United States: Options Can Be Used To Compensate Tax-Exempt Executives

Tax-exempt organizations face many difficulties in competing with for-profit organizations to retain their senior employees. For-profit organizations may select from a variety of methods of rewarding senior employees, including a deferral of the payment of salary, phantom stock plans, restricted stock and employer stock options. In contrast to the variety available to a for-profit business, a tax-exempt organization’s menu of incentive compensation plans is limited. An exempt organization cannot offer equity ownership either in the form of stock or an option to buy stock of itself. Further, promises to pay unfunded deferred compensation avoids current federal income taxation only if the deferred compensation is subject to a substantial risk of forfeiture; the employee must risk losing the compensation if his/her employment terminates early.

Recently, tax-exempt organizations looking to solve these compensation problems have focused on the use of "private options" to satisfy the need for additional compensation choices to compete successfully with for-profit businesses. Private options are options not to acquire stock of the employer, which, of course, is not available, but instead are options to purchase shares of a mutual fund selected by the executive. The executive of a tax-exempt organization, like an employee of a for-profit business who receives options to purchase stock, will be able to obtain the benefits of the appreciation in the mutual fund shares without any cash investment. In fact, better than the employer’s options, mutual fund shares provide diversification that an employee of a for-profit business holding options to purchase his or her employer’s stock does not have. Options also provide more flexibility and control over when the compensation of the employee is taken into income than promises to pay a sum on a specified future date. When the executive exercises the option, he or she pays the exercise price and the organization is required to deliver the mutual fund shares to which he or she is entitled.

Section 83 of the Internal Revenue Code generally provides that property transferred to an employee as compensation for services is treated as income to the employee. The employee is required to pay tax on an amount equal to the fair market value of the property received. If the property is subject to forfeiture in the event that the employee terminates his or her employment before a specified time period elapses, the receipt of income for federal income tax purposes is postponed until the risk of forfeiture terminates. On the termination of the risk of forfeiture, the employee reports income equal to the fair market value of the property on that date. An unfunded promise to pay compensation in the future, in the case of for-profit employees, does not result in the receipt of current taxable income for the employee. The employee is required to report the income only when he or she actually receives the cash. However, in the case of a tax-exempt employer, an employee is required to report as taxable income the amount of any cash that the employer promises to pay as compensation in the future, unless the payment is subject to a risk of forfeiture, whether or not the compensation is paid at that time. If the payment of deferred compensation is subject to a risk of forfeiture, the employee recognizes taxable income on the date the risk of forfeiture terminates, whether or not the compensation is paid at that time.

Options to purchase property from an employer are treated differently. Under Treasury Regulation Section 1.83-7, an employee who receives options to purchase property including stock, generally does not recognize current income at the time the option is granted. (Special rules apply to incentive stock options, which are only options to purchase employer stock.) Instead, the employee is required to recognize income at the time the option is exercised. The income that must be recognized is equal to the difference between the fair market value of the property received and the exercise price paid by the employee.

Usually, options granted to executives carry an exercise price equal to the fair market value of the property (usually employer stock) on the date of grant of the option. In essence, the employee holds a right to the appreciation in the stock between the date of grant and the date of exercise. However, options may be issued that have an exercise price that is less than the fair market value of the property at the time the option is granted. It is unclear at what point the discount from fair market value of the exercise price becomes so great, and the exercise price so small, that the employee will be treated as having received the property itself from the employer. While it is not clear how large a discount from fair market value may be taken, case law indicates that a substantial discount from fair market value will not convert an option into a transfer of the underlying property.

The prohibition of deferring non-forfeitable income by an employee of a tax-exempt organization does not apply to a transfer of property governed by Section 83 of the Code. A grant of an option to purchase property from the employer constitutes a transfer of property for purposes of Section 83. The option is not subject to the prohibition on deferring income. As a result, an executive of a tax-exempt organization may defer income for federal income tax purposes by accepting as compensation options to purchase shares of mutual funds.

Although Section 83 is generally applied to grants of stock options to buy employer stock, the statute is not limited to employer stock. Like an executive receiving options to buy employer stock, an executive of a tax-exempt organization will not be required to report the value of options to purchase mutual fund shares from his or her employer. A substantial discount from the current fair market value of the mutual fund shares should not result in any current income.

The tax-exempt organization can hedge the possible adverse economics of a substantial appreciation in the mutual fund shares simply by buying the shares subject to the option. Any increase in the value of the mutual fund shares will be matched by an increase in the value of the mutual fund shares held by the tax-exempt organization.

To illustrate how this might work, assume that a tax-exempt organization grants an employee an option to purchase 1,000 shares of mutual fund XYZ having a current value of $10,000 for an option price of $2,500. Assume further that the employee exercises the option two years later at a time when the shares of mutual fund XYZ have a value of $15,000. The tax-exempt organization would purchase 1,000 shares of XYZ Corporation at the time the option is granted and would deliver those shares to the employee on the date the option is exercised in exchange for the $2,500 option price. The employee would not recognize any taxable income until the option is exercised. At that time, the employee would be taxable on $12,500 (the difference between the fair market value of the mutual fund shares he receives and the option price), at ordinary income rates and subject to withholding and employment taxes. The employee would have a tax basis in the mutual fund shares acquired equal to $15,000.

Option grants will not avoid the impact of Intermediate Sanctions (See GT Alert, February 2001 "IRS Issues Temporary Regulations on Intermediate Sanctions"). A tax-exempt organization electing to use options as a part of the compensation of a senior executive needs to make sure that the fair market value of the options issued coupled with other compensation does not result in an excess benefit transaction between the executive and the tax-exempt employee.

We believe that using options to buy shares of a mutual fund in this manner is a tool for tax-exempt organizations to use to compete effectively for executive talent with for-profit businesses. The executive receives a right that may appreciate without current income tax, even though the option is vested at the time of grant. The executive can recognize income at the time he or she desires, rather than being locked into a specified date. We think that most tax-exempt organizations should consider this in their arsenal of available compensation plans.

© 2001 Greenberg Traurig