Probate & Trust Law Section Conference Manual ... - Minnesota CLE

not property for purposes of Section 83. 14 If the
note is not property for that purpose, then arguably
any tax consequence to the recipient is deferred until
payments are received under the note.
One problem with this analysis is that the
term property as used in Section 83 primarily relates
to the “thing” which when received by the employee
from the employer the will trigger tax consequences.
The regulations seem to be distinguishing this thing
from a promise that is insufficient to trigger those
consequences. Every day that an employee works
creates an inherent obligation on the employer to
pay the employee. Yet, the tax law does not exact
its punishment until the employee is actually paid
that obligation. It seems likely that the regulations
were directed to unfunded promises of this kind. An
actual sale for a note is clearly distinguishable.
Some proponents have also been tempted to
argue that the installment sale rules of Section 453
should apply to an option sale. However, there are
clear technical problems with this argument. Not
the least of these is the characterization of the
income triggered by Section 83 as compensation
income, which is not eligible for deferral under
Section 453.
Regardless of the rationale, however, the
IRS recently clamped down on this position. IRS
Notice 2003-47, 2003-30 I.R.B. 132, warns that the
IRS will challenge any assertion that income is
deferred because the purchase consideration is a
deferred payment obligation. Furthermore, the IRS
has added such transactions to the roster of “listed
transactions” for purposes of the reporting and list
maintenance requirements applicable to tax shelters.
Moreover, Notice 2003-47 and
accompanying changes to the Section 83 regulations
take the position that a transfer of NQSOs to a
related buyer is considered a non-arm’s-length
transfer. For this purpose, the buyer is treated as
related to the seller under the expanded versions of
the Section 267(b) and Section 707(b)(1) attribution
rules. Hence, regardless of the nature or amount of
the consideration, sales of NQSOs to family
members do not cut off Section 83 exposure, at least
in the IRS’ opinion. Such exposure continues
through the date of exercise or sale to a party
unrelated to the employee, at which time the
14 Regs. Section 1.83-3(e) provides that “property” does
not include an “unfunded and unsecured promise to pay
money or property in the future.”
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employee is potentially liable for additional tax. As
shown by the example above, this approach can
cause some of the economic gain to be taxed twice.
The IRS’ approach is clearly overkill. First,
it treats as a listed transaction any sale for a deferred
payment obligation. This goes too far. The Notice
should have been limited to deferred payment
transactions where the seller claims an income
deferral. If the seller reports all the sale gain in the
year of the sale, where is the abuse? From a tax
perspective, the transaction is no different than a
cash sale, which is not a listed transaction. Second,
the Notice draws a line between arm’s-length and
non-arm’s-length sales based solely upon the
relationship of the parties. This approach
completely ignores abundant authority that arm’slength
transactions can be effected between related
parties. Moreover, the Notice ignores provisions
like Section 7872 that establish specific criteria for
securing arm’s-length treatment for transactions
between related parties.
Nevertheless, the Notice and new
regulations cast a pall over all related party sales of
NQSOs and sales where installment or other
deferred payment obligations are involved. Clearly,
sales of NQSOs have significant potential benefits
for estate planning purposes, even where there is an
immediate income tax levied on the note amount.
However, effecting such transactions is now more
problematic because of the heightened scrutiny
inherent in their “listed transaction” status 15 and
because such sales are now considered to be nonarm’s-length
for purposes of Section 83.
Any sale inevitably involves a certain
amount of risk. In particular, if the underlying stock
fails to perform as expected, then the amount
ultimately realized by the buyer from exercising the
options and selling the resulting stock may not be
sufficient to satisfy the note. As a consequence, the
buyer’s other assets may have to be tapped to satisfy
the remaining obligations. 16 If the buyer is the
15 It would appear that “listed” status could be avoided by
having an unrelated party, such as a bank, finance the
transaction. However, such financing would undoubtedly
be more burdensome and perhaps more expensive than an
internally-financed transaction.
16 It is true that the seller’s remedies could be limited to
the options by making the note nonrecourse. However,
this may raise serious questions as to whether the
transaction is a bona fide sale, which in turn would raise
gift tax exposure.