Effect of Title 26 section 83 (c) (3) on timing of taxable income
Equity Compensation Experts:
Yesterday I had two dicussions with a member of the IRS's
Office of Division Counsel/Associate Chief Counsel. We discussed the
impact of Title 26 Section 83 c) (3) as it refers to Section 16(b) of the
Securities Act of 1934.
Section 83 (c) (3) says
"so long as the sale of property at a profit could subject a person to suit under section 16(b) of the Securities Act of 1934, such person's rights in such property are--
(A) subject to a substantial risk of forfeiture, and
(B) not transferable."
The conclusion that we reached is that employee stock options exercised by officers and directors are not taxable upon exercise but are taxable when the stock is sold.
Does anyone, who is familiar with Section 16 (b) and section 83 c) (3), agree with that conclusion. If the above conclusion is correct, then that would tend to change some things for officer and directors who exercise ESOs.
John Olagues
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Wow John. That would certainly change a lot of things for officers and directors.
I know there are some very good securities and tax attorneys in this group. I hope they will find some time to provide a response. I will also reach out to some people who may not be members...
Thanks
Dan
Dan:
It all depends on what the following means:
"so long as the sale of property at a profit could subject a person to suit under section 16(b) of the Securities Act of 1934, such person's rights in such property are--
(A) subject to a substantial risk of forfeiture, and
(B) not transferable."
Section 16b) applies only to Officers and Directors. It essentially says that if an officer or director buys and sells company securities withing 6 months of each other and makes a profit, the profit is recoverable by the company. If the company refuses to recover it from the officer or director, then any stock holder has a private right of action to force the recovery by filing a suit.
If a sale of 5000 shares is made at 30 after the officer or director purchased 5000 shares in the open market of stock at 29 three months earlier, then the $5000 profit is recoverable by the company. If he receives 5000 shares from an exercise of 5000 ESOs and sells the stock at 31 but buys 5000 shares in the market three months later at 29, then the $10,000 profit is recoverable.
If the sale is made after the purchase is made three months earlier, then the executive "will" be subject to a suit when he makes the sale at a higher price.
If the sale is made when no prior purchase of stock is made, the the officer or director could be subject to a suit and will be subject to a suit if he subsequently purchases the stock at a lower price.
So could the officer or director be subject to the Section 16b) suit when he sells the stock. The answer is yes he could. And that means that his rights are subject to a substantial risk of forfeiture and his rights are not tranferable.
Therefore, unless he sells the stock he received from the exercise, he does not have a tax liability from the exercise.
John
John,
While this position is interesting, I would not think most people would, or could, rely on on it without a formal PLR or other document from the IRS. I would caution companies and individuals to get appropriate counsel before proceeding down this path.
Dan
This IRS link seems to cover some of this topic: http://www.irs.gov/irb/2005-32_IRB/ar08.html
Internal Revenue Bulletin:
2005-32
August 8, 2005
Rev. Rul. 2005-48
Table of Contents
Restricted property received for services; securities
law. This ruling clarifies that, except as otherwise provided by
section 83 of the Code, transfer restrictions on restricted stock or other
section 83 property do not prevent the property from being substantially vested
for purposes of section 83.
ISSUE
If an employee exercises a nonstatutory option more than six months
after grant, but is subject to restrictions on his ability to sell the stock
obtained through exercise of the option under rule 10b-5 under the Securities
Exchange Act of 1934 and the contractual provisions described below, is the
employee required to recognize income under section 83 of the Internal Revenue
Code at the time of the exercise of the option?
FACTS
On January 2, 2005, Employee E, an employee of Company M, is granted
a nonstatutory option to purchase M common stock. Although the option is
immediately exercisable, it has no readily ascertainable fair market value
when it is granted. Under the option, Employee E has the right to purchase
100 shares of M stock for $10 per share, which is the fair market value of
an M share on the date of grant of the option.
On May 1, 2005, M sells its common stock in an initial public offering.
As required under the Underwriting Agreement, Employee E agrees not to sell,
otherwise dispose of, or hedge any common shares, options, warrants, or convertible
securities of M from May 1 through November 1 of 2005 (“the lock-up
period”).
Also on May 1, 2005, M adopts an Insider Trading Compliance Program,
under which, as applied to 2005, insiders (such as Employee E) may trade M
shares only between November 5 and November 30 of that year (“the trading
window”). Under the Program, if Employee E trades M shares outside
the trading window without M’s permission, M has the right to terminate
Employee E’s employment. However, the exercise of nonstatutory options
for M shares is not prohibited under the referenced agreements.
On August 15, 2005 (during the lock-up period and outside the trading
window), M stock is trading on an established securities market at more than
$10 per share. On that date, Employee E fully exercises the option, paying
the exercise price in cash, and receives 100 M shares. Employee E’s
rights in the shares received as a result of the exercise are not conditioned
upon the future performance of substantial services. As of that date, Employee
E is in the possession of material nonpublic information concerning M that
would subject him to liability under Rule 10b-5 under the Securities Exchange
Act of 1934 (“Exchange Act”), 17 C.F.R. § 240.10b-5,
if Employee E sold the M shares while in possession of such information.
LAW AND ANALYSIS
Section 83(a) provides that if, in connection with the performance of
services, property is transferred to any person other than the person for
whom such services are performed, the excess of the fair market value of the
property at the first time that the rights to the property are either transferable
or not subject to a substantial risk of forfeiture (“substantially vested”),
whichever occurs earlier, over the amount paid for the property is included
in the gross income of the service provider in the first taxable year in which
the rights to the property are substantially vested.
For purposes of section 83, a “transfer” of property occurs
when a person acquires a beneficial ownership interest in the property (disregarding
any “lapse restriction”). See section 1.83-3(a)(1) of the Income
Tax Regulations.
Under section 1.83-3(h), a restriction which, by its terms, will never
lapse (also referred to as a “nonlapse restriction”) is a permanent
limitation on the transferability of property that will require the transferee
of the property to sell (or offer to sell) the property at a price determined
under a formula and that will continue to apply and be enforced against the
transferee or any subsequent holder (other than the transferor). An obligation
to resell (or to offer to sell) the transferred property to a specific person
or persons at its fair market value at the time of the sale is not a nonlapse
restriction.
The term “lapse restriction” means a restriction other than
a nonlapse restriction and includes (but is not limited to) a restriction
that carries a substantial risk of forfeiture. See section 1.83-3(i).
For purposes of section 83, property is substantially nonvested when
it is both subject to a “substantial risk of forfeiture” and is
“nontransferable” within the meaning of sections 1.83-3(c) and
(d), respectively. Property is substantially vested when it is either transferable
or not subject to a substantial risk of forfeiture.
Whether a risk of forfeiture is substantial (or not) depends upon the
facts and circumstances. A substantial risk of forfeiture exists where rights
in property that are transferred are conditioned, directly or indirectly,
upon the future performance (or refraining from performance) of substantial
services by any person or the occurrence of a condition related to the purpose
of the transfer, and the possibility of forfeiture is substantial if such
condition is not satisfied. Property is not subject to a substantial risk
of forfeiture to the extent that the employer is required to pay the fair
market value of a portion of the property to the employee upon the return
of the property. The risk that the value of property will decline during
a certain period of time does not constitute a substantial risk of forfeiture.
A nonlapse restriction, standing by itself, is not a substantial risk of
forfeiture. See section 1.83-3(c)(1).
For purposes of section 83, the rights of a person in property are “transferable”
if the person can transfer any interest in the property to any person other
than the transferor of the property, but only if the transferee’s rights
in the property are not subject to a substantial risk of forfeiture. Accordingly,
property is transferable if the person performing the services or receiving
the property can sell, assign, or pledge (as collateral for a loan, or as
security for the performance of an obligation, or for any other purpose) his
interest in the property to any person other than the transferor of the property,
and if the transferee is not required to give up the property or its value
in the event that the substantial risk of forfeiture materializes. See section
1.83-3(d).
Section 83(e)(3) provides that section 83(a) does not apply to the transfer
of an option without a readily ascertainable fair market value. However,
section 83(a) does apply to such an option at the time that it is exercised,
sold, or otherwise disposed of. If the option is exercised, section 83(a)
applies to the transfer of property pursuant to the exercise. If the option
is sold or otherwise disposed of in an arm’s length transaction, section
83(a) applies to the transfer of money or other property received in the same
manner as it would have applied to the transfer of property pursuant to an
exercise of the option. See section 1.83-7(a) of the regulations.
Under section 83(c)(3) of the Code and section 1.83-3(j) of the regulations,
if the sale of property at a profit within six months after the purchase of
the property could subject a person to suit under section 16(b) of the Exchange
Act, 15 U.S.C. § 78p(b), the person’s rights in the property
are treated as subject to a substantial risk of forfeiture, and as not transferable,
until the earlier of (1) the expiration of such six-month period, or (2) the
first day on which the sale of the property at a profit will not subject the
person to suit under section 16(b). Because, when enacting section 83(c)(3),
Congress decided that the only provision of the securities law that would
delay taxation under that section would be section 16(b), potential liability
for insider trading under Rule 10b-5, for example, does not cause rights in
property taxable under section 83 to be substantially nonvested.
Section 16(b) liability is triggered by either a “purchase and
sale” or a “sale and purchase” of a security registered
under section 12 of the Exchange Act, 15 U.S.C. § 78l, within a
period of less than six months by an officer, director, or greater-than-10-percent
owner of the corporation that issued the security. 15 U.S.C. §§ 78p(a)
and (b). The combination of a purchase and a sale event (in either order)
within a six-month period is what triggers section 16(b) liability.
Before May 1, 1991, the acquisition of stock as the result of the exercise
of an option was viewed as a “purchase” for section 16(b) purposes.
Thus, the six-month period under section 16(b) was measured from the date
an option was exercised.
However, effective May 1, 1991, the Securities and Exchange Commission
(“SEC”) adopted new rules under section 16; thereafter, for purposes
of that section, derivative securities, including options, generally were
treated as the functional equivalents of stock ownership. Ownership Reports
and Trading by Officers, Directors and Principal Security Holders, SEC Release
No. 34-28869, 56 Fed. Reg. 7242, 7248 (Feb. 21, 1991). Stated another way,
the SEC recognized “that holding derivative securities is functionally
equivalent to holding the underlying equity securities for purposes of Section
16, since the value of the derivative securities is a function of or related
to the value of the underlying equity security.” Id.
Accordingly, the SEC determined that the acquisition of an option should
be deemed the significant event for purposes of section 16(b), not the exercise.
Id.
In implementing this change, the SEC provided that any acquisition or
disposition of an option involves either a “purchase” or “sale”
for section 16(b) purposes. 17 C.F.R. §§ 240.16b-6(a), 240.16a-1(c),
and 240.16a-1(b). The SEC exempted from section 16(b) exercises and conversions
of options that (like Employee E’s) have a fixed exercise price due
at the exercise or conversion, other than options that are out-of-the-money
at the time of exercise. 17 C.F.R. § 240.16b-6(b). In other words,
after May 1, 1991, the six-month holding period under section 16(b) is measured
from the date an option is granted, not when it is exercised (with exceptions
not applicable here). Thus, after May 1, 1991, section 16(b) interacts with
section 83 as follows: if, for example, shares are acquired through the exercise
of a nonstatutory option in a transfer taxable under the rules of section
83, the holder of the shares would not be subject to section 16(b) liability
as a result of an immediate sale of the shares unless the sale occurred during
the six-month period beginning with the date of grant of the option. Even
if an optionee exercises an option and sells the underlying shares within
six months of the date of grant of the option, an exemption from liability
under section 16(b) may be available under other provisions of the SEC rules.
See 17 C.F.R. §§ 240.16b-3(d)(1) and
(2). If such an exemption is available within six months of the date of grant,
the compensation income attributable to the employee’s exercise of the
option is includable in the employee’s gross income on the later of
the date of exercise and the date the exemption becomes available. If such
an exemption is not available within six months from the date of grant, the
compensation income attributable to the employee’s exercise of the option
would be includable in the employee’s gross income on the later of the
date of exercise or the date that is six months from the date of grant.
Applying the above rules, because the option is granted to Employee
E on January 2, 2005, the section 16(b) period applicable to the option expires
on July 2 of that year. Accordingly, the section 16(b) period expires before the
date that Employee E exercises the option and the M shares are transferred
to Employee E (on August 15). Thus, the shares are not subject to a substantial
risk of forfeiture under section 83(c)(3) as a result of section 16(b). Moreover,
neither the Underwriting Agreement nor the Insider Trading Compliance Program
imposes a substantial risk of forfeiture, because the provisions of those
agreements do not condition Employee E’s rights in the shares upon anyone’s
“future performance (or refraining from performance) of substantial
services” or on a “condition related to a purpose of the transfer”
of the shares to Employee E. Accordingly, neither section 83(c)(3) nor the
provisions of those agreements preclude taxation under section 83 when the
shares resulting from exercise of the option are transferred to Employee E.
These conclusions are consistent with the court’s decision in Tanner
v. Comm’r., 117 T.C. 237 (2001), aff’d,
No. 02-60463 (5th Cir. Mar. 26, 2003); but see Robinson
v. Comm’r., 805 F.2d 38 (1st Cir.
1986), rev’g, 82 T.C. 444 (1984).
Additionally, the restrictions imposed by the referenced agreements
and Rule 10b-5 on Employee E’s sales (or other trading) of the M shares
are “lapse restrictions,” because the restrictions imposed by
the Underwriter’s Agreement and Rule 10b-5 are temporary and the restrictions
imposed by the Insider Trading Compliance Program are inapplicable during
the window period. Accordingly, these restrictions are ignored when valuing
the shares. See section 83(a).
The Department of the Treasury and the Internal Revenue Service intend
to amend the § 83 regulations to explicitly set forth the holdings
in this revenue ruling.
HOLDING
Under section 83, the compensation income attributable to Employee E’s
exercise of the option for M shares is includible in Employee E’s gross
income when the shares obtained through exercise of the option are transferred
to Employee E, and the amount of compensation income is determined without
regard to the share-transfer restrictions imposed by the Underwriter’s
Agreement and the Insider Trading Compliance Program.
DRAFTING INFORMATION
The principal author of this revenue ruling is Michael Hughes of the
Office of Division Counsel/Associate Chief Counsel (Tax Exempt and Government
Entities). For further information regarding this revenue ruling, contact
Mr. Hughes or Robert Misner at (202) 622-6030 (not a toll-free number).
Dan:
The principle author of the Ruling you cite , Mr. Michael Hughes, is the person at the IRS with whom I had my discussions.
Most officers and directors sell the stock immediately after exercise. So it may not matter to them tax wise. But it may matter to people who sell a part of or none of the received stock.
Of course I am not a tax expert. But there should be some that may have a better understanding of 83 c) (3) than I do. I spoke with one tax expert and he disagrees with the conclusion that I expressed, but with the qualification that he is not sufficiently familiar with Section 16(b).
John
We don't know the specific circumstances that were presented to Mr. Hughes for his input. I would agree that tax arises at the sale of the shares only if the option exercise and sale of shares occurred within six months from date of the initial grant. Nevertheless, Rev Rul 2005-48 (which is still effective) is clear about tax arising at an option exercise which occurs more than six months following the grant date. I can see some uncertainty where a second 16(b) period comes into play because of, for example, another grant of options is made within 12 months of the first grant. Because of the way 16(b) matches up purchases and sales, one could argue that the second 16(b) period affects the exercise of the first set of options by imposing a de facto risk of forfeiture. In the past we have made this argument with the IRS National Office, but they concluded that the exercise of the first set of options would be taxable at the later of exercise date or the end of the six-month period following the grant of those same options. Their concern was that someone receiving annual grants of options would always be in a 16(b) period and thus could push off income tax for many years. I would agree with Mr. Hughes' conclusion only if the IRS has changed its position in this regard or there are other specific circumstances of which we are not aware.
Dear Alan:
The last sentence in Section 83 (a) says that
"The preceding sentence shall not apply if such person sells or otherwise disposes of such property in an arms lenght transaction before his rights in such property become transferable or not subject to a substantial risk of forfeiture".
The only time that that sentence would come into play would be if the rights of the employee are subject to a substantial risk of forfeiture or are not transferable and he sells the stock (or options) at arms lenght.
Section 83 (c) (1) defines "Substantial risk of forfeiture" as the individuals rights to full enjoyment of such property are conditioned upon the future performance of substantial services by any individual
Section 83 (c) (2) defines "Transferability of property". The definition says that the rights are transferable only if the rights are not subject to a substantial risk of forfeiture.
Section 83 (c) (3) presents a scenario when the individual's rights to property could be subject to a substantial risk of forfeiture and not transferable so long as a sale at a profit could subject him to a suit under section 16 (b).
So to sum up, we have property that can be sold even if a person's rights are still subject to a substantial risk of forfeiture or the rights are not transferable.
And it seems that the only times that the last sentence of 83(a) will come into play is if the individuals rights are either conditioned upon the future performance of
substantial service or a sale of property is made that could subject the seller to a suit under 16 (b).
If the property is sold under either of these two conditions, then the last sentence in 83 (a) applies and the preceding part of 83(a) DOES NOT apply.
Mr Michael Hughes from the IRS told me that if the rights of an individual in shares that were held would be subject to forfeiture and not transferable because of 83 (c) (3), and the holder sold those shares in the market, then the sentence in 83 (a) would come into play. But then, how would the profit be calculated. Is it capital gain or ordinary income? Because the preceding sentence in 83 (a) DOES NOT apply.
Whether the sale of stock at a profit could subject a person to suit under section 16(b) depends on the circumstances and an interpretation of a number of stautes and rules.
Whether a sale "will subject" a person is another question.
To be validly sued under 16 (b) requires both a sale (non- exempt) and a purchase (non-exempt) within 6 months and a profit made. A puchase without a sale will not subject a person to a suit under 16 b, nor will a sale without a purchase within 6 months. However it seems that a sale (non exempt) after the purchase (non exempt) within 6 months where there is a profit not only could subject the seller to a suit but defintely will. On the other hand, a sale prior to a possible purchase where a profit is made (because he bought the stock lower) could submit the seller to a suit and if he makes the purchase, it definitely will if he does not voluntarily return the profit to the company.
So could a sale at a profit subject the person to a suit under 16 (b). It could and it will if he purchases the stock within 6 months at a lower price.
Now some may claim that 83(c) (3) applies only to grants of options or restricted stock and the subsequent sale of the specific options or restricted stock as being the two parts of the 16(b) violation. I do not believe that is so. If it did, then section 83 (c) (3) would say something like "So long as the sale of granted property at a profit over the grant price could subject a person to suit...."
Cheers:
John