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

Recall that Section 83 triggers the
recognition of compensation income upon the
disposition of NQSOs whether or not the transfer is
at arm’s-length. 21 If the employee is the sole
participant in the LP or LLC, there is little doubt
that the interests she takes back in the exchange
equal the FMV of the NQSOs contributed. No
discounts should apply because immediately after
the transfer she can withdraw the contributed assets
and receive back full value. However, the question
of value becomes somewhat more murky if others
participate in the formation of the LP or LLC, since
in that case the value of LP or LLC interest may be
eligible for the discounts.
Nevertheless, transferring NQSOs to an LP
or LLC represents an exchange for value. While
Section 721(a) offers non-recognition treatment
upon a transfer of “property” to a partnership in
exchange for a partnership interest, the rules of
Section 83 should override this safe harbor. The
income generated by any transfer of the options is
compensation income and not the proceeds of the
sale or exchange of an asset, capital or otherwise.
However, if the employee takes back all the LP or
LLC interests at formation, the check-the-box
regulations provide that the entity will be
disregarded. Instead, the employee will be treated
as the continuing owner of the transferred NQSOs
and their tax attributes. 22 As a consequence, the
transfer of the NQSOs to an LP or LLC owned
entirely by the employee should be ignored until the
LP or LLC acquires another equity owner.
When the employee transfers an interest in
the LP or LLC, then the LP or LLC should spring
into existence for tax purposes. The 100%-owner
should be treated as transferring the NQSOs to the
LP or LLC in exchange for the interests the owner
holds at that time. 23 This deemed transfer should be
subject to Section 83. Therefore, the employee
should be treated as receiving compensation income
equal to the FMV of the LP or LLC interests
received when he transfers interests to his heirs or to
trusts for them. As noted above, at that time the
interests should not qualify for discounts, so the
21 The question of arm’s-length status seems to affect
only whether Section 83 continues to apply to the future
exercise or disposition of options by the transferee, not
the amount or timing of the income generated in the
initial transfer.
22 See Reg. Section 301.7701-2(a).
23 Cf. PLR 200222026.
– 9 –
compensation income should equal the FMV of the
NQSOs. However, because of the relationship of
the employee to the LP or LLC, the deemed transfer
should be treated as a non-arm’s-length transfer,
even though he is deemed to have received full
FMV for the NQSOs. As a result, the employee will
be exposed to additional tax upon the exercise of the
options by the LP or LLC.
The result is a bit different if the LP or LLC
admits additional partners at formation. However,
the tax consequences should be similar. 24 Upon
formation, the employee should be treated as
making a non-arm’s length transfer of the NQSOs to
the LP or LLC, causing the employee to recognize
income equal to the FMV of the interests he receives
at formation. So, the exercise of the options by the
LP or LLC will expose the employee to a second
incidence of tax under Section 83. However, since
partnership status exists from the outset, there is the
possibility that the measure of the income at
formation could be less, if discounts are justified by
the lack of marketability and control. Nevertheless,
the adverse income tax consequences certainly make
this strategy problematic. 25
24 The following analysis assumes that the other
participants contribute assets in exchange for their
interests. If they do not, then the transaction is likely to
be treated as a gift of the requisite portion of the NQSOs
by the employee to the other participants, followed by
their exchange of those NQSOs for their ownership
interests. Cf. TAM 200432015. These deemed gifts, of
course, would be non-arm’s-length transfers (as would
the deemed transfers to the LP or LLC), meaning that the
employee would remain exposed to Section 83 for
subsequent events. Hence, the deemed transfers by the
donees to the LP or LLC should trigger compensation
income to the employee, as should the later exercise of
the options by the partnership. The author is aware that
some commentators cite 2 private letter rulings for the
proposition that a donative transfer to a partnership does
not trigger recognition under Section 83. See PLRs
199927002 and 199952012. However, it is doubtful that
these rulings can be read that way. In characterizing
donative transfers as non-arm’s-length, the rulings
specifically refer only to gifts to individuals and trusts,
not partnerships. This indicates that the rulings did not
actually address the tax issues arising from a donative
transfer to partnerships.
25 Note that non-arm’s-length treatment probably applies
in these situations regardless of the percentage ownership
actually obtained by the employee at formation. A
partnership is related to the employee if the employee
holds as much as 20% of the LP or LLC. Even if the
employee actually holds less (which is unlikely if the LP
or LLC is being used as a wealth transfer device), he/she