Gross Income
Exercise of Options Using Borrowed Funds
Under Sec. 83(a), if property is transferred in connection with the performance of services, the employee who performed the services has gross income in an amount equal to the excess of the fair market value (FMV) of the property over the amount paid for the property. Sec. 83(a) also states that both the income event and the measurement of FMV of the property occur only when the property is first either transferable or not subject to a substantial risk of forfeiture. Under Regs. Sec. 1.83-3(a)(1), a transfer of property occurs when a person acquires a beneficial ownership interest in such property. When property is received in the form of a nonqualified stock option, Sec. 83(e)(3) requires that the option must have a readily ascertainable FMV to be taxed to the employee at grant.
In Racine, 7/3/07, the Seventh Circuit addressed the issue of when a transfer occurs for Sec. 83 purposes. The decision provides a cautionary tale for taxpayers who use nonrecourse debt to finance the exercise of their stock options.
Facts
Racine was employed by a large telecommunications company during the 2000 tax year. As part of her compensation package, she was granted nonstatutory employee stock options that were not actively traded on an established market. From March–July 2000, she exercised options to purchase 25,257 shares. The exercise price was $58,811, and the FMV of the shares at the time of exercise was $1,972,706. The company remitted about $625,000 in income tax withholding on her gain of over $1.9 million and demanded reimbursement from her before it would give her clear title to the shares. To finance the exercise price and the tax, Racine borrowed about $684,000 on margin from a market-maker broker.
Soon after the option exercise, the FMV of the stock began to plummet and the broker issued margin calls. In November 2000, Racine sold 18,291 shares at $15.61 per share, and in May 2001 she sold 1,836 shares at $20.41 per share.
On her 2000 return, Racine claimed a $368,000 refund, asserting that the shares were transferred to her when they were sold in November 2000 and May 2001 and not at exercise. The IRS granted the refund but demanded the money back after an audit. The Tax Court agreed with the Service and concluded that the refund was issued in error and that Racine should pay back more than $500,000.
Regs. Sec. 1.83-3(a)(2) provides that in a purchase transaction, if the amount paid for property is in whole or in substantial part indebtedness secured only by the acquired property (i.e., nonrecourse debt), the transaction may be viewed as the equivalent of the grant of an option. Thus, the regulations take the position that the acquisition of property with nonrecourse debt may not constitute a transfer of the property so acquired.
Seventh Circuit Decision
On appeal, Racine argued that buying stock with borrowed money is like replacing one option with another: As long as a broker supplies the capital, the taxpayer has nothing at risk and can walk away freely, allowing the broker to sell the collateral in the market to cover the loan.
In her argument, Racine reasoned that the nonrecourse nature of the debt (as provided in Regs. Sec. 1.83-3(a)(2)), combined with the fact that none of her capital was at risk (as provided in Regs. Sec. 1.83-3(a)(6)), make her transaction look like Regs. Sec. 1.83-3(a)(7), Example (2), in which a nonrecourse loan works like an option by allowing an em-ployee to capture any gain in the stock’s value without taking a risk of loss.
According to Racine, Congress intended to deny capital gains treatment to those who do not make any capital investment in their options; see Palahnuk, 70 Fed. Cl. 87, 92 (2006). Thus, Racine concluded that because she exercised her options using a loan from a market-maker broker, she had no capital at risk and therefore no transfer occurred until the market-maker broker sold the stock to satisfy the margin calls on her account.
The Seventh Circuit affirmed the decision of the Tax Court and held that a transfer occurs when a taxpayer exercises an option and acquires full legal and beneficial ownership of stock. The court determined that the margin loan in question was not a nonrecourse debt and that Racine bore the risk of loss. The court further disagreed with Racine’s analogy of her situation to that described in Regs. Sec. 1.83-3(a)(7), Example (2), which the court said dealt with whether the investor bears the risk that the price of the asset at issue will decline and not whether the risk is to the investor’s other assets. The court also indicated that the holder of a call option (unlike Racine but like the employee in Example (2)) cannot lose because he or she can walk away from the option if the price declines. In addition, the court noted that Sec. 465, which limits business expense deductions to amounts at risk, does not define transfer for purposes of Sec. 83.
The crux of the Seventh Circuit’s ruling was that Racine bore the risk of loss at all times and never made a serious attempt to reduce her financial exposure to the possibility that the stock could drop in price. The court commented that if Racine wanted to reduce her exposure she could have hedged with put options, sold the stock and invested in a diversified portfolio, or withdrawn the money from the stock market altogether.
Observations
This case highlights three courses of action an individual taxpayer should consider when deciding to exercise nonstatutory stock options that do not have a readily ascertainable FMV at the date of grant if the taxpayer does not have enough money to fund the exercise of the options.
The first consideration would be to create an arrangement under which the shares could be obtained and sold instantaneously and the proceeds from the sale could be used to finance the exercise price. In Racine’s case she held on to the shares after obtaining them and as such fell into a classic whipsaw when the price of the stock declined.
If such an arrangement is not possible, a second alternative would be to finance the exercise price with nonrecourse debt; the holder of property purchased with such debt generally has no risk that the property will decline in value unless (and until) he or she puts his or her own capital into the transaction. However, it is important to note that the test for transfer status when using nonrecourse debt becomes unclear as the borrower makes payments on the debt. As payments are made and the debt becomes smaller, the risk of decline in stock value is gradually shifted to the borrower, and he or she eventually takes on the role as true beneficial owner of the property.
Finally, if a taxpayer chooses to take Racine’s course of action and finance the exercise with a margin loan, the risk should be mitigated as soon as possible. Whether, as the court said, by hedging with put options or by withdrawing the money from the stock market altogether, the taxpayer should formulate and employ a strategy to lessen the exposure that would be created by a substantial decrease in the price of the stock.
From Jim Maio, CPA, San Diego, CA
Tax Treatment of Compensation Received as a Nonprofessional Representative
Most baby boomers, who are now between the ages of 42 and 60, will soon face two major events in their lives: planning for retirement and the death of their parents. Many of these individuals will take on the role of personal representative (executor) of their parents’ estates when their parents die and will receive compensation from the estate for these services. From a tax standpoint, how is this income taxed? Is it considered self-employment (SE) income subject to both SE tax and income tax? Can this compensation be claimed as earned income for the purposes of contributing to an IRA?
SE Income
According to Regs. Sec. 1.1402(c)-1, a taxpayer must carry on a trade or business, either as an individual or as a member of a partnership, in order to have net SE earnings. According to Rev. Rul. 58-5:
Generally, nonprofessional fiduciaries (that is, for example, persons who serve as executor or administrator in isolated instances, and then as personal representative for the estate of a deceased friend or relative) will not be treated as receiving income from a trade or business unless all of the following conditions are met:
(a) There is a trade or business among the assets of the estate,
(b) The executor actively participates in the operation of this trade or business,
(c) The fees of the executor are related to the operation of the trade or business.
However, according to Rev. Rul. 58-5, in some circumstances, even though the estate’s assets do not include a trade or business, if the management activities required of the executor for administering the estate are sufficient in scope and duration, these activities could constitute operation of a trade or business and the income be deemed SE income.
In Rev. Rul. 72-86, the IRS distinguished between the SE treatment of the fees paid to executors and fees paid to persons serving in a fiduciary capacity as members of a corporation’s board of directors. According to the IRS, the fees received from a corporation for performing services as a board director are SE income because the individual’s work is on a regular and continuous basis and is based on that individual’s qualities or expertise. The Service stated that fees paid to a nonprofessional executor or personal representative (except in certain circumstances) are not SE because the services are performed on an isolated basis and stem from a personal relationship with the decedent that is not based on particular expertise or special qualities.
The IRS summarizes its position on fees received by nonprofessional executors or personal representatives in Publication 559, Survivors, Executors, and Administrators:
All personal representatives must include in their gross income fees paid to them from an estate. If paid to a professional executor or administrator, self-employment tax also applies to such fees. For a nonprofessional executor or administrator (a person serving in such capacity in an isolated instance, such as a friend or relative of the decedent), self-employment tax only applies if a trade or business is included in the estate’s assets, the executor actively participates in the business, and the fees are related to operation of the business.
Earned Income
Contributions to an IRA are allowable if a taxpayer has compensation and it is includible in his or her gross income for the year (Sec. 219(b)). Under Sec. 219(f), compensation is defined as earned income under Sec. 401(c)(2). This term means earnings from self-employment with respect to a trade or business in which personal services of the taxpayer are a material income-producing factor. It appears, then, that nonprofessional executors or personal representatives who handle estates without trade or business assets cannot be deemed to be in a business themselves. Thus, the fees received by these individuals are not subject to SE tax and are not earned income for IRA contribution purposes.
Conclusion
According to current tax law, fees received for personal services performed in operating a trade or business are subject to SE tax and are allowed as earned income for purposes of contributing to an IRA. The IRS generally does not consider fees received as nonprofessional executors or personal representatives to fall into this category. The main reasons cited are lack of (1) continuing services and (2) special qualities or expertise. However, being a nonprofessional executor or personal representative does involve a considerable amount of time and effort. The individual usually is involved in taking an inventory and marshalling the assets of the estate, meeting with an attorney, making investment decisions, selling the principal residence, and distributing the assets to the beneficiaries.
The treatment of the fees paid to nonprofessional personal representatives is seemingly out of step with the federal government’s policies regarding retirement savings. For example, the recently enacted Heroes Earned Retirement Opportunities Act, P.L. 109-227, allows military personnel who receive tax-free combat pay to count it as earned income for IRA contribution purposes. Previously, this pay was not deemed earned income because it was not includible in gross income. Moreover, the federal government encourages taxpayers to save for and fund retirement so they will not be dependent on the government for support during retirement. Arguably, both government and taxpayer interests could be furthered if taxpayers, depending on their particular situations, could either pay SE tax and contribute to an IRA or choose not to do so.
From Elizabeth C. Conner, CPA, University of Colorado, Denver, CO, and Michael V. Schaefer, CPA, Sole Practitioner, Denver, CO (Neither Affiliated with PKF North American Network)
