Debt Reduction Is Not a Purchase Price Reduction

Rev Rul. 2004-37 involved a change in circumstances all too familiar to employees of companies in certain volatile industries. For example, in the 1990s, technology companies routinely rewarded employees with options to purchase stock. To exercise these seemingly lucrative options, the employees would often issue notes to the employer. When the technology bubble burst and stock prices tumbled, the employees ended up holding stock worth much less than the remaining debt. To ameliorate the financial effect and retain employees, some employers agreed to reduce the debt.

In Rev. Rul. 2004-37, the Service ruled, in part, that a debt reduction will not be treated as discharge of indebtedness (DOI), excludible from an employees income as a purchase price reduction under Sec. 108(e)(5); rather, the reduction will generally cause the employee to recognize compensation income under Sec. 83.

  

Facts

In year 1, an employer (a corporation) grants an option to an employee to purchase 1,000 shares of the employers common stock at an exercise price of $75 per share, the fair market value (FMV) on the grant date.

On January 1 of year 2, the FMV of 1,000 shares of the employers stock has increased to $100,000 and the employee exercises the option and purchases 1,000 shares in exchange for a 10-year nontransferable $75,000 recourse note secured by the stock. The note provides for interest payments on December 31 of each year the stock is outstanding. The interest rate on the note is not less than the appropriate applicable Federal rate on the issue date. As a result of exercising the option, the employee includes $25,000 as compensation income under Sec. 83(a) in year 2. The employer reports $25,000 of compensation income on the employees Form W-2 and claims a corresponding deduction in year 2 under Sec. 83(h). In years 2 and 3, the employee makes the required interest payments under the note.
On January 1 of year 4, the FMV of the employer stock declines to $50,000 and the employer and the employee agree to reduce the notes stated principal amount from $75,000 to $50,000. The employee claims that the debt reduction resulted in DOI income, nontaxable under Sec. 108(e)(5).
 

Analysis

A review of the DOI income rules is necessary to understand the employees argument. Sec. 61(a)(12) includes in gross income income from the discharge of indebtedness. DOI income arises when a creditor releases a debtor from an obligation incurred at the outset of the debtor-creditor relationship. When a debt arises out of a property purchase, the cancellation or reduction of the amount due may be treated as a reduction of the purchase price, rather than as income. If the discharge is treated as a purchase price reduction, the debtor generally reduces basis in the purchased property and does not recognize DOI income. This rule of law was initially developed by the courts and later codified in Sec. 108(e)(5). In general, six basic factors must be satisfied:

• The debt is a debt of the purchaser of property;

• The debt is owed to the seller of the property;

• The debt arose out of the purchase of property;

• The debt is reduced;

• The reduction does not occur in a title 11 case or when the debtor is insolvent; and

• But for this provision, such decrease would be treated as income to the purchaser from DOI.

In Rev. Rul. 2004-37, the employee apparently argued that the Sec. 108(e)(5) criteria were met when the employer decreased the notes principal.

The Service categorized the employees claim as an aggressive executive stock transaction by a corporate insider. In applying Sec. 83, the Service ruled that an employee will generally recognize compensation income when the debt is reduced. The Sec. 83 regulations are the basis for its ruling. Under Regs. Sec. 1.83-4(c), if debt treated as an amount paid for Sec. 83 purposes is subsequently cancelled, forgiven or satisfied for an amount less than the debt, the amount that is not, in fact, paid is includible in the employees gross income for the tax year in which such cancellation, forgiveness or satisfaction occurs. The Service concluded that if the reduction of the notes stated principal satisfies Regs. Sec. 1.83-4(c), then the reduction is a way for the employer to compensate the employee; any income resulting from the reduction is not income to the employee from DOI subject to Sec. 108.

In the ruling, the Service determined that the reduction in principal was a cancellation, forgiveness or satisfaction of an amount less than that of the note, because the debt reduction was a significant modification under the Sec. 1001 regulations. Under Regs. Sec. 1.1001-3, there is an exchange of the unmodified note for the modified note between an employee and an employer and a satisfaction of the original debt. The unmodified notes adjusted issue price is $75,000 and the modified notes issue price is $50,000; see Sec. 1273(b)(4) and Regs. Sec. 1.1275-1(b). As a result, under Regs. Sec. 1.83-4(c), the employee would recognize compensation income of $25,000 (the excess of the unmodified notes adjusted issue price over the modified notes issue price). The employee would recognize the compensation income in year 4, when the modification occurred.

The Service cautioned that other alterations to the notes terms could also result in a significant modification under the Sec. 1001 regulations, triggering compensation income. For example, if the employer had reduced the notes interest rate or changed the note from recourse to nonrecourse, that would have generally resulted in compensation income to the employee.

Although there appears to be an overlap between the Sec. 83 regulations and Sec. 108(e)(5), the Service applied Regs. Sec. 1.83-4(c), dismissing Sec. 108(e)(5) with minimal analysis. Because it did not acknowledge the overlap or provide the rationale for this position in the ruling, it is difficult to predict whether Rev. Rul. 2004-37 will have a far-reaching effect.

From Mary Van Leuven, J.D., LL.M., Washington, DC