The last issue of the Journal of Deferred Compensation published an article1 that purported to examine the tax ramifications of discounted stock options, an increasingly popular technique for compensating executives of tax-exempt organizations (and at for-profit companies, too, though this article concentrates on tax-exempts). Its bleak conclusion was that “the astute and prudent practitioner” will avoid this device.

The author presented only a slender and question-begging rationale for his position. The issue as he saw it (and we agree with this formulation) is whether discounted options are a species of deferred compensation that is taxable under section 457(f), discussed more fully below, as soon as the holder’s rights are not contingent upon the performance of substantial future services. He then cited the IRS’s declaration that section 457(f) applies to all forms of deferred compensation2, as conclusive proof that discounted stock options are deferred compensation. This guidance, which was intended simply to answer the argument that section 457 applied only to deferrals made at the employee’s election, says nothing at all about options and is pertinent only if one assumes the fact to be proved.

The fact that an enterprise is exempt from federal income tax does not reduce the degree of talent required to manage its operations. Indeed, the absence of a financial “bottom line” can make management more difficult by obscuring the signposts of success and failure. Exempt employers have the same need to attract top-flight executives as for-profit firms, and the top attraction, in both the taxed and non-taxed worlds, is money.

By their very nature, exempt organizations cannot offer the equity incentives that are commonplace at for-profit enterprises. Since 1987 they have also been deprived of the right to offer tax-effective deferred compensation. The present value of an exempt employer’s unfunded, unsecured promise to pay compensation in the future is immediately includible in the employee’s income, unless the payment is contingent upon the performance of substantial future services4. For taxable employers, the rule is the opposite: no taxable income for the employee until the promised compensation is actually or constructively received.5

Thus a taxable employer can entice executives with the prospect of future income (subject to the risk that the employer may not survive to pay it) without current tax liability. If an exempt employer makes the same promise, the recipient must pay taxes at once.

Exempt employers need a competitive response to those compensation techniques that are available only to for-profit talent seekers. A possible answer is the grant of options to purchase property at a discount.

The Internal Revenue Code taxes options in much the same manner as unfunded deferred compensation. Nothing is included in taxable income when the option is granted,6 just as nothing is included when a taxable employer makes a promise to pay compensation in the future. Instead, the employee is taxed upon receipt, that is, upon exercise of the option in one case or the payment of the deferred compensation in the other.

The similarity in tax consequences does not extend to every detail. A promissee of deferred compensation cannot have an unrestricted right to receive payment at any time; if he does, he is considered to be in “constructive receipt” of income, which is the same as actual receipt from the tax point of view7. An option holder, by contrast, can be allowed to exercise his option at any time. Exercise cuts off his ability to benefit disproportionately from future appreciation and thus serves as a substantial restriction on receipt that negates the constructive receipt doctrine.8

Options and deferred compensation also are treated differently for Social Security tax (“FICA”) purposes. The present value of unfunded deferred compensation is includible in FICA wages when the right to the compensation vests (a close parallel to the income tax rule for exempt organizations),9 while the gain on an option is includible only at the time of exercise.10

Traditionally, compensatory options are written on employer stock, providing not only future income but also an incentive for the recipient to do what he can to maximize stock value. There is, however, no difference in tax treatment if employees are granted options to purchase other types of property11. Since exempt organizations cannot grant options on their own stock in any case, their option packages typically utilize mutual funds. Options on individual stocks, real estate or some other type of property could also be used but are far less common.

In a prototypical exempt organization option program, the employer grants executives options to purchase mutual fund shares at some percentage of their net asset value as of the date of grant. The executives may agree in return to forgo compensation that they would otherwise receive in the future, or the options may be additional pay in the nature of a bonus. The organization will usually cover the options by purchasing shares of the pertinent mutual funds and holding them either in its investment portfolio or in a separate “rabbi trust”12. The period during which options may be exercised varies widely. Sometimes the plan follows the pattern of options on employer stock, which rarely remain outstanding for longer than ten or fifteen years and tend to expire shortly after termination of employment. At other times, the exercise period is more liberal. There is no strong reason to limit it, because there is no relationship between the option holder’s job performance and the value of the property subject to the option.

Discounted options raise two significant tax issues. First, is a discounted option in substance a species of deferred compensation to which section 457(f) applies? Second, assuming that it is not, is the differential between strike price and fair market value included in taxable income at the time of grant, or does it simply increase the gain at the time of exercise?

The option program described above can serve many of the purposes of a traditional deferred compensation program, but it is not quite as flexible. For instance, options cannot readily mimic defined benefit-type deferred compensation plans, and the employer cannot guarantee a particular rate of return. The employer also incurs the cost of holding the optioned property (or, if it issues a “naked” option, the risk that it will have to buy appreciated property in the future).

The last point is particularly significant, as an example will show. Let us contrast the traditional “account balance” deferred compensation plan of Taxable Employer A with the option program of Exempt Employer B.

Under A’s plan, executives may defer their annual bonuses. The deferred amounts are transferred to a rabbi trust, where they are invested in Mutual Fund X. Let us suppose that Executive M defers a $30,000 bonus. The rabbi trust will receive $30,000 and will buy 3,000 shares of X (net asset value $10 per share at the time of purchase).

B’s plan lets executives receive their bonuses in the form of options to purchase shares of X. The exercise price is fixed so that, on the date of grant, the options are “in the money” by an amount equal to the bonus. Hence, Executive N’s $30,000 bonus results in his receipt of options to buy, say, 4,000 shares of X (total fair market value of $40,000) for $10,000. B sets up a rabbi trust and contributes $40,000 to purchase shares to cover the option.

At the outset, A’s rabbi trust has assets worth $30,000 and a liability of the same amount. B’s trust holds property with a value of $40,000, offset by a $30,000 liability (since N would pay it $10,000 if he exercised his option immediately). Note, though, that B has $10,000 more capital tied up in the plan that does A.

Now let us suppose that ten years have passed, that shares of X are worth $30 and that both M and N cash out their benefits under the plan. M receives 3,000 shares with a total value of $90,000 (unrealistically ignoring the effect of distributions, but taking them into account would merely complicate the example without changing its moral). N exercises his options, paying $10,000 to receive 4,000 shares worth $120,000. N earns more than M, because he gets the benefit of appreciation on one-third more shares. Correspondingly, his employer suffers the detriment of having transferred $10,000 more into trust than did A, without receiving any return on that investment.

There are various ways in which B can mitigate its loss. The simplest is to increase the option exercise price at a rate that reflects its cost of capital. If, in our example, the exercise price increased by six percent per annum, it would have grown after ten years to $4.48 per share from the original $2.50, and N would have to pay approximately $18,000 to acquire 4,000 shares.

It would undoubtedly be an overstatement to declare that Congress, in the course of enacting section 457 of the Internal Revenue Code, carefully weighed the distinctions between options and deferred compensation and fashioned tax rules based on that analysis. Nevertheless, it drew a clear dichotomy between the tax treatment of these two forms of compensation.

Excluded from the scope of section 457(f) is “that portion of any plan which consists of a transfer of property described in section 83”13. Someone obviously recognized that some section 83 transactions include features that could arguably be characterized as “deferred compensation” and decided that, in those instances, the principles of section 83 should take priority.

The principal argument against removing options from the ambit of section 457(f) relies on section 83(e), which states that section 83 “shall not apply to . . . the transfer of an option without a readily ascertainable fair market value”14. The section 83 regulations, however, interpret that exclusion to mean only that sections 83(a) and (b) do not lead to any income inclusion at the point where such an option is issued15. In fact, those regulations say a great deal about the tax consequences of options without a readily ascertainable fair market value,16 seemingly occupying the whole field of the taxation of compensatory options. The section 457(f) exception refers broadly to “a transfer of property described in section 83”. The issuance of an option is unquestionably “a transfer of property”,17 albeit one that does not normally result in current tax liability. And it is “described in section 83”, because that section tells us when and how it results in taxation.

It is also worth noting that, in closely parallel contexts, the Internal Revenue Code treats options as a nondeferred form of compensation. As already noted, options are not treated as deferred compensation under section 3121(v)(2)18. Similarly, section 404(a)(5), governing employers’ deductions with respect to any plan “deferring the receipt of compensation”, does not apply to deductions arising from the exercise of options. Instead, the employer is entitled to a deduction under section 83(h).

Perhaps the strongest point in favor of taxing discounted options under section 457(f) is psychological rather than logical. Because options can fill many (though not all) of the roles traditionally assigned to deferred compensation, some commentators leap to the conclusion that they should be taxed in the same way. As an abstract theorem of tax policy, that view may have merit, but, in the real world of the Internal Revenue Code, there are many instances in which different roads lead to the same goal yet result in different tax burdens. No one is obligated to select the route that happens to lead to the highest tax bill.

There are times when taxpayers claim to be traveling down one road and in reality follow another. Then the IRS traffic cops, applying the doctrine of “substance over form”, insist on basing tax results on the real, rather than the pretended, route.

The key to identifying such “sham transactions”, where substance is inconsistent with form, is whether the indicia of the purported form are substantively present. To attack discounted options on substance-over-form grounds, one must show that the instruments in question lack the characteristics of options, not that they can be used as a substitute for some varieties of deferred compensation.

This consideration leads to the second question that we posed. Should a discounted option be treated as an option, with all gain taxed at the time of exercise, or is it, in substance, an immediate transfer of property, with the discount taxable at the date of grant?

The regulations contemplate the possibility that options may be issued with an exercise price below fair market value19. But if the discrepancy is extreme, the features that distinguish an “option” may disappear.

The key economic difference between owning property and having an option to purchase the same property is the differing impact of changes in the property’s value. Both gains and losses affect option holders more dramatically. For instance, if the option exercise price today is 50 percent of fair market value and fair market value doubles tomorrow, the immediate value of the option does not merely double but leaps four-fold. On the other hand, a 50 percent decline in the property’s value makes the option temporarily worthless.20

As the exercise price shrinks in relation to the value of the property, the economics of ownership and options converge, so that the option gradually sheds its substantive qualities. Somewhere - presumably before the exercise price reaches zero - it no longer can reasonably be labeled an “option”.

Deeply discounted options have occasionally shown up in litigation, sometimes with exercise prices of a fraction of cent per share. The IRS has consistently taken the position that these instruments ought to be treated as options for tax purposes. Its motive, needless to say, is to ensure that appreciation between the date of grant and the date of exercise would is taxed as ordinary income rather than capital gain. For equal and opposite reasons, taxpayers have argued for recognizing substance over form. In a few long-ago cases, they were successful,21 but, in the one in which the issue was most squarely presented, the court sided with the IRS:

The taxpayers argue that the agreement price of one mill a share was so minuscule ($150 for 150,000 shares selling publicly at 50 cents or more a share) that no one ever doubted that the right to purchase would be exercised. . . .

The taxpayers do not argue that [the date of exercise] is an inappropriate date to determine the realization of income if the agreement for the sale of stock is viewed as an option. . . . Since the parties chose to make the taxpayers’ right to the stock dependent on the payment of a sum of money, the Tax Court could quite properly consider the taxpayers’ right an option, thus giving effect to the transaction in the form in which the taxpayers molded it. . . . To distinguish, as the taxpayers would have us do, between transactions having the same form, in this case, the option form, on the basis of the amount of payment required would introduce unnecessary uncertainty into future cases.22

It would be far from prudent to take this case as authority for the proposition that anything that is called an option will be treated as one for tax purposes. Indeed, the IRS’s acquiescence in Morrison23 hints that it might be willing to apply “substance over form” if it discerned a revenue advantage in doing so. We also know of cases in which IRS agents have raised the question on audit, though without conclusive results.

Practitioners have tended to view 25 percent of fair market value at date of grant as a “safe” exercise price that retains the substantive characteristics of an option. That figure is based partly on the facts present one of the leading Supreme Court cases in the area24 and partly on instinct. Several years ago, an IRS task force attempted to reach agreement on when a discounted option turned into an outright transfer. While its efforts led to no official pronouncements, it is reported to have settled on a range of 20 to 30 percent as a conservative threshold.

In conclusion, options offer tax-exempt organizations a mechanism for making their compensation packages competitive with those offered by for-profit employers. The legal basis for taxing those options under section 83 rather than section 457 is very strong, so long as the exercise price is not excessively low in relation to fair market value at the date of grant (with the caveat that the term “excessively” is not well defined).

Nonetheless, options are not a panacea, and employers are ill-advised to throw together programs without adequate consideration of their consequences. Among the plan design and administration issues that need to be pondered are -

Discounted option programs have proven to be a valuable tool for many tax-exempt employers, offering a way to “level the playing field” in executive recruiting. Being a relatively new concept, they may still have to undergo legal challenges, but, in our view, the odds are good that they will survive and eventually become part of the standard compensation package that most tax-exempt executives will take for granted.

1. Richard D. Landsberg, Bruce J. McNeil and Thomas Brisendine [sic], “Through the Looking Glass Darkly: Discounted Options and the Tax-Exempt Executive”, Journal of Deferred Compensation (Fall 1999) 1. As discussed elsewhere in this issue, Mr. Brisendine should not have been listed as a co-author.

6. Treas. regs., §1.83-7(a). The exception is when the fair market value of the option privilege is “readily ascertainable” at the date of grant, a condition that almost never exists unless the option is traded on an established market. Treas. regs., §1.83-7(b)(3); Cramer v. Commissioner, 64 F.3d 1406 (9th Cir., 1995), cert. denied, 517 U.S. 1244 (1996).

8. Cf. Revenue Ruling 80-300, 1980-2 C.B. 165; Revenue Ruling 82-121, 1982-2 C.B. 79; PLR 8829070. These rulings deal with stock appreciation rights, but the constructive receipt analysis for options is identical.

12. A rabbi trust is a trust whose assets are subject to the claims of the employer’s creditors, so that the employee is not considered to derive any current economic benefit from his interest in the trust). Having no economic benefit, he has no current taxable income under the principles of Revenue Ruling 60-31.

17. The regulations carefully point out that the grant of an option is not a transfer of the property subject to the option. They do not suggest that an option is not “property” or that its issuance is not a transfer. Treas. regs., §1.83-3(a)(2). By contrast, the definition of “property” excludes “an unfunded and unsecured promise to pay money or property in the future”. Treas. regs., §1.83-3(e).

20. For the sake of simplicity, we pretend for the moment that the “value” of an option at any point equals the difference between the value of the optioned property and the exercise price. As students of Messrs. Black and Scholes are aware, that is not really the case.

21. Lauson Stone, 19 T.C. 872 (1953), aff’d sub nom. Commissioner v. Stone’s Estate, 210 F.2d 33 (3d Cir., 1954); Colton v. Williams, 209 F.Supp. 381 (N.D.Ohio, 1962); Jack F. Morrison, 59 T.C. 248 (1972), acq. 1973-2 C.B. 3.

24. Commissioner v. LoBue, 351 U.S. 243 (1956). The exercise price of the options at issue there was $5.00 per share, and the fair market value of the optioned stock on date of grant ranged from $8.69 to $19.50 per share.