Current developments.

• Author: Elinsky, Peter I.
• Position: Part 2 - Employee benefits

This two-part article provides an overview of recent developments in employee benefits, including qualified and nonqualified retirement plans, welfare benefits and executive compensation. Port II focuses on recent developments in areas such as stock options, reasonable compensation, voluntary employees' beneficiary associations, health care coverage and fringe benefits.

This two-part article provides an overview of recent developments in employee benefits, including qualified and nonqualified retirement plans, welfare benefits and executive compensation. Part I, published in the November 1998 issue, focused on recent developments affecting qualified retirement plans, employee stock ownership plans and individual retirement accounts. Part II, below, focuses on recent developments in areas such as stock options, reasonable compensation, voluntary employees' beneficiary associations, health care coverage and fringe benefits.

Stock Options

Employees of Corporate Partnership

The IRS outlined in Letter Ruling 9822012(32) the tax consequences when a C corporation grants stock options and stock appreciation rights (SARs) to individuals employed by a partnership in which the Corporation and an S corporation are general partners.

C Corp. is engaged in the construction of commercial and industrial buildings; S Corp. is engaged in construction and real estate activities. Neither corporation has employees; each is a general partner in P, a partnership through which they conduct their activities. C wants to establish nonqualified stock option (NQSO) and SAR plans. Under the NQSO plan, selected P employees will be offered nontransferable NQSOs to acquire C stock. The goal is to retain key employees by offering them a stake in C, whose value is directly tied to P's performance. The exercise price will be the stock's book value at the grant date, adjusted for any outstanding NQSOs.

Under the SAR plan, all salaried P employees would be eligible for SAR awards. The SARs will be awarded annually in conjunction with performance reviews conducted by C's executive management committee. On exercise of a SAR, P would pay the employee cash equal to the increase in value of C stock. All SARs are contingent on continuing employment.

The IRS issued the following rulings regarding this arrangement:

* The NQSOs will be treated as not having a readily ascertainable fair market value (FMV) at grant; thus, under Regs. Sec. 1.83-7(a), C's grant of an NQSO to a P employee will not result in a taxable event to the employee.

* A P employee who exercises an NQSO will have ordinary- compensation income equal to the stock's FMV on the exercise date, less the exercise price, under Sec. 83(a) and Regs. Sec. 1.83-7.

* When a P employee exercises an NQSO and includes the spread in income, P will be entitled to a deduction for that amount under its normal method of accounting, under Regs. Sec. 1.83-6(a)(3).

* An employee's basis in stock acquired through the exercise of an NQSO will equal the exercise price plus the income the employee recognizes, under Regs. Sec. 1.83-4(b) and Rev. Rul. 78-182.(33)

* The employee's holding period for the stock acquired through the exercise of an NQSO with cash will begin on the exercise date, according to Regs. Sec. 1.83-4(a).

* Any subsequent sale or exchange of stock acquired through exercise of an NQSO will result in capital gain or capital loss to the employee, under Secs. 1001(a) and 1222.

* The grant of a SAR to a P employee will not require him to include any amount in income, under Regs. Sec. 1.451-2(b) and Rev. Rul. 80-300.(34)

* When a P employee exercises a SAR, the cash he receives is includible compensation income, under Rev. Rul. 80-300.

* When a P employee exercises a SAR, P will be allowed a deduction for the corresponding amount in the tax year in which or with which the employee's tax year of inclusion ends, under Sec. 404(a)(5).

Transferring NQSOs to Charity

The IRS ruled in Letter Ruling 9737014(35) that the transfer of options to a charity should be treated as a non-arm's-length transfer. However, because of the control retained over the exercise of the options, no charitable deduction may be claimed until the options are actually exercised.

A company granted two employees NQSOs. The options did not have a readily ascertainable FMV as defined in Regs. Sec. 1.83-7(b) on the date of grant. The plans under which the options were granted permitted the option holders to donate them anonymously to charity.

The first employee transferred the options to an intermediary, who held them in a combined brokerage and custody account established on the employee's behalf. The intermediary must exercise the options on a specified date, which the employee has reserved the right to change. Once the options are exercised, the intermediary must immediately sell the shares and deposit the proceeds (less the exercise price, taxes and costs of sale) in the employee's account. The employee will then designate a charity to which the intermediary will transfer the amounts attributable to the sale. If the employee dies before the options are exercised, the intermediary is to transfer the options to a charity previously identified by the employee. The charity can then exercise the options at any time.

The second employee intends to donate the options to certain charities, subject to an agreement. There are two possible ways of exercising the options under the agreement. Either the charity can pay cash to exercise the options or a broker will pay the exercise price, plus any taxes. If the broker exercises the options, the broker will sell sufficient stock to cover its expenses. The charity can then choose whether to receive the remaining shares or have the broker sell those shares and remit the proceeds to it.

The agreement will permit the second employee to retain the right to veto a proposed exercise of the options during his life. If he dies before the options are exercised, the charity can exercise the options at any time.

Sec. 83(e)(3) provides that Sec. 83(a) does not apply to the transfer of an option without a readily ascertainable FMV, but Sec. 83(a) and (b) apply when the option is exercised. If the option is disposed of in an arm's-length transaction, Sec. 83(a) and (b) apply as if the option had been exercised. Neither the Code nor the regulations address what happens if an option is disposed of in a transaction that is not arm's-length.

The IRS held that the rules for dispositions of nonvested property not at arm's length, found in Regs. Sec. 1.83-1 (c), apply; accordingly, it ruled that the employees will not recognize income or gain on the transfer of the options. Further, if the options are exercised while the employees are alive, they will recognize compensation income (and the company will receive a corresponding deduction) equal to the excess of the FMV of the optioned shares on the date of exercise over the exercise price. Such compensation will constitute "wages" for Federal income tax withholding purposes. Finally, if the options are not exercised until after the employees die, the compensation income will not be "wages." Under Regs. Sec. 1.83-6(a)(3), the company will be entitled to a deduction under its normal method of accounting for the income recognized by the employees.

The IRS also considered the employees' charitable deductions for these transfers, as well as the gift and estate tax implications. In Letter Rulings 9737015 and 9737016,(36) the IRS held that, because the employees retained control over the exercise of the options, they will not be entitled to charitable deductions until the options are actually exercised. The amount deductible will be the value of the stock received on exercise, less the exercise price and applicable taxes. For gift tax purposes, the employees will not be deemed to have made a completed gift to any charity until the options are exercised. However, assuming the charities are organizations described in Sec. 2522(a), the contributions to them will be eligible for the gift tax charitable deduction. Finally, the value of any options not exercised at the employees' deaths will be included in their gross estates, as will be the value of any options exercised within three years of their deaths.

These rulings illustrate that, when structuring a gift of NQSOs, identifying the donee is critical to achieving the most favorable tax consequences for the donor. For transfers of options to a charity, it is to the donor's advantage to ensure that the transfer is not a completed gift. As in these rulings, if an employee retains sufficient control over options transferred to or for the benefit of a charity so as to prevent the transfer from being a completed gift, he must recognize income when the options are exercised, but will also be entitled to a charitable deduction at that time equal to the value of the shares received at exercise, less the expenses of exercise. If the transfer of the options constituted a completed gift, the employee could claim a charitable deduction only for the value of the options on the date transferred to the charity and would still recognize income when the options were exercised.

Constructive Exchange

In Letter Ruling 9736040,(37) the IRS detailed the tax consequences of an employee's exercising compensatory stock options by constructively surrendering previously acquired employer stock in payment for the shares to be received. The ruling provides a good review of the applicable rules.

Constructive surrender: X Corp. maintains two stock option plans (the Plans). Options granted under the Plans may be either incentive stock options (ISOs) or NQSOs.

The Plans provide that the exercise price may be paid in cash or in shares of common stock transferable to X and having an FMV on the transfer date equal to the exercise price. X wants to allow employees to exercise their options by constructively surrendering shares they already own (Payment...