Debt reduction is not a purchase price reduction.

• Author: Van Leuven, Mary

Rev. Rul. 2004-37 involved a change in circumstances all too familiar to employees of companies in certain volatile industries. For example, in the 1990s, technology companies routinely rewarded employees with options to purchase stock. To exercise these seemingly lucrative options, the employees would often issue notes to the employer. When the technology bubble burst and stock prices tumbled, the employees ended up holding stock worth much less than the remaining debt. To ameliorate the financial effect and retain employees, some employers agreed to reduce the debt.

In Rev. Rul. 2004-37, the Service ruled, in part, that a debt reduction will not be treated as discharge of indebtedness (DOI), excludible from an employee's income as a purchase price reduction under Sec. 108(e)(5); rather, the reduction will generally cause the employee to recognize compensation income under Sec. 83.

Facts

In year 1, an employer (a corporation) grants an option to an employee to purchase 1,000 shares of the employer's common stock at an exercise price of $75 per share, the fair market value (FMV) on the grant date.

On January 1 of year 2, the FMV of 1,000 shares of the employer's stock has increased to $100,000 and the employee exercises the option and purchases 1,000 shares in exchange for a 10-year nontransferable $75,000 recourse note secured by the stock. The note provides for interest payments on December 31 of each year the stock is outstanding. The interest rate on the note is not less than the appropriate applicable Federal rate on the issue date. As a result of exercising the option, the employee includes $25,000 as compensation income under Sec. 83(a) in year 2. The employer reports $25,000 of compensation income on the employee's Form W-2 and claims a corresponding deduction in year 2 under Sec. 83(h). In years 2 and 3, the employee makes the required interest payments under the note.

On January 1 of year 4, the FMV of the employer stock declines to $50,000 and the employer and the employee agree to reduce the note's stated principal amount from $75,000 to $50,000. The employee claims that the debt reduction resulted in DOI income, nontaxable under Sec. 108(e)(5).

Analysis

A review of the DOI income rules is necessary to understand the employee's argument. Sec. 61(a)(12) includes to gross income "income from the discharge of indebtedness." DOI income arises when a creditor releases a debtor from an obligation incurred at the outset of the debtor...