Tax Prophet ®

MEMORANDUM

_________________________________________________________________________

 

Tax Consequences of Receipt and Exercise

of Stock Options or Warrants

I. FACTS:

1. Background

Taxpayer, typically locates and arranges financing (hereafter "Funding") for start-up companies. As part of the consideration paid for this Funding, the corporation may grant Taxpayer stock warrants.

Typically, the Taxpayer is paid a fee each time there is money received by the start-up company under the Funding. The fee is paid to the Taxpayer from the Funding source and not the start-up company.

The warrants are usually issued when the Funding first becomes available. Sometimes a portion of the warrants is issued when the Funding first becomes available, with the remainder of the warrants issued as the Funding line is being utilized.

Stock warrants are similar to stock options in which the holder of the warrant may acquire a certain number of corporate stock shares by exercising the warrant. (Note: Unless otherwise noted, the terms warrants and options are used interchangeably). The warrants are issued by the corporation to obtain access to the Funding.

At no time was Taxpayer hired as an employee or service provider by these start-up companies. He did not sign an employment contract or independent contractor agreement with these companies, and did not provide labor or services under the control or supervision of these companies. He was not paid by the company on an hourly, daily or project basis and did not submit invoices for services rendered.

At all times, the Taxpayer worked for his company and acted as a broker, locating and arranging the Funding to these companies, and he was compensated in that capacity by the Funding Source.


II. ISSUES:

1. Were the warrants received by the Taxpayer issued in connection with services provided to the companies such that Section 83 of the Internal Revenue Code applied to the warrants?

2. What are the tax consequences of receipt and exercise of the warrants?


III. CONCLUSION:

1. The warrants received by Taxpayer were issued in connection with corporate Funding transactions and IRC Sec. 83 did not apply.

2. The warrants are taxable upon receipt at their fair market value on the date of grant. There is no taxable event if the warrants are exercised and the stock is received. However, once the warrants are exercised, the holding period for the stock acquired commences. If the warrants are sold or expire unexercised, then the Taxpayer has capital gain or loss. If the warrants (or the stock acquired by the warrants' exercise) are held for more than one year, the gain or loss will be long term.

Note: These conclusions will apply to an LLC formed by the Taxpayer in the future. Also, this opinion will apply to future transactions which are structured in a manner consistent with the Facts, provided there are no changes in the law subsequent to the date of this opinion.


IV. ANALYSIS:

NOTE:  After this memo was written, TAM 200043013 was released by IRS in which it confirmed that warrants transferred in connction with a loan were not services under IRC Sec. 83.

IRS quoted Centel Communications Co. vs. CM (920 F 2d 1335 (7th Cir. 1990), stating "the courts noted that the legislative history of section 83 indicates that its purpsoes is limite to setting comprehensive rules for the tax treatment of deferred compensation arrangements made between employers and employees [or independent contractors]."

1. For IRC Sec. 83 to apply, property must be issued in connection with the performance of services.

IRC Sec. 83 taxes as compensation the transfer of property, including stock, options and warrants, "in connection with the performance of services" ("compensatory options").

Stock options under IRC Sec. 83 involve the grant by an employer to an employee (or independent service provider) of an option to purchase the employer's stock as compensation for services rendered, or to be rendered, to the employer. An option grants an individual the right, in writing, to purchase stock for a stated period of time, when the holder of the option is not obligated to make the stock purchase.

2. Exclusion for Options Not Granted in the Compensatory Context

Not all options granted to someone who performs services are "in connection with" the services. Certain types of stock options are not granted in a compensatory context and thus are not subject to IRC Sec. 83 ("investment options"). Investment options include options issued in transactions involving corporate stock and corporate debt. Investment options are considered capital assets in the hands of the option holder.

Note: If a compensatory option has been taxed at its grant, in most cases it becomes an investment option for tax purposes because the compensation element in the transaction is closed.

3. Warrants in General

A warrant is an option granted by the issuer of the stock to which it pertains and usually has an expiration date one or several years from the date it is granted. Warrants are granted (or issued) for a number of purposes, but typically are granted in connection with the private placement of debentures or notes to the lender to obtain favorable financing. Warrants are generally taxed in the same manner as options.

4. Taxation of Options or Warrants:

Warrants and options are taxed under these general rules:

(1) There is no gain or loss when an option is acquired.

(2) The option holder recognizes gain or loss when (a) the option period ends and the option is not exercised or (b) when the option is exercised or sold.

(3) If the option is exercised, usually there is no taxable event. When an option is sold or expires, the character of gain or loss depends on the underlying property that is the subject of the option. Unless the holder is a dealer in securities, the character will be capital gains or loss.

(4) When an option is exercised, the stock basis is the exercise price increased by the premium paid for the option, if any, and commission costs. Under IRC 1223(6) and Weir v Cm. 10 TC 996 (1984) aff’d per curiam, 172 F2d 222 (3d Cir, 1949), the stock's holding period begins on the date of acquisition. The taxpayer cannot tack on the holding period of the option prior to its exercise.

IRC Sec. 1226(3) reads as follows:

In determining the period for which the taxpayer has held stock or securities acquired from a corporation by the exercise of rights to acquire such stock or securities, there shall be included only the period beginning with the date on which the right to acquire was exercised.

4. Options Received in Connection With Investments are not Considered Compensation

IRC Sec. 83 applies to transfers of options in connection with services. In Centel Communications Co., Inc. v. Comr., 92 T.C. 612 (1989), aff'd, 920 F.2d 1335 (7th Cir. 1990), stock warrants were granted by a corporation to three shareholders who then guaranteed the corporation’s bank loans. The court found that the personal guarantees, performance guarantees, and subordinations given by the shareholders were essentially assumptions of additional financial risk taken by them in their role as shareholders or investors.

The court reasoned that since the shareholders were not employees of the corporation, the personal guarantees were shareholder/investor actions taken by such individuals to protect their investment in the corporation and, as such, did not constitute "performance of services" within the meaning of Section 83. The court reviewed the Tax Court’s findings and stated:

After reviewing the evidence presented by the parties, the Tax Court concluded that Davis, Grey and Electric [the Taxpayers] did not perform "services" to Fisk [The Corporation] by guaranteeing Fisk's loans. Consequently, the warrants granted to the three stockholders were not issued "in connection with" the performance of services and could not qualify for treatment under Section 83. The Tax Court carefully examined the legislative history of Section 83 and the relevant case law in order to determine what is meant by "service" in Section 83. It concluded from those sources that "service" usually connotes an act performed by an employee or independent contractor for the employer rather than aid lent to the company by a stockholder.

The Tax Court found that Davis, Grey and Electric, by offering guarantees to their company, assumed additional financial risk in their role as stockholders. In giving the guarantees, the three stockholders were making additional contributions to capital in a self-serving effort to protect their substantial stock investment in Fisk, Centel's predecessor. They were not employees or independent contractors laboring or performing "services" for Fisk. [emphasis added]

The court then stated:

The transfer of warrants to stockholders Davis, Grey and Electric in return for their guarantee of Fisk's corporate indebtedness simply is not the kind of transaction Congress intended Section 83 to encompass.

The court then noted:

Stock options are only transferred "in connection with the performance of services" when an employer transfers options to an employee or independent contractor. No known case applies Section 83 to a company's grant of options to a mere shareholder.

Centel is consistent with an earlier case, Oregon Metallurgical Corp. v. U.S., 12 Cl. Ct. 447 (1987) which held that a stock option issued by a corporation to its majority shareholder as consideration for the shareholder's guarantee of a loan is a capital expenditure and, therefore, is not deductible under Section 83.

The court determined in Oregon Metallurgical Corp. that the consideration paid as a stock option was a capital expenditure because it was an expense paid to obtain loan financing, and Regs. Section 1.83-6(a)(4) bars a Section 83 deduction for a property transfer that is a capital expenditure:

Plaintiff argues that Section 83 is applicable because the transfer of options to Armco as compensation for the loan guarantee was a transfer of property in connection with the performance of services within an employee/employer relationship. The Tax Regulations, however, bar a deduction under Section 83 for transfers of property constituting a capital expenditure. Thus, the dispositive question on the applicability of Section 83 in this case is whether the compensation paid for the loan guarantee was a capital expense. [emphasis added]

The court then concluded that compensation paid for a loan expense was a capital expense:

In Duffy v. United States, 231 Ct. Cl. 679, 690 F.2d 889 (1982), the Court of Claims explained that "[e]xpenses paid or incurred in obtaining loan financing are capital expenditures that must be amortized over the life of the loan" and the court required the capitalization of amounts paid to an individual for services rendered in locating and arranging financing. Id. at 688, 690 F.2d at 895.

In Blitzer v. United States, 231 Ct. Cl. 236, 684 F.2d 874 (1982), the court required the capitalization of a fee paid for services in obtaining HUD approval of a loan. Id. at 267-69, 684 F.2d at 894. In this case, the fees paid to Armco in the form of stock options were for a $2,000,000 loan guarantee without which First National Bank would not have made the loan. The court finds plaintiff's expenses were capital in nature because the consideration paid to Armco for the guarantee was incurred as a prerequisite to obtaining financing.

Duncan Indus., Inc. v. United States, 73 T.C. 266, 273 (1979) (holding that a "loan fee" that was a prerequisite to obtaining a loan and paid for in the form of discounted stock was to be capitalized); Rev. Rul. 75-172, 1975-1 Cum. Bull. 145 (fees paid to a lender for the cost of legal services made in connection with obtaining a loan are to be capitalized). Moreover, the court finds that the stock issued to Armco in exchange for Armco's loan guarantee should be capitalized because "[e]xpenses paid or incurred in obtaining loan financing are capital expenditures that must be amortized over the life of the loan." Duffy v. United States, 231 Ct. Cl. 679, 688, 690 F.2d 889, 895 (1982) (citing Duncan Indus., Inc. v. Commissioner, 73 T.C. 266, 273 (1979) and Trivett v. Commissioner, 36 T.C.M. (CCH) 675, 680-81 (1977), aff'd, 611 F.2d 655 (6th Cir. 1979)). Therefore, plaintiff does not qualify for a Section 83 deduction. [emphasis added]

In PLR 9737001 (Note: private letter rulings cannot be cited as precedent) the IRS ruled that stock and options transferred in exchange for cable network access were not transferred in connection with the "performance of services".

In this case, the facts submitted indicate that the MSOs were granted the opportunity to purchase Taxpayer's stock at a discount, and received the warrants, in exchange for their agreeing to transmit Taxpayer's television show. Taxpayer's primary objective was to secure access to one or more of the MSOs' limited number of channels. Taxpayer was concerned that, unless they offered this premium, the MSOs may have filled these channels with other programming.

[W]e conclude that section 83 does not apply in this case because the stock was not sold, and options were not granted, to the MSOs in connection with the performance of services … we conclude that they were granted for the predominate purpose of gaining access to channel space.

Accordingly, since section 83 of the Code does not apply with respect to the stock transferred by Taxpayer, the amount paid for access to the MSOs channels is measured by the difference between the value of the stock at the date it was sold… Likewise, since the warrants were not issued in connection with the performance of services, the amount considered to have been paid for the channel access is the warrant's fair market value on their grant date. [Emphasis added]

Applying these cases to the Taxpayer’s facts, the Taxpayer was not an employee or independent contractor of the corporations and did not perform labor or services in connection with the receipt of his warrants. The Taxpayer received warrants as part of the Funding transactions. Warrants issued in conjunction with obtaining Funding are capital expenditures and cannot be deducted by the corporation. IRC Sec. 83 bars an employer a deduction for capital expenditures and, likewise, the courts have held that those receiving options or warrants in connection with capital expenditures are not subject to IRC Sec. 83 as well.

In conclusion, Taxpayer is not subject to IRC Sec. 83 when he received warrants in connection with the Funding. He is taxed on the fair market value of the warrants when he received them.





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