Using options to compensate service providers at the formation of a new entity.

• Author: Salzberg, Barry
• Position: Brief Article

When a service provider is to be compensated with an equity interest in an entity, the use of an in-the-money call option may provide the best tax results.

If a shareholder contributes services for an equity interest in a new entity rather than cash or other property, Sec. 83 controls. The provider of services will recognize income equal to the excess of the fair market value (FMV) of the property received over any amount paid for the property. This determination is made at the earlier of the date that the rights to the property are transferable or are not subject to a substantial risk of forfeiture.

The use of stock options as property transferred to a service provider may provide numerous tax benefits. Under Regs. Secs. 1.83-3(a)(2) and 1.83-7(a), the transfer of an option that does not have a readily ascertainable FMV at the date of the grant will not be a transfer of property. Most nontraded stock options cannot be valued when granted. A call option is a contingent claim because the holder has the right, but not the obligation, to exercise the option. If the option is in-the-money (the FMV of the underlying assets exceeds the option's exercise price as of the date of grant), the holder can profit from appreciation...