performance of services" for Sec. 83 purposes. Sec. 83(h) provides that the service recipient is entitled to a compensation deduction equal to the amount included by the service provider under Sec. 83(a).


Alves: The "transferred in connection with the performance of services" language is to be interpreted broadly; see Alves, 79 TC 864 (1982), aff'd, 734 F2d 478 (9th Cir. 1984). In Alves, stock received by the taxpayer was held to be compensatory, because (1) the taxpayer was employed by the company and (2) some of the stock issued had employment-related restrictions on exercise or transfer. The court held that the stock was issued "in connection" with the performance of services, even though the taxpayer had paid for the stock on issuance. Thus, the court held that the increase in the stock's value at the time the restrictions lapsed was taxable to the taxpayer as compensation. The Tax Court and the Ninth Circuit held that the statute's plain language did not require that the property be transferred as "compensation" for the performance of services, but only "in connection with" the performance of services.

In affirming the Tax Court's holding that the stock was obtained in connection with the performance of services, the Ninth Circuit looked to the fact that the taxpayer purchased the stock when he signed his employment agreement and that the stock restrictions were linked explicitly to his tenure with the company. Even though the stock was purchased, so that the taxpayer had an interest in the company as an investment, the value that accrued from the time of the original purchase until the restrictions lapsed was determined to be compensation in its entirety. The court did not propose a bifurcation of the value between the original investment function and the compensation feature.

Centel Communications: In 1989, the Tax Court held that warrants were not issued in connection with services; see Centel Communications, 92TC 612 (1989). Centel was attempting to deduct compensation expense related to the issuance of warrants. The Tax Court noted that two shareholders (directors) provided loan guarantees to the company, but without mention or expectation of compensation. The warrants were issued several years later, in consideration of the increased risks assumed by the shareholders/directors under the terms of the loan and other financial guarantees. The Tax Court held the warrants were not issued "in connection" with the performance of services; thus, the company was not entitled to a compensation deduction. The warrants were issued for the loan guarantees; the court noted that none of the individuals to whom the warrants were issued were in the business of making such guarantees.


Centel provides a narrow opportunity for some warrants issued "in connection" with services. Several other rulings have held that warrants issued were not in connection with services, but they tend to follow a fact pattern related to lending arrangements and lending services; see, e.g., TAM 200043013. In each of these situations, the warrants were determined to be wholly related to services or not; the courts have not produced any findings that would bifurcate the value. This may be based on the "in connection with services" language, as opposed to other language, presenting a difficult situation for companies that issue warrants encompassing more than one objective.

Based on the available guidance, if a warrant is issued in consideration for both services and financial risk, the taxpayer should report the entire amount as compensation under Sec. 83. At the same time, the service recipient is entitled to a deduction based on the amount included in the service provider's compensation.

One way for companies considering issuing warrants to avoid this problem is to have a separate warrant arrangement for the capital investment related to the offering. Warrants to key individuals, directors or other service providers can be the subject of a separate warrant/option agreement. This approach would clearly bifurcate the warrant grants between the two objectives. Otherwise, the service provider may be faced with the prospect of recognizing ordinary income when the warrant is exercised.

Similar issues related to the classification of the warrants arise under Statement of Financial Accounting Standards No. 123, Share-Based Payment (SFAS 123r); the compensatory nature of the warrants must be determined for financial reporting purposes.

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Article Details
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Author:Tuley, Patrick A.
Publication:The Tax Adviser
Date:Nov 1, 2006
Previous Article:Installment agreement fees.
Next Article:Beware U.S. tax rules on grants to foreign organizations.

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