Intrafamily Installment Sales of Nonqualified Stock Options

Today's employees of dot-com companies are fast becoming tomorrow's millionaires. Every day, Internet companies are going public; their initial public offerings are making their workers wealthy, often via the use of nonqualified stock options (NQSOs). This article suggests that these noveau riche clients sell their NQSOs on an installment basis to a family-controlled entity, thereby deferring taxes and converting ordinary income to capital gain.

James R. Hamill, Ph.D., CPA
Professor and Rogoff Erickson Diamond & Walker LLP Lecturer
Anderson Schools of Management
University of New Mexico
Albuquerque, NM

Roger W. Lusby, III, CPA, AEP, CMA
Equity Member
Frazier & Deeter, LLC
Atlanta, GA

For more information about this article, contact Dr. Hamill at (505) 277-8890 or hamill@anderson.unm.edu or Mr. Lusby at (404) 659-2213 or rlusby@frazier-deeter.com .

Executive Summary

• Tremendous wealth has been created via IPOs, but unlike past generations, it is being shared with employees through stock options.

• The value of a stock option has three elements--intrinsic value, leverage value and price protection value.

• Provided at least one payment is received in a year other than the year of sale, the sale of an option should be eligible for installment reporting (unless one of the Sec. 453 exceptions applies).

Everyone is talking about the equity markets. Companies want to go public or be acquired at outlandish multiples, the media is consumed with dot-coms and e-commerce is the rage. Initial public offerings (IPOs) and stock options are now a part of everyone's vocabulary. Tremendous wealth has been created, but unlike past generations, it is being shared with employees through stock options.

How much wealth has been generated? Exhibit 1 below lists 10 IPOs with large one-day gains. Employees holding stock options at these companies saw their wealth increase three to seven times in a single day.

This unprecedented growth in the value of the equity markets, and the increasing use of equity-based compensation, means that many employees have significant wealth in unexercised incentive stock options (ISOs) or nonqualified stock options (NQSOs). Under Sec. 422(b)(5), an ISO, by its terms, is not transferable by an employee. To create the proper incentives for equity-based compensation, many NQSOs are also nontransferable. However, in response to employee demands, many employers have amended their NQSO plans to permit transfers to the option holder's family members (including trusts or partnerships established for their benefit).

The IRS has ruled that a gift of NQSOs is a completed transfer for gift tax purposes and has suggested a safe harbor for transfer tax valuations of such options.¹ When an option is exercised by the transferee, however, the employee is required to recognize the compensation income resulting therefrom.²

An alternative to a gift of an NQSO is a sale to a partnership or trust controlled by the employee's family. Such a sale must be permitted by the employer's plan; however, employee demand to sell an option position to family members, rather than to transfer by gift, may induce employers to agree to plan modifications permitting a sale to designated parties similar to those permitted to acquire unexercised options by gift. The dot-coms grant equity-based compensation through their many e-commerce ventures. These companies are particularly well-suited to the option sale strategies suggested in this article, because they anticipate significant appreciation in the value of their stock and are likely to be more flexible in designing or modifying stock option plan terms.

This article analyzes the benefits of a sale of NQSOs to an entity controlled by the option holder's family. If a sale is structured to qualify for installment reporting of the intrinsic gain on the sale date, the employee may be able to achieve both (1) gain deferral and (2) conversion (from compensation income to capital gain) of gains realized by the family-controlled entity (FCE) after the date of sale and through the date of option exercise. This analysis includes the income tax consequences of such a sale, including the availability of installment reporting and valuation issues. Because the installment sale strategy necessarily depends on an employer's willingness to permit such a sale, the effects of such a sale on the employer's tax situation and on the incentive aspects of the stock option plan are also discussed.

NQSO Income Timing

Sec. 83 governs the tax treatment of a transfer of property in exchange for the performance of services. Generally under Sec. 83(a), the service provider includes in income the excess of the fair market value (FMV) of the property transferred over the amount (if any) paid for the property.³ If, however, the property is subject to a substantial risk of forfeiture and is not freely transferable, the taxable event is deferred until the risk of forfeiture lapses or the property becomes freely transferable. A substantial risk of forfeiture generally exists under Sec. 83(c)(1) if an employee must perform substantial future services to retain the property; property is not freely transferable unless it can be transferred free of forfeiture risk. In the unlikely event the employee can locate a buyer who will take the property subject to the forfeiture risk, he is taxed when the property is transferred for value; otherwise, the taxable event is the date of lapse of the forfeiture restriction.

Sec. 83 is the statutory authority for the taxation of NQSOs, even though Sec. 83(e)(3) states that Sec. 83 does not apply to the transfer of an option without a readily ascertainable FMV.⁴ The Sec. 83 regulations govern whether an option has a readily ascertainable FMV and is, therefore, subject to Sec. 83 at the date of grant of the right. To understand why an NQSO does not have a readily ascertainable FMV, one must first review the economic aspects of an option.

Option Basics

An option gives a holder a right (but not an obligation) to acquire the property subject to the option right by paying the designated exercise price within the period specified in the option contract. An employee holding an NQSO will not exercise that option and acquire the stock unless the option is "in the money" (i.e., the FMV of the stock exceeds the exercise price). The value of an option to acquire stock has three elements. First, the intrinsic value of an option refers to the excess (if any) of the stock's value over the exercise price. This is the value that would be realized on an immediate exercise of the option right; it increases as the value of the stock subject to the option right increases.

Second, the option has leverage value, because it allows an employee to maintain a long position in employer stock without having to commit capital or pay taxes until option exercise. This value may be thought of as the return that an employee could earn on funds otherwise used to acquire the stock subject to the option right. This leverage value is similar to an interest-free loan; the leverage value decreases as the time to maturity of the option decreases and with the appropriate discount rate.⁵

Third, because an option holder would never exercise an out-of-the-money option, he suffers no economic loss for a decline in the stock's value below the option exercise price. Thus, although stock returns tend to be distributed evenly, with possible positive and negative returns, an option has a "kinked" or "stacked" distribution, in which any probability associated with stock price movements below the exercise price is associated with a zero payoff. Thus, an option offers price protection (i.e., insurance) value for stock price movements below the exercise price. This price protection value is higher with more volatile stocks, because the probability of an option finishing out-of-the-money is higher with such stocks.

Valuation: For NQSOs to acquire stock traded on an established market, the intrinsic value is readily determinable at any date. However, the leverage and price protection elements are quite difficult to value, particularly as the time to maturity of the option right lengthens. For this reason, Regs. Sec. 1.83-7(b)(2) states that, unless an option is traded on an established market,⁶ it cannot have a readily ascertainable FMV unless it is transferable, not subject to forfeiture risk, immediately exercisable and has an "option privilege" that may be readily valued. "Option privilege" is defined by Regs. Sec. 1.83-7(b)(3) and basically refers to non-intrinsic value (previously referred to as leverage and price protection values). The inability to capture the value of an option renders Sec. 83 inapplicable until the option is exercised, at which time the employee is subject to Sec. 83 treatment on the stock acquired. Thus, the stock, not the option, is the property for Sec. 83 purposes. The employee, on receiving the stock, recognizes ordinary compensation income.

Income recognized: Notwithstanding the foregoing, if an option is transferred for value before exercise, the amount received should fix the compensation for Sec. 83 purposes. This conclusion is supported by Regs. Sec. 1.83-7(a); the IRS so ruled in Letter Ruling 9533008,⁷ involving a right to a corporate employer's share of profits realized by a partnership.

In the ruling, the income right was held to be an unfunded, unsecured promise to pay, which is not property under Regs. Sec. 1.83-3(e). However, when the contingent right to compensation was sold to a family trust established by the employee's children, the IRS held that the employee would recognize ordinary income based on the value of the right on the sale date. This result was necessary to ensure that the income was taxed to the party who earned it. Any post-sale appreciation would be reported as capital gain when the stock is sold by the transferee trust. Because (1) an option is similar to the contingent profits right that was the subject of the ruling, (2) an option is not treated as property for Sec. 83 purposes and (3) a disposition for value also raises the issue of ensuring that the inherent compensation income is taxed to the party who earned it, the ruling's logic should apply equally to a pre-exercise transfer for value of an NQSO.

In Letter Ruling (FSA) 200005006,⁸ the IRS concluded that an arm's-length sale of a compensatory option creates the same tax result as if the option had been exercised. The IRS stated that Regs. Sec. 1.83-1(b)(1) provides that, on an arm's-length disposition of nonvested property, the service provider recognizes compensation income at the date of transfer; any post-transfer gains are taxed to the transferee. If such a disposition is not at arm's length, Regs. Sec. 1.83-1(c) provides that the transferor will also recognize compensation income for gains realized after the date of transfer. In the case of an option, no compensation income should result for gains realized after exercise. FSA 200005006 states, "we see no reason why the rules in Treas. Reg. 1.83-1(b) and (c) regarding arm's length and non-arm's length dispositions of restricted stock should not apply to compensatory options."

Tax planning: A sale of an NQSO for value to an FCE may create two tax benefits. First, any appreciation from the date of sale through the date on which the option would, absent the sale, otherwise have been exercised, may be converted from compensation income to capital gain (if the sale is at arm's length).

Second, if the sale can qualify for installment reporting, the compensation income is deferred until payments are actually received from the FCE. Post-exercise appreciation is deferred until the stock sale and is reported as capital gain whether the option is sold or exercised by the employee. Thus, the character of the post-sale and pre-exercise appreciation may be converted by the sale strategy,⁹ suggesting that the family sale strategy is most advantageous early in the life of the option, when the value is low. Also, because the intrinsic value of an option is generally more significant than the leverage or price protection elements, an early sale can reduce the FCE's required payment, because the intrinsic value is likely to be low at that time.¹⁰

Moreover, because many employees holding substantial NQSO positions are heavily invested in employer stock, a family sale may also allow for diversification of family holdings if the option is exercised (and the stock is sold) shortly after the initial sale. Proceeds of the second sale may then be invested in a diversified portfolio without tax ramifications, provided that no distributions are made from the FCE. While this strategy may, at first, appear to forfeit the capital gain deferral benefits, the deferral is simply shifted to the new securities acquired in the diversified portfolio. However, a sale-exercise strategy must consider if the benefits of installment reporting of the compensation income will be preserved if the FCE closes the option position after the initial sale.

Installment Reporting of NQSO Gain

The deferral benefits of the option sale strategy can be significantly enhanced if the compensation income triggered on option sale can be reported on the installment method. Because the family's intent is to create a taxable sale, it is important that the terms of the installment note support its characterization as debt, not as equity. If the note has equity characteristics, the IRS may contend that the disposition is a nontaxable exchange under Sec. 721(a). The income through date of exercise would then be compensatory in nature and should be allocated to the transferor under Sec. 704(c). Although Subchapter K contains no provision similar to Sec. 385 (which can recharacterize corporate debt as equity), the IRS has recharacterized partnership debt as equity in abusive transactions.¹¹ It may be appropriate to consider IRS ruling guidelines for attribution waivers in Sec. 302 redemptions, because they relate to the requirement that a redeemed shareholder not retain an equity interest. These guidelines suggest that the installment note should not (1) have a term in excess of 15 years, (2) be subordinated to other partnership creditors and (3) make interest payments contingent on profits.¹²

As was mentioned, Regs. Sec. 1.83-7(a) provides that if an option is sold in an arm's-length transaction, Sec. 83(a) will apply to the transfer in the same manner as it would to a transfer of the property subject to the option right. Sec. 83(a) would generally require that the option holder report any income from the sale in the year of transfer. However, Sec. 453(a) states that income from any installment sale shall be reported using the installment method. Thus, a question arises as to whether a sale of compensatory options meets the definition of an installment sale. Provided at least one payment is received in a year other than the year of sale, the sale of an option should be eligible for installment reporting (unless one of the Sec. 453 exceptions applies).

Sec. 453 allows income from a sale or exchange to be reported as payments are received. Although Sec. 453(b)(2) does not allow installment reporting for certain dispositions of dealer real property or personal property inventory, there is no explicit ban on reporting compensation income generated by an option sale on the installment method. Sec. 453(k)(2)(A) denies use of the installment method for sales of stocks or securities traded on an established market. In three related rulings,¹³ the IRS held that installment reporting is available for a class of stock that is unregistered and, therefore, not tradable under the Securities Act of 1933, even though the issuer also had a class of registered stock traded on an established market. The rulings noted that the Sec. 453(k)(2) prohibition relates to stock tradable in the hands of the taxpayer, because such stock could be converted into immediate liquidity in the public market, mitigating the need for installment reporting. Because NQSOs are not traded on an established market, an option holder should qualify for installment reporting of any gain realized from a private sale of such options.

Sec. 453(e) limits the benefits of intrafamily installment sale reporting when the related-party buyer resells the property within two years of the initial sale. In such case, the proceeds of the second sale are deemed received by the first seller, accelerating the gain reported within the family. For Sec. 453(e) purposes, a grantor and a fiduciary of a trust are related in the same manner as a partner and a partnership. However, this provision applies only when the second seller disposes of the property that was the subject of the initial installment sale. Because one objective of an option sale may be to allow a family to diversify its holdings, the FCE may want to exercise the options immediately on purchase, then sell the stock thereby acquired and diversify into other securities. Such a strategy raises several issues.

First, if the FCE paid FMV for the option shares, an immediate exercise should not result in any gain to it, because the entity's basis in the options will equal their value, unless (as was discussed) the sale is recast as a nontaxable contribution. The cost would at least equal the options' intrinsic value and the stock basis would be increased by the exercise price; the FMV of the stock received on exercise will not exceed the sum of the basis in the options and the exercise price paid to acquire the stock. In fact, the FCE may realize a loss if (as would be expected in an arm's-length transfer) its basis in the options includes leverage and price protection values. This realized loss may arguably be disallowed under Sec. 1091(a), the "wash sale" rules, because the FCE will dispose of an option position and contemporaneously acquire a long position in stock of the employer corporation. Sec. 1091(a) states that options are treated as stock or securities for purposes of determining whether a substantially identical position was established within 30 days of the sale giving rise to the loss. However, the IRS has ruled that a call option contract and the shares of stock subject to the call are not substantially identical property for Sec. 1091 purposes.¹⁴

Second, if the FCE sells the stock immediately after option exercise, is the amount realized treated as received by the initial seller under Sec. 453(e)? The initial installment sale was of the options, not the stock acquired on their exercise. Thus, it is arguable that the disposition of the options through their exercise would be the second sale, and the lack of any amount realized from exercise would avoid the related-party resale problem. However, the IRS could argue that the disposition of the stock within two years of the original option sale would trigger the related-party resale rules to the extent of the stock sale proceeds. Further, Sec. 453(e) supports this view by referring to the "amount realized" on the second disposition, which, under Sec. 1001(b), would be the FMV of the stock received from the options' exercise. For this reason, it might be prudent to wait more than two years after the initial sale before selling the stock and diversifying the investment portfolio.

Third, as was mentioned, the option sale strategy would be expected to work best early in the option right's life or before an IPO, because the intrinsic value generally would be low and the compensation income realized on a sale to an FCE reduced. An early sale would start the Sec. 453(e) two-year resale period, thereby permitting earlier implementation of the diversification strategy. However, the leverage and price protection values would also be greater early in the life of the option right, which suggests that the option should not be exercised without careful consideration of the loss of these two elements of value. Thus, the FCE may lose the value of the option privilege by an immediate exercise strategy; the benefits of establishing a diversified portfolio must be weighed against the loss of the option privilege value.

Effects on Employer

An employer must agree to allow a sale of NQSOs to a family partnership or trust. NQSOs are granted to employees primarily to align the employee's goals with those of the employer and its shareholders. Specifically, an option holder has an incentive to help the value of the equity to grow. Allowing an employee to freely sell option shares for value would sever the alignment of the employee and the employer's objectives. However, if the option may be transferred only within the family, the employee continues to have an incentive to work to increase the value of the equity. This is why many employers have amended their option plans to permit a gift of options to family members or to FCEs. There seems to be no difference between permitting a gift or a sale of options to FCEs; however, an employer may be expected to be less enthusiastic if the FCE plans to immediately exercise the options and sell the stock. Thus, an employer may desire some restrictions on an employee's ability to immediately pursue a diversification strategy. Limited restrictions imposed by the employer (e.g., a waiting period before disposing of the position in employer stock) may also be acceptable to the employee if the two-year resale rule is a concern to installment reporting.

Sec. 83(h) allows an employer a deduction at the same time and in the same amount as the income reported by the employee. Because an employee's objectives in an installment sale of NQSOs includes minimizing and/or deferring compensation income, his employer will have adverse interests from a tax reporting perspective. However, if the employer is a relatively young company (e.g., a dot-com), it may be in a net operating loss position and, therefore, indifferent to a deferral of the deduction for the gain realized on the option sale date (and a loss of a deduction for gains arising after the sale and before exercise), particularly if the option sale strategy enhances employee morale.

Valuation Issues

The ability to convert post-sale stock gain from ordinary income to capital gain requires that the sale to the FCE be at arm's length.¹⁵ The option must be valued as of the sale date to support an arm's-length transfer; the terms of the installment note must be similar to those found in third-party sales.

Because an unexercised option has leverage and price protection values in addition to the more readily determinable intrinsic value, it is a challenging task to value such an asset. In Rev. Proc. 98-34,¹⁶ the IRS provided a safe-harbor method for transfer tax valuations of compensatory stock options. This method allows use of accepted models for valuation of market-traded options (e.g., the Black-Scholes and binomial models), with no discounts for features such as lack of free transferability. Because compensatory stock options differ on many important attributes from market-traded options, a well-regarded model such as Black-Scholes may nonetheless not accurately value compensatory options. The lack of free transferability and the inability to use the option in forming a risk-free hedge violate the assumptions of the Black-Scholes model.

Before adopting the strategy suggested in this article, a qualified valuation expert should be consulted. Such an expert must have extensive knowledge of the economic aspects of an option so that the features unique to a compensatory option may be taken into account when applying one or more of the accepted option valuation models.¹⁷

Example: L, a long-time client, is an executive at W Co., an exciting Web-based company that recently completed an IPO. L has a high net worth, not including the value of his 500,000 W NQSOs, in which he is fully vested. He feels the company is fully priced and would like to diversify his holdings while minimizing taxes. L wants to retire in 10 years and wants to know what his after-tax proceeds may be at that time.

The FMV of each option share is $52; the exercise price is $2. The options expire at the end of 2003 and have an expected market growth rate of 10%. L's Federal marginal ordinary income rate is 39.6%; his Federal long-term capital gains (LTCG) rate is 20%; his state ordinary and LTCG rate is 6% (the deduction for state and local income taxes has been ignored). L's FICA tax rate is 1.45%, because his compensation is above the Social Security wage base. The sale of stock options to an FCE is for the options' intrinsic value. The installment sale is for 10 years with a balloon payment. (Imputed interest has been ignored.)

In Variation 1 the options are exercised, sold and reinvested into a diversified portfolio. In Variation 2 the options are sold to an FCE in an installment sale, and later exercised by the FCE.

This analysis can be generalized to fit other fact patterns. The options will be sold to an FCE for their intrinsic value, which is excess of the FMV of the stock subject to the option right over the exercise price ($50 per share in this example). The leverage and insurance values of the option are disregarded for simplicity, which may raise the issue of whether the sale is at arm's length. However, there are several reasons why the intrinsic value assumption in the example is reasonable.

First, leverage value refers to the ability to earn a return on funds that would otherwise be invested to maintain a long position similar to the option position. In the example, L must pay $2 to acquire the stock, and would also have to pay tax of $23.53 (47.05% of the $50 per-share compensation) on the compensation income realized if the options were immediately exercised. Thus, maintaining the option position allows L to avoid paying the $2 exercise cost and the $23.53 tax cost before the expiration of the option right, a seemingly considerable leverage value. However, if the option were sold for value, the buyer (i.e., the FCE) would not be subject to any tax if the options were immediately exercised. Thus, the FCE would price the leverage feature based solely on the avoidance of a $2 per-share exercise price for the remaining term of the option right. This leverage value would be insignificant. Because the installment sale strategy would allow L to avoid compensation income for 10 years (well beyond Dec. 31, 2003, the date he would otherwise recognize that income), the deferral advantages of the sale strategy actually reduce the value L would place on the leverage component below that assigned to it by the FCE. Because L is closing his investment with an installment sale rather than by option exercise, the option position has virtually no leverage value to him.

Second, the insurance (i.e., price protection) component of the option's value refers to the ability to avoid incurring losses for stock price movements below the exercise price. Because this option is "deep in the money" and has only a few years until maturity, there is little probability that the stock price will move below $2 per share. Thus, the option has little or no insurance value.

The example also ignores the imputed interest rules. The FCE should pay interest at the applicable Federal rate. L could then return the interest to the FCE as a contribution or gift. However, a failure to provide for interest would cause the note (and option sales price) to be discounted, so that the transfer is for less than full and adequate consideration. If the option transfer price were not at arm's length, any post-sale appreciation through the date of exercise would also be compensation income to the seller, under FSA 200005006. Although it is critical to the success of this strategy that the note call for adequate interest, the example focuses on the advantages of deferral and conversion of income attributable to the stock position and, thus, does not separately illustrate the effects of interest payments.

L could obtain the $1 million needed to cover the exercise cost and the $11,762,500 needed to cover the tax liability by an immediate sale of 245,433 shares of W stock. This sale would not create any further tax liability, because the basis of the shares would equal their FMV at the date of exercise.

In Variation 2, it is assumed that the FCE immediately exercises the options and sells the shares. As was discussed, it may be advisable to wait more than two years after the initial sale before the options are exercised. In such case, the FCE would have some capital gains tax when the options are exercised. Because the capital gains tax would be paid before the 10-year period, the present value of the benefits of the installment sale strategy would be somewhat diminished. Also, the FCE must have $1 million available to exercise the options. Whether the FCE immediately exercises and sells the shares or waits two years to do so, the sale of stock would provide cash to pay the exercise price.

The installment sale strategy provides approximately $14 million additional value to the family. Although this benefit is based on the assumptions made and is scaled by the magnitude of an employee's option position, it allows an employee to realize a benefit almost 50% greater than the intrinsic value of his options on the date the strategy is implemented. Most of the benefit comes from the deferral of compensation recognized on the sale date. It is possible to convert the character of gains realized after the sale and through the exercise date. In the example, there is no conversion benefit; it is assumed, for comparison purposes, that L would exercise the options before their expiration date. If, in the absence of a sale, L were to wait until Dec. 31, 2003 to exercise his options, he would recognize approximately one-third more compensation income (assuming 10% annual growth in W stock). This income would be subject to a combined 47.05% rate (instead of the 26% LTCG rate assumed in the example). Thus, if the alternative to a sale is to hold the options until maturity, the benefits of the installment sale are even greater. In Variation 2, post-sale gains are taxed as capital gains, even if the options are not exercised until two years after the sale.

It can be argued that it is inconsistent to assume that L would hold open the option position until expiration in Variation 1, but close his position by sale in Variation 2. However, if the option is not sold, the leverage value is significant, because the compensation income may be deferred by not exercising. Thus, it may be rational to defer exercise to maintain the option's leverage value. In contrast, if the option is sold on an installment basis, the leverage value to both L and the FCE is quite small, because only the exercise price must be paid if the option is immediately exercised. The compensation income is deferred through the installment sale; thus, there is no reason to hold the option open just to preserve the leverage value attributable to deferral of the compensation income.

Conclusion

A sale of NQSOs to an FCE, if permitted by an employer's plan, can result in a deferral of post-sale and pre-exercise gains in the underlying stock and a conversion of such gains from ordinary income to capital gains.¹⁸ Conversion results in a loss of an immediate tax deduction for the employer, making this strategy particularly well suited for start-up companies with tax losses, such as dot-coms. When the sale is on an installment basis, pre-sale gains in the option position, which are generally recognized on exercise of the option right, may also be deferred well beyond the normal recognition date. The powerful effect of deferring the tax on the exercise of NQSOs should be sufficient incentive for select employees to consider this aggressive strategy. This strategy is further enhanced if the employee has other assets such that the FCE would not need to make distributions for a number of years, thereby deferring the ultimate tax liability, while allowing the employee (and his family) to diversify their overall investment portfolio.