February 01, 2005
Executive Stock Option Settlement Initiative
The Internal Revenue Service today announced a settlement initiative for executives and their companies for a tax scheme involving the transfer of stock options or restricted stock to family controlled entities.
A. Transaction Fundamentals. The transactions covered by this settlement initiative are deceptively simple. Here are key elements of a representative transaction:
- A public company grants nonqualified stock options to a senior executive.
- The executive transfers the stock options to a related entity, usually a family limited partnership (FLP), owned and controlled by the executive’s family.
- The parties structure the transfer as a “sale” and the FLP “pays” the executive for the options with a long-term, unsecured promissory note (up to 30 years) with a balloon payment at maturity.
- Shortly after the option transfer, the FLP exercises the stock options and then (often immediately) sells the stock in the open market.
B. The Tax Objective. The exercise of stock options by an executive normally triggers taxable compensation measured by the stock’s fair market value less the amount paid for the shares. By transferring the options to a related entity for a long-term note, the executive attempted to achieve two main tax objectives:
- Defer recognition of the compensatory (ordinary) income item until receipt of the balloon payment on the note many years later.
- “Freeze” the compensatory part of the stock options so any market appreciation of the underlying stock after the transfer is taxed at preferential capital gain rates.
Professional service firms and financial institutions aggressively promoted these transactions in the late 1990s and early 2000s, often leveraging their relationship as the company’s independent auditor, tax advisor or banker.
C. Corporate Governance Matters. These transactions raise important questions about corporate governance and auditor independence. Although not necessarily universal practices, here are some examples the Service has seen in its examination of these transactions:
- Payroll Override. Corporate employees were told to manually override the company payroll system to avoid issuing the executive a Form W-2 that would otherwise include the stock option income.
- Plan Amendments. The corporation’s Board of Directors authorizes an amendment to the Company Stock Option Plan permitting these stock option transfers to family controlled entities.
- Loss of Corporate Tax Benefits. The corporation deferred for many years a tax deduction for its executive stock option compensation to match the executive’s attempt to defer inclusion of that same income.
- Promoters’ Fees. The corporation paid the executive’s promoter fee, claiming a tax deduction but not including the purely personal payment on the Form W-2.
- Conflicts of Interest. Real or perceived conflicts of interest may exist where independent auditors certify to the public the accuracy and integrity of the company’s financial statements and these auditors advise senior executives on their personal tax issues aboutabusive tax shelters they promoted, the same executives that oversee the relationship with the auditing firm.
The Service notes that on December 14, 2004, the Public Company Accounting Oversight Board issued ethics and independence proposals regulating auditors’ tax services for audit clients and their senior management.
D. Settlement Terms for Participants. Summarized below are the terms available for executives and companies that take part in the settlement initiative:
- Parties. The Service encourages the executive, the FLP and the company to take part in the settlement initiative. However, the executive (with the FLP) may participate with or without the company. Similarly, the company mayparticipate with or without the executive but participation by the company alone requires disclosure of all its current and former officers, directors and employees that took part in Notice 2003-47 transactions.
- Transaction Merits.
- The initiative requires the executive to recognize 100% of the stock option income:
- Income recognition when the FLP sold the stock or if the stock has not yet been sold income recognition in 2004.
- The compensation recognized is the difference between the market value of the stock on the day the FLP exercised the options and the exercise price.
- The transaction costs paid by the company, the FLP or the executive to plan and carry out the transaction including promoter, professional and stock option appraisal fees are allowable.
- The executive and the company each pay the applicable FICA taxes on the stock option income.
- The company at its election is allowed a compensation deduction for the amount included by the executive in: (i) the year the executive reports the stock option compensation under this initiative, (ii) the year the executive transferred the options to the FLP, (iii) the year the options are exercised, or (iv) 2004.
If the company takes part in the initiative but the executive does not, it will pay income tax withholding for supplemental wages at the applicable rate (25 to 28 percent, depending on the year) of the executive’s stock option income.
- Unless the Executive previously made a disclosure of the transaction under Announcement 2002-2, the executive will pay a 10% penalty on the additional income taxes for the failure to include the stock option income.
- There will be no penalties assessed against the companies.
E. Tax Results for Non-Participants.
- Executives. Those executives (and their FLPs) not taking part in the settlement initiative will receive a Notice of Proposed Adjustment, Form 5701, with the following adjustments:
- The executive has compensation income on the transfer date of the options to the FLP.
- When the options are exercised, the executive will have additional compensation income equal to the excess, if any, of the market value of the stock over (i) the amount included as compensation at the time of the transfer, and (ii) the exercise price paid.
- No deduction is allowed to the FLP or the executive as an expense for the transaction costs paid.
- Assessment of a 20 percent accuracy related penalty on the taxes resulting from the transaction.
- Assessment of the executive’s share of FICA taxes on the includible compensation income at transfer and at exercise.
- Corporations. For those companies not taking part in the settlement initiative, assessing additional taxes and penalties for the following issues will be considered for inclusion in the Notice of Proposed Adjustment, Form 5701:
- Assessment of income tax withholding for supplemental wages at a rate of 25 to 28 percent of the stock option income at the time of transfer and at exercise.
- Assessment of both the employer’s and employee’s FICA tax on the includible stock option income at the time of transfer and at exercise. The 10 percent failure to deposit penalty will also be assessed on the employer’s share of the FICA tax.
- Assessment of a 20 percent accuracy related penalty on the tax resulting from the failure to pay the income tax withholding and the employer’s and employee’s FICA tax.
- If the company paid and claimed a deduction for the executive’s transaction costs and did not issue a Form W-2 for the amounts paid, disallowance of the deduction and assessment of a 20 percent accuracy related penalty on the resulting underpayment of tax.
- Assessment of a 10 percent information reporting penalty on the compensation income not reported on Form W-2, for disregard of the requirement to file and provide correct Forms W-2.
- Disallowance of a deduction for the compensation income until the year included in the executive’s income.
F. Dispute Resolution Procedures. Taxpayers not taking part in this settlement initiative and unable to resolve their issues at examination may have their disputed issues considered by Appeals. Appeals has independently considered the issues raised by these Transactions about the Executive (and the FLP) and has evaluated the potential litigation hazards. Appeals has decided that the Executive and the FLP should not expect a determination on either the tax or penalty issues more favorable than that reflected in the initiative and its determination may be less favorable
G. Unknown Taxpayers. The Service believes there are many executives that have not come forward to disclose their involvement in transactions declared abusive in Notice 2003-47. The Service will aggressively pursue these taxpayers through various means, including disclosures from investor lists secured through promoter audits of professional firms and financial institutions, if necessary, the use of John Doe Summonses issued to promoters and Information Document Requests issued in corporate tax examinations targeting disclosures of executives’ Notice 2003-47 transactions.
Announcement 2005-19 contains the detailed terms and conditions for this settlement initiative and can be found at IRS.gov and will be published in the Internal Revenue Bulletin, 2005-11, dated March 14, 2005.
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