Source: http://stromata.tripod.com/id166_m.htm
Timestamp: 2018-09-18 19:37:28
Document Index: 432813407

Matched Legal Cases: ['§1', '§1', '§1', '§83', '§1', '§1', '§1', '§1', '§1', '§1', '§1']

Sales of Stock Options to Family Limited Partnerships: Caveats
A popular tax strategy, marketed by several major accounting and law firms, seeks to convert the gain on the exercise of stock options from ordinary income to long-term capital gain through transactions with a family limited partnership. Despite its popularity, this technique relies on dubious interpretations of the law and is highly vulnerable to IRS challenge.
The strategy works like this: An executive sells vested stock options to a family limited partnership (“FLP”). The sale price is determined by an independent appraisal. In return for his options, the executive receives an unsecured, nonassignable note from the FLP (which, in the soundest versions of the scheme, has substantial other assets and will be able to pay off the note even if the option becomes worthless).
The tax treatment that the parties desire is as follows:
1. The sale of the options will be considered an arm’s-length disposition, so that “sections 83(a) and 83(b) apply to the transfer of money or other property received in the same manner as sections 83(a) and 83(b) would have applied to the transfer of property pursuant to an exercise of the option”, Treas. regs., §1.83-7(a).
2. The note received by the executive will be treated as the receipt of an unfunded, unsecured promise to pay that is not considered “property” for purposes of section 83. Treas. regs., §1.83-3(e). Hence, he will not recognize any income until he receives payments under the note.
3. When the FLP exercises the options, neither it nor the executive will recognize income, because section 83 will not apply at that point.
4. When the FLP sells the stock acquired by exercise of the options, it will recognize long or short-term capital gain, depending upon its holding period.
These results rest upon two premises: that the sale to the FLP is an arm’s-length transaction and that the receipt of FLP’s note is not a taxable event to the executive. A different conclusion on either point leads to less desirable consequences:
1. If the sale is not at arm’s length, the executive will recognize income at the time of the sale equal to the value of the sales proceeds (though the amount may be zero if the note is not “property”). Cf. Treas. regs., §1.83-1(c). When the options are subsequently exercised, the gain (reduced by income previously recognized) will be included in the executive’s - not the FLP’s - income, because section 83 income is taxable to the person who performed the services in connection with which property was transferred, rather than to the owner of the property. I.R.C., §83(a).
2. Even if the sale is at arm’s length, the executive may be taxed on the value of the FLP’s note, on the theory that the note of a solvent maker other than the employer confers economic benefit. (Note that, if the FLP has no substantial assets other than the options that it has just purchased, the IRS will have good grounds for attacking the entire transaction as a sham.)
There is very little pertinent authority on either of the crucial issues. Most of the cases and rulings on which advocates of the FLP strategy rely either are very old (generally antedating the enactment of section 83) or deal with idiosyncratic circumstances. They are therefore of limited value in construing the statute and regulations, which prima facie are not favorable to the taxpayer’s position.
Arm’s-length transaction. Section 83 treats the grant of an option (other than the exceedingly rare option with a readily ascertainable fair market value at the date of grant) as an open transaction that closes when the holder exercises the option or disposes of it in an arm’s-length sale or exchange. Whether a disposition is at arm’s length depends upon facts and circumstances. Closely related parties, such as spouses or a father and adult son, normally are not considered to deal at arm’s length but can do so if their economic interests diverge. Cf. FSA 200005006; Estate of Stranahan v. Commissioner, 472 F.2d 867 (6th Cir., 1973)
In the transactions considered here, the seller often will effectively control negotiations for both sides or will have a community of economic interest with the partnership, calling into question whether “arm’s-length” is a proper characterization. In those cases, the FLP strategy will work only if “arm’s-length transaction” is read to include an transfer whose terms are the same as would have existed if the parties had truly been independent. In other words, the arm’s-length standard must be reinterpreted as a fair market value standard.
There is no doubt that a seller’s failure to receive fair market value from a related buyer is powerful evidence against the existence of an arm’s-length transaction. See, e. g., Robert C. Enos, 31 T.C. 100 (1958); Treas. regs., §1.83-1(c). It does not follow that the receipt of fair market value is a sufficient, as well as a necessary, condition. “Arm’s-length transaction” and “fair market value” are not identical concepts, and one cannot assume that the use of one term rather than the other in the statute and regulations has no significance.
In section 83, there is a fairly obvious reason for closing the transaction at the time of an arm’s-length disposition. Once an option has been sold to a stranger, the seller no longer cares whether the value of the property subject to the option rises or falls. Hence, there is no clear connection between his services and the later transfer of the property when the option is exercised. The most reasonable course of action, then, is to impose tax at the time of the disposition of the option. Furthermore, one can presume that, in a sale between unrelated parties, the price reflects that current value of the option, as neither party has any reason to deal on concessionary terms.
Where, on the other hand, the purchaser is related to the seller, changes in value after the sale continue (often, if not always) to be of interest to the latter. For example, a family limited partnership is often an integral part of the seller’s estate plan, and the individuals who will ultimately receive partnership profits are generally the objects of his bounty. The option thus continues to serve as a reward for services rendered and thus not unreasonably could be viewed as remaining within the purview of section 83, regardless of the terms on which it was transferred.
In addition, determining the fair market value of an untraded option is a highly imprecise exercise. The IRS and the courts are not likely to favor a statutory interpretation that demands reliance on valuations when plausible alternatives are available. They may also question whether the contemplated terms of the sale are truly identical to those that would be agreed between unrelated parties. The transaction will not achieve its tax purposes if the note is assignable (as it would then very likely be treated as a cash equivalent), but it is more than a little unusual for a seller of valuable rights to accept payment in a form of an instrument that he cannot resell or pledge as collateral for a loan. This method of payment could in itself be viewed as evidence against the existence of an arm’s-length sale.
The most that can be said against the preceding analysis is that some cases and rulings seem to view the price at which property changes hands as virtually the only pertinent evidence as to the arm’s-length nature of the exchange. None of those authorities, however, faces the question squarely. The following appear to be most nearly on point:
1. PLR 9533008 dealt with an individual’s sale of the right to receive contingent future compensation. The purchaser was a trust established by his adult children. Because the seller’s rights did not constitute “property”, the ruling was based on assignment of income principles rather than section 83. The assignment of income issue was “whether the assignor retains sufficient power and control over the assigned property or over receipt of the income to make it reasonable to treat him as the recipient of the income for tax purposes”, Commissioner v. Sunnen, 333 U.S. 591, 605 (1948). The IRS concluded that the seller in this case had effectively transferred all of his rights to the income, citing various facts:
A and B are cash basis taxpayers and intend to assign their entire interest in the partnership income rights. The sale will be irrevocable. The consideration for the sale will be provided from funds of the beneficiaries of the trust, not from A or B. The trust assumes a real risk that the payments that it receives from the partnerships will never equal or exceed the consideration that the trust will be required to pay to A and B under the Purchase Agreement. Therefore, A and B appear to be within the Blair principle [sc., “the taxpayer had assigned not merely the right to receive the income but [his] entire equitable interest in the trust corpus”].
The next paragraph of the ruling refers to the transaction as “an arm’s length sale”, but that characterization is not significant (since an effective assignment of income does not require an arm’s-length transaction), nor is it based on the fact that the rights were sold for their fair market value (asserted by the taxpayer but not noted in the summary of the facts that form the basis for the ruling).
2. In Pagel, Inc.,91 T.C. 200 (1988), aff’d, 905 F.2d 1190 (8th Cir., 1990), a corporation received warrants as compensation for underwriting services and later sold them to its sole shareholder. At issue was whether its profit on the sale should be taxed as capital gain or ordinary income. After rejecting the taxpayer’s argument that the warrants had readily ascertainable fair market value at the time of their receipt by the corporation, the court discussed the calculation of the amount of income to be recognized upon their sale and stated, “Although the transaction was between petitioner and its sole shareholder, neither petitioner nor respondent has suggested that the sales price of $314,900 was other than the fair market value of the warrant or that the sale of the warrant was other than an arm’s-length transaction.” In the absence of any disagreement between the parties, the court had no reason to probe the validity of those characterizations. If it had, it might or might not have found that the sale price was sufficient to establish the existence of an arm’s-length transaction. As the opinion stands, it offers no precedent in favor of that position.
3. In Hughes A. Bagley, 85 T.C. 663 (1985), aff’d, 806 F.2d 169 (8th Cir., 1986), a case that involved a sale of options between unrelated parties, the Tax Court stated in passing that the “‘arm’s length’ requirement [for closing a section 83 transaction] is intended to assure [sic] that the statutory scheme is not circumvented by means of a disposition for less than fair consideration”. As noted above, that is indeed one of the requirement’s purposes, but the court’s statement does not prove that it is the only purpose or that any disposition for fair consideration is necessarily at arm’s length.
No other authority gives even colorable support to the automatic equation of a sale at fair market value with an arm’s-length transaction. In light of the structure of the statute, there is no strong argument in favor of that position. The proper factors to consider appear to be how closely the parties are related, the extent to which their economic interests diverge and whether the purchasers are the seller’s dependents or objects of his bounty. The terms of the sale are, at most, evidence that may make a difference where the relationships and economic interests are otherwise unclear.
Effect of receipt of partnership’s note. Although the facts will often be unfavorable to the contention that the sale of options to an FLP is an arm’s-length transaction, exceptions may exist. For example, the seller may have no personal interest in the partnership and may negotiate the terms of the sale with adult partners whose economic interests are adverse to his own. In those instances, one must determine whether the seller recognizes income at the time of the sale or as the FLP makes payments on the note.
The regulations state,
If the option is sold or otherwise disposed of in an arm’s length transaction, sections 83(a) and 83(b) apply to the transfer of money or other property received in the same manner as sections 83(a) and 83(b) would have applied to the transfer of property pursuant to an exercise of the option. [Treas. regs., §1.83-7(a)]
The question, therefore, is how section 83 applies to an employer’s transfer of a third party obligation in connection with the performance of services. If that transfer would be a taxable event, so will the option seller’s receipt of the FLP’s note. If, on the other hand, the note is treated in the same manner as an unfunded, unsecured promise by the employer, taxation is postponed until actual or constructive receipt of payment by the seller.
For purposes of section 83, “an unfunded and unsecured promise to pay money or property in the future” is not “property”. Treas. regs., §1.83(e). This definition derives from the principles set forth in Revenue Ruling 60-31, 1960-1 C.B. 174, which held that a mere promise to pay future compensation for services did not confer current economic benefit upon the service provider and thus did not give rise to immediate tax liability.
Neither the section 83 regulations nor Revenue Ruling 60-31 discusses whether a note constitutes “an unfunded and unsecured promise” or is instead a species of “property”. The regulations under section 61 do address that question but not very helpfully:
Except as otherwise provided by . . . paragraph (d)(6)(i) of this section, . . . [n]otes or other evidences of indebtedness received in payment for services constitute income in the amount of their fair market value at the time of the transfer. [Treas. regs., §1.61-2(d)(4)]
The exception, however, Treas. regs., §1.61-2(d)(6)(i), makes this provision inapplicable “to the transfer of property (as defined in §1.83-3(e)) after June 30, 1969,” except “to the extent such rules are not inconsistent with section 83”, which leaves us again without clear guidance.
There are two possible characterizations of a note, as “property” or “not-property”:
1. If the note is not property, section 1.62-1(d)(4) applies directly, and its fair market value must be included in income when it is received. It seems likely that a note from an FLP with substantial financial assets and bearing a market rate of interest would have a fair market value equal to its face value.
2. If the note is property, section 1.62-1(d)(4) still governs unless it is inconsistent with section 83 (or the note is “subject to a restriction that has a significant effect on the fair market value”, which is not the case here). The inclusion of the fair market value of vested property in gross income at the time of transfer is, of course, quite consistent with the principles of section 83.
The regulations, then, strongly support the position that an employer’s use of a third party note to pay for services results in immediate recognition of income equal to the note’s fair market value. It follows that the receipt of such a note upon the arm’s-length disposition of an option would have the same consequences.
This argument is not necessarily dispositive, however, because the regulation does not define “note or other evidence of indebtedness”. Read very broadly, any promise evidenced by a writing could fit within the bounds of that phrase - an interpretation that is inconsistent with Revenue Ruling 60-31. (The IRS’s abortive attempt to repudiate that ruling, in the proposed §1.61-16 regulations, was overturned by Congress, and the agency is now prohibited from trying again.)
It might be difficult to make an argument that the FLP’s note should be demoted to the status of “an unfunded and unsecured promise”. The only feature that points in that direction is nonassignability, which prevents the payee from converting the maker’s promise into immediate cash. In other section 83 contexts, though, a similar inability to realize cash does not affect the time of taxation. For instance, an employee who receives nonforfeitable, but nontransferable, property is taxed on the property’s value, regardless of whether he can currently sell it or use it as collateral. Nevertheless, let us assume arguendo that, in at least some situations, the FLP’s obligation would not be classified as a “note or other evidence of indebtedness”. Would its receipt have the same tax consequences as a similar unfunded, unsecured promise by the recipient’s employer?
Revenue Ruling 60-31 did not consider a situation in which a service provider received an unfunded, unsecured promise of payment from someone other than the recipient of the services. It could be argued that, logically, one unfunded, unsecured promise is no better than another, but, with one possible exception (the Childs case, to be considered presently), the extant authorities deal with promises by service recipients and parties closely related to them. (Cf. Berry v. U.S., 593 F.Supp. 80 (M.D.N.C., 1984), aff’d, 760 F.2nd 85 (4th Cir., 1985), where the court held that a personal guarantee of a basketball player’s deferred compensation by the owners of his team did not give rise to constructive receipt of income under the economic benefit doctrine.)
Richard A. Childs, 103 T.C. 634 (1994) is the strongest authority for treating the receipt of an unfunded, unsecured promise as a nontaxable event regardless of the identity of the promisor, but neither the analysis nor the facts are lucid enough to furnish reliable guidance. The taxpayers were attorneys who were entitled to deferred payments of legal fees agreed to as part of the settlement of a lawsuit. Under the settlement agreement, the defendants, who were responsible for paying the fees, assigned their obligation to a third party (First Executive), which then purchased annuity contracts from its insurance company subsidiary to cover the promised stream of payments. The IRS argued that, as a result of this transaction, the taxpayers’ rights to future compensation were funded and that they therefore were liable for tax on the value of the annuities. The court, after reviewing various more or less pertinent cases, summarized them as follows:
Taken together, these cases stand for the proposition that funding occurs when no further action is required of the obligor for the trust or insurance proceeds to be distributed or distributable to the beneficiary. Only at the time when the beneficiary obtains a nonforfeitable economic or financial benefit in the trust or the insurance policy is the provision for future payments secured or funded. However, if the trust or policy is subject to the rights of general creditors of the obligor, funding has not occurred.
Applying these principles to the case before it, the court treated First Executive as the “obligor” and found that the annuity contracts remained subject to the claims of its general creditors. Therefore, the obligation was not funded. It is not clear why the role of “obligor” was attributed to a company that had not been a party to the lawsuit and that was, so far as one can gather from the facts disclosed in the opinion, simply acting as an annuity provider, but the court seems nonetheless to have equated Executive Life with the recipient of services. Otherwise, its opinion would stand for the untenable proposition that the purchase of an annuity payable from an insurance company’s general account never results in funding. (If the insurer is the “obligor”, a contract supported by its general account, which is by definition subject to the claims of its creditors, cannot meet the Childs standard for being considered secured or funded.) Therefore, the case does no more than restate the principle that a service recipient does not fund promised compensation until it places assets beyond the reach of its own creditors. The assets need not necessarily by protected from every creditor in the world.
More directly on point are Revenue Rulings 69-50, 1969-1 C.B. 140, amplified by Revenue Ruling 77-420, 1977-2 C.B. 172, and 69-474, 1969-2 C.B. 105. Each considered an arrangement under which a physician performed services for patients covered by health insurance policies and agreed to defer receipt of a portion of the payments due from the insurer. In the first ruling, the physician had no other relationship to the insurer. The IRS held that he performed services for the patients and received current economic benefit from his right to receive compensation from the insurance company. His agreement to postpone enjoyment of that benefit, having been made with the third party payor rather than with the recipients of the services, did not effectively defer it, and he was therefore currently taxable on the income. In the other ruling, the physician was employed by the insurer, and his deferred compensation arrangement was treated in the same manner as any similar agreement between employer and employee. These contrasting rulings indicate that the IRS perceives a difference between an unfunded, unsecured promise by an individual’s employer and a similar promise made by a third party.
In conclusion, the IRS would have more than one ground for arguing that the value of the FLP’s note was immediately taxable to the seller of the options, and there is no clear contrary authority. It does not seem probable then, unless extraordinary facts and circumstances are present, that courts would agree with the hoped-for tax consequences of the FLP-option strategy.