Compensating partnership employees with corporate partner stock.

• Author: Calianno, Joseph M.

In a recently published letter ruling, the IRS appears to have adopted the cash purchase model of proposed regulations under Sec. 1032 in determining whether a partnership recognizes gain when it compensates its employees with stock of its corporate partner.

In Letter Ruling 9903037, corporate partners A and B (and subsidiaries of their respective consolidated groups) transferred employees (partnership employees) to their partnership. As part of the arrangement, it was anticipated that B and C (A's parent and the parent of the consolidated group that included A) would grant nonstatutory stock options and stock appreciation rights (SARs) to the partnership employees, under B's and C's stock incentive plans. The options would not have a readily ascertainable fair market value (FMV).

Analysis

One issue that the Service addressed was whether the partnership had to recognize gain on the transfer of the B and C stock to its employees when they exercised the options and SARs. More specifically, the IRS examined whether the partnership would be deemed to have a "zero basis" in the B and C stock transferred to the employees.

The letter ruling focused on Sec. 83, which generally provides for the tax treatment of compensatory transfers of property for services, and Rev. Rul. 80-76, which applies those rules when a parent's stock is used to compensate a subsidiary's employees. In Rev. Rul. 80-76, a P shareholder transferred P stock directly to X, a key employee of S, a controlled subsidiary of P. S was treated as receiving P stock as a contribution to capital and immediately disposing of that stock to compensate its employee. The IRS concluded that, because Sec. 83 applied to the transfer of the parent's stock to the subsidiary's employee, the subsidiary did not have to recognize gain on the transfer.

In Letter Ruling 9903037, the Service relied on Rev. Rul. 80-76 to conclude that the partnership would not recognize gain or loss as a result of the transfer of the B and C stock to its employees on the exercise of the options or SARs. In addition, the partnership would be entitled to a deduction equal to the FMV of the B and C stock transferred on exercise of the options and SARs that would be granted after the employees were transferred to the partnership. Finally, the Service concluded that A, B and C would not recognize gain or loss as a result of the transfer of B and C stock.

The conclusion that the partnership did not recognize gain on the transfer...