Debt modifications for employees: does Sarbanes-Oxley nullify Rev. Rul. 2004-37?

• Author: Nash, Claire Y.
• Position: Gross Income

In early 2002, Congress enacted the Sarbanes-Oxley Act, P.L. 107-204 (SOX), in response to accounting scandals of public companies including Enron, Worldcom, Tyco, and others. This legislation had widespread impact on how companies conduct and report their business affairs. One of its provisions prohibited companies from making loans to their directors and/or executive officers (SOX [section] 402(a)). This provision is rather broad and prohibits both direct and indirect loans and arranging or extending credit for directors and/or executive officers. SOX allowed existing loans to remain outstanding as long as no modifications were subsequently made.

In 2004, the IRS issued Rev. Rul. 2004-37, which addressed certain modifications of employee debt by the employer. Specifically, the ruling discussed modification of recourse debt used by an employee to satisfy the exercise price of a nonqualified stock option. The ruling concluded that subsequent modifications of this debt would result in compensation income to the employee rather than a nontaxable adjustment to the basis of the stock acquired in the exercise.

The effective date of the SOX prohibition on loans to directors and/or executive officers is July 30, 2002. The IRS issued Rev. Rul. 2004-37 over a year and a half later on February 25, 2004. The ruling could still apply to loans made to employees before July 30, 2002, which are available for adjustment under the statute, but what impact did the ruling actually have by the time it was issued? The authors have heard several tax professionals and one of the ruling's co-authors, Jean Casey, suggest that the ruling is no longer relevant in light of the SOX prohibition.

Did SOX nullify Rev. Rul. 2004-37 before it was even issued? This item will discuss the prohibition on loans and loan modifications in SOX and the tax consequences of loan modifications in Rev. Rul. 2004-37. It will also show that the ruling is still relevant and discuss situations in which the ruling could affect taxpayers.

Sarbanes-Oxley Act of 2002

The Sarbanes-Oxley Act made sweeping changes to the way businesses conduct and report their business activities. One of its provisions dealt with employers making loans to employees. SOX [section] 402(a) provides that publicly traded companies cannot make personal loans to directors or executive officers (Securities Exchange Act of 1934 (1934 Act) [section] 13(k)(1)). Specifically, the act provides that companies cannot extend or maintain credit, arrange for the extension of credit, or renew an extension of credit either directly or indirectly to any director or executive officer.

SOX does include exceptions, though they are very limited. First, any extension of credit that existed on the enactment date is not prohibited, subject to the act's provisions, but material modifications to that debt on or after the enactment date are prohibited (1934 Act [section] 13(k)(1)). The second type of loan that is outside this prohibition is an extension of credit by a securities firm to a director or executive officer that is made in the ordinary course of the company's business if that loan is

* Of a type made available to the public, and

* Made on terms that are no more favorable to the director and/or executive officer than to the public.

This second exception also includes loans made by financial institutions or companies that regularly extend credit to the public and can apply only to the types of credit typically extended by the company (1934 Act [section] 13(k)(2)).

The prohibitions extend to "issuers," as defined in SOX. Essentially, issuers are publicly traded companies and others that issue securities required to be registered under the 1934 Act (SOX [section] 2(a)(7); 1934 Act [section] 3). Note that companies that are not traded...