Qualified plan/option arrangement.

• Author: Cvach, Gary Q.

The IRS has issued Letter Ruling 9712033, detailing the tax consequences of an arrangement under which an employer will contribute stock options to its qualified profit-sharing plan. Soon thereafter, however, the Service stated in Ann. 9745 that it intended to reexamine the plan qualification and other tax issues raised by such an arrangement. The: Department of Labor had earlier published a proposed prohibited transaction exemption on what appears to be the same arrangement; see 61 Fed. Reg. 68791.

Company is a publicly held corporation engaged primarily in the financial services and insurance businesses. Company sponsors a qualified profit-sharing plan, which includes a Sec. 401 (k) arrangement and provides a discretionary match. Company wants to: amend the plan to provide for contributions in a combination of cash and options to buy Company stock. Only participants with less than $40,000 of annual compensation are eligible for: cash contributions, which will vest immediately.

Company will contribute options to the plan for each employee who is an active employee on the grant date and is eligible to participate in the plan, and will calculate the fair market value (FMV) of the options at that time using a "reasonable method." The number of shares covered by the options allocated to each participant will equal 10% of the participant's eligible compensation, divided by the option price. Officers subject to the reporting requirements of Section 16(a) of the Securities Exchange Act of 1934 will not be eligible for options.

The options will be exercisable only while the participants are active employees--except when a participant terminates employment due to death, disability or retirement, in which case the exercise period will be extended. The options will have a 10-year term, and will become exercisable at a rate of 20% per year over five years. The options' per-share exercise price will be the FMV of the underlying stock, measured by the closing price on the day before the grant date. Exercises will be cashless; the participant will authorize the plan's trustee to sell enough of the shares covered by the exercise to pay the exercise price. Thus, the number of shares the plan receives on exercise will equal the spread divided by the pershare exercise price.

The stock the trust receives on exercise will vest under the plan's terms and Sec. 411, and will not be distributable to the employee until retirement, hardship or...