Unexpected tax consequences of buying employer stock with loan proceeds.

• Author: Fairbanks, Greg A.

Over the years, companies and their compensation advisers have developed creative ways to compensate executives for their services and align the executives' interests with those of shareholders. To accomplish this, companies often grant stock options, restricted stock, and other forms of equity-based compensation to the executives.

In order to give an executive ownership in the company, some private companies have chosen to conduct a private offering that allows a select group of executives to purchase stock from the company. Because the executive will often not have enough cash on hand to pay the purchase price, the company will sometimes lend the purchase price to the executive.

The use of a loan and purchase agreement can dramatically change the income tax treatment of this stock acquisition. What is considered a simple stock acquisition with no income tax consequences can turn into a very complex situation that could give the executive and the company headaches. This item explores the possible tax treatment when an executive purchases employer stock with a loan from the employer.

Basic Situation

ABC Company is a closely held private corporation. G has been the CEO of ABC for the past five years and has proven to be a valuable asset to the company. The shareholders of ABC have decided to allow G to purchase shares from the company for $500,000, which is the fair market value (FMV) of the shares. ABC plans to give G all the rights of ownership.

G does not have access to enough cash to pay for the stock, so ABC decides to allow G to purchase the stock in exchange for a note equal to $500,000. ABC has decided that: (1) the note should accrue interest at a market rate; (2) the stock should be collateral for the loan; and (3) the loan should be payable in full at the end of five years. ABC would like to understand the tax consequences if the loan is a nonrecourse loan (i.e., G has no personal liability) or a recourse loan (G has personal liability) and the tax treatment if ABC forgives a portion of the loan when it matures.

Why the Executive May Be Required to Recognize Compensation Income

First, ABC should understand that G may be required to recognize compensation income in this transaction. Sec. 83 governs the taxation of property, including stock, that is transferred to a service provider in connection with the performance of services. It provides that when the stock becomes vested, the service provider recognizes compensation income equal to the stock's FMV, less any amount paid for the stock. G and ABC may not think Sec. 83 would apply to a stock sale because G paid full value for the stock. However, the IRS would most likely take the position that the stock is subject to Sec. 83 because it was transferred in connection with the performance of services. That is, G provides services to ABC, so the IRS is likely to take the position that any transfer of stock to G is in connection with the performance of services.

Regs. Sec. 1.83-3(f) provides that property transferred in recognition of past, present, or future services is transferred in connection with the performance of services. A factor that may indicate that the stock was not transferred in connection with the performance of services is that other persons were able to purchase the stock on similar terms...