Listed Transaction (LT #22)

Abusive Option Sales to FLPs/Related Parties
IRS Notice 2003-47

According to the Wall Street Journal, this tax shelter was sold to as many as 42 corporations and corporate executives across the United States by the Big-4 accounting firms, Ernst & Young LLP, KPMG LLP, PriceWaterhouseCoopers LLP and Arthur Andersen LLP.  Wells & Weil, "IRS Identifies Option Tax Shelter Involving Major Accounting Firm," 2/22/04, at D2.  The transaction is reported to call for executives to transfer their stock options to FLPs or similar entities controlled by family members or related parties, for the "sole purpose of receiving the options and avoiding taxes", enabling the executives to defer taxes on the stock options for up to 30 years. Id. 

In IRS Notice 2003-47, the IRS points out that the exception under Regs. Section 1.83-7(a) occurs when the recipient of the option sells the option in an arm's-length transaction. The IRS has become aware of promoters who believe that the individual holder of a nonstatutory stock option does not have to recognize compensation income when the related party exercises the option and the individual does not recognize income until the note is paid off. The related party purports to owe no tax until the underlying stock is sold. However, by this notice, the IRS intends on challenging the deferral in these situations, on the basis that the transaction with the related party and/or the deferred payment obligation are not bona fide, lack substance, or lack a business purpose.

NOTE: Regulations have been issued which clarify that a sale or other disposition of a nonstatutory compensatory option to a related person will not be treated as a transaction which closes application of Section 83 with respect to the option. Under these regulations, a person is related to the recipient of the option if either: (1) they bear a related party relationship as defined in Sections 267(b) or 707(b)(1)(using 20% instead of 50% and including the spouse of any member of the family as "family"); or (2) the option recipient and such person are engaged in trade or businesses under common control (as defined in Sections 52(a) and (b)). Related persons do not include the service recipient with respect to the option or the grantor of the option.

On October 19, 2004, the IRS issued a Coordinated Issue Paper, assisting its field agents in addressing the legal issues involved with the transaction.  In this paper, the IRS addresses 11 subissues:  (1) is the transfer an arm's length transaction for purposes of Regs. 1.83-1 and 1.83-7?; (2) does the receipt of the deferred payment obligation, such as a note or annuity, at the time of the transfer result in immediate recognition of income?; (3) is the employer or other service recipient entitled to a deduction under IRC Section 83(h), and if so, is the deduction limited because of IRC Section 162(m)?; (4) the applicability of FICA, FUTA, and federal income tax withholding provision; (5) does the related party entity acquire a basis in the stock options or restricted stock obtained; (6) may the transaction be recast under the partnership anti-abuse rule; (7) may the transaction be challeged under existing judicial doctrines; (8) will the deferred payment obligation be recognized as valid debt; (9) if the transaction lacks economic substance, will the legal expenses or fees paid or incurred to create the transaction be deductible; (10) do the disclosure provisions of 1.6011-4 apply to transactions entered into prior to the release of IRS Notice 2003-47; and (11) should the IRS assert accuracy related penalties. 

On February 22, 2005, the IRS issued IRS Announcement 2005-19, proposing a settlement initiative that would be open to taxpayers until May 23, 2005.  Under the initiative, executives would have to include 100% of their stock option "compensation" into income, along with applicable interest, plus employment taxes, and a 10% penalty. 

If you believe that you may have engaged in a transaction that is the same or substantially similar to the transaction described above, Federal law may require you to disclose your and other parties' participation in any such "listed transaction" on IRS Form 8886.  If you were a material advisor with respect to the same, you may have reporting obligations and list maintenance obligations.  For more information about Federal law reporting or disclosure requirements or questions about this or any other potentially abusive tax shelter, please contact us.