Exercise of options using borrowed funds.

• Author: Maio, Jim

Under Sec. 83(a), if property is transferred in connection with the performance of services, the employee who performed the services has gross income in an amount equal to the excess of the fair market value (FMV) of the property over the amount paid for the property. Sec. 83(a) also states that both the income event and the measurement of FMV of the property occur only when the property is first either transferable or not subject to a substantial risk of forfeiture. Under Regs. Sec. 1.833(a)(1), a transfer of property occurs when a person acquires a beneficial ownership interest in such property. When property is received in the form of a nonqualified stock option, Sec. 83(e)(3) requires that the option must have a readily ascertainable FMV to be taxed to the employee at grant.

In Racine, 7/3/07, the Seventh Circuit addressed the issue of when a transfer occurs for Sec. 83 purposes. The decision provides a cautionary tale for taxpayers who use nonrecourse debt to finance the exercise of their stock options.

Facts

Racine was employed by a large telecommunications company during the 2000 tax year. As part of her compensation package, she was granted nonstatutory employee stock options that were not actively traded on an established market. From March-July 2000, she exercised options to purchase 25,257 shares. The exercise price was $58,811, and the FMV of the shares at the time of exercise was $1,972,706.The company remitted about $625,000 in income tax withholding on her gain of over $1.9 million and demanded reimbursement from her before it would give her clear tide to the shares. To finance the exercise price and the tax, Racine borrowed about $684,000 on margin from a market-maker broker.

Soon after the option exercise, the FMV of the stock began to plummet and the broker issued margin calls. In November 2000, Racine sold 18,291 shares at $15.61 per share, and in May 2001 she sold 1,836 shares at $20.41 per share.

On her 2000 return, Racine claimed a $368,000 refund, asserting that the shares were transferred to her when they were sold in November 2000 and May 2001 and not at exercise. The IRS granted the refund but demanded the money back after an audit. The Tax Court agreed with the Service and concluded that the refund was issued in error and that Racine should pay back more than $500,000.

Regs. Sec. 1.83-3(a) (2) provides that in a purchase transaction, if the amount paid for property is in whole or in substantial part indebtedness...