New IRS approach to stock-option compensation.

• Author: Smith, Annette B.

The IRS has taken a surprising approach to deductions related to stock-option compensation under cost-sharing agreements. In Field Service Advice (FSA) 200003010, it determined that the value of compensatory stock options is a cost that must be shared with (or charged out to) affiliates under Regs. Sec. 1.482-2A(d)(4). What is most surprising is that the Service did not require that the compensation be calculated under Sec. 421 (for a disqualifying disposition) or under Sec. 83 (for a nonqualified stock option (NQSO)). Rather, it measured the options' values on the date they were granted, based on a modified Black-Scholes valuation method.

Cost-Sharing under Sec. 482

Sec. 482 provides that the IRS could distribute, apportion or allocate gross income, deductions, credits or allowances among controlled entities if necessary "to prevent evasion of taxes or to clearly reflect the income of those entities." For any transfer or license of intangible property (within the meaning of Sec. 936(h)(3)(B)), the income for such transfer or license should be commensurate with the income attributable to the intangible.

Regs. Sec. 1.482-2A(d)(4) provides that for intangibles developed pursuant to a bona-fide cost-sharing agreement, no allocation will be made for their development "except as may be appropriate to reflect each participant's arm's length share of the costs and risks of developing the property." Costs taken into account "include, but are not limited to, costs or deductions for compensation, bonuses, and travel expenses attributable to employees directly engaged in performing such services." Neither the statute nor the regulations addresses compensatory stock options.

In FSA 200003010, a U.S. parent entered into research and development (R&D) cost-sharing and service agreements with two of its controlled foreign corporations (CFCs). The costs shared or charged out under the agreements included labor that the R&D departments booked. The parent granted stock options to employees (presumably of the parent) who worked in these R&D departments. The parent claimed deductions under Sec. 83(h) for compensation related to NQSOs, and under Sec. 421(b) for disqualifying dispositions of incentive stock options (ISOs). None of these amounts was shared with the CFCs. The Service allocated income from the CFCs to the parent under Sec. 482 equal to the options' value on the grant date, under the Black-Scholes option-pricing model.

The IRS based its result on...