Stock warrants and options: compensation or investment sweetener?

• Author: Tuley, Patrick A.

Many start-up companies issue stock warrants or options under one of two scenarios: (1) to induce potential investors to purchase stock in an offering or (2) as compensation for executives, directors or other service providers. When these situations are distinct, the tax treatment is very straightforward.

Tax Ramifications

If a warrant is investment-related, the stock takes a basis equal to the warrant's exercise price, plus any value attributable to the warrant on the initial offering. There is no taxable income to the warrant holder on exercise. The holding period for the stock begins on exercise. Any gain on the ultimate disposition of the stock is capital gain (short-term or long-term, depending on how long the stock was held).

If the warrant is compensatory and does not have a readily ascertainable fair market value, it is not taxable on grant or issue. Instead, taxability is deferred under Sec. 83 until the warrant is exercised. On exercise, the difference between the exercise price and the stock's value is taxed as compensation (i.e., ordinary income).

Shareholders/Service Providers

A dilemma exists when warrants are issued to shareholders who are also service providers. Often, the warrant agreement stipulates service requirements, vesting or other service-related parameters; however, the number of warrants issued is tied to the number of shares purchased. The number of warrants issued does not necessarily have any direct relationship to the role of the service provider/investor or the services to be provided. In this regard, the tax law is unclear. In addition, it does not provide any practical means for bifurcating the compensation-related feature of a warrant from its investment-related function.

Sec. 83 covers the treatment of property received in connection with the performance of services. Sec. 83(a) requites the service provider to include in taxable income the excess of the value of the property received over the amount paid for it. In addition, Kegs. Sec. 1.83-3(f) indicates that property transferred to an employee or independent contractor in recognition of the performance of services is considered "transferred in connection with the performance of services" for Sec. 83 purposes. Sec. 83(h) provides that the service recipient is entitled to a compensation deduction equal to the amount included by the service provider under Sec. 83(a).

Cases

Alves: The "transferred in connection with the performance of services" language is...