New IRS Approach to Stock-Option Compensation

The IRS has taken a surprising approach to deductions related to stock-option compensation under cost-sharing agreements. In Field Service Advice (FSA) 200003010, it determined that the value of compensatory stock options is a cost that must be shared with (or charged out to) affiliates under Regs. Sec. 1.482-2A(d)(4). What is most surprising is that the Service did not require that the compensation be calculated under Sec. 421 (for a disqualifying disposition) or under Sec. 83 (for a nonqualified stock option (NQSO)). Rather, it measured the options' values on the date they were granted, based on a modified Black-Scholes valuation method.

Cost-Sharing under Sec. 482

Sec. 482 provides that the IRS could distribute, apportion or allocate gross income, deductions, credits or allowances among controlled entities if necessary "to prevent evasion of taxes or to clearly reflect the income of those entities." For any transfer or license of intangible property (within the meaning of Sec. 936(h)(3)(B)), the income for such transfer or license should be commensurate with the income attributable to the intangible.

Regs. Sec. 1.482-2A(d)(4) provides that for intangibles developed pursuant to a bona-fide cost-sharing agreement, no allocation will be made for their development "except as may be appropriate to reflect each participant's arm's length share of the costs and risks of developing the property." Costs taken into account "include, but are not limited to, costs or deductions for compensation, bonuses, and travel expenses attributable to employees directly engaged in performing such services." Neither the statute nor the regulations addresses compensatory stock options.

In FSA 200003010, a U.S. parent entered into research and development (R&D) cost-sharing and service agreements with two of its controlled foreign corporations (CFCs). The costs shared or charged out under the agreements included labor that the R&D departments booked. The parent granted stock options to employees (presumably of the parent) who worked in these R&D departments. The parent claimed deductions under Sec. 83(h) for compensation related to NQSOs, and under Sec. 421(b) for disqualifying dispositions of incentive stock options (ISOs). None of these amounts was shared with the CFCs. The Service allocated income from the CFCs to the parent under Sec. 482 equal to the options' value on the grant date, under the Black-Scholes option-pricing model.

The IRS based its result on LoBue, 351 US 243 (1956), Apple Computer, 98 TC 232 (1992), and Sun Microsystems, TC Memo 1995-69. It concluded that these cases confirm that amounts paid in consideration for services are compensation even though they are paid in the form of property. It then held that compensation paid for purposes of the cost-sharing agreements included compensation relating to stock options, despite the lack of direct statutory or regulatory support.

Timing and Valuation of the Options

The FSA concluded that in the absence of specific regulations under Sec. 482 for valuing compensatory stock options, any reasonable method and timing of valuation can be used, as long as it was consistent. The Service considered two methods to be reasonable. The options' value could be measured (1) at grant, under a modified Black-Scholes option-pricing model or (2) at exercise (or at a disqualifying disposition of ISO stock or stock purchased under an employee stock purchase plan (ESPP)), in which the value would be equal to the spread between the value of the underlying stock at such time and the options' exercise price. Rather than follow the method used by the parent (valuation at exercise or disqualified disposition), the IRS valued the options at grant under the Black-Scholes method.

Inconsistent Results

The use of the Black-Scholes value of the options on the grant date conflicts with the specific statutory treatment of ISOs and NQSOs. Under Sec. 421(a), neither the grant nor the exercise of an ISO (or an option to purchase stock under an ESPP) gives rise to employee compensation in-come or a corresponding employer deduction. Under Sec. 421(b), compensation income and the related deduction arise only on a later disqualifying disposition of the underlying stock. Under Sec. 83, there is no employee income or employer deduction on the grant of a nonqualified option, as it does not have a readily ascertainable fair market value. Generally, this means a deduction is available only when the employee exercises the option. It would be more reasonable (and consistent with the Code) to require that Sec. 482 allocations of stock-option compensation conform to the timing and valuation rules set forth in the relevant statutory provisions.

From Susan Lennon, J.D., Washington, DC