United States: IRS Offers Settlement for Stock Option Tax Shelter Transactions

On February 22, 2005, the IRS announced a settlement initiative regarding certain transactions in which an executive sells stock options to a family limited partnership. The IRS has apparently identified more than $700 million in unreported taxable gains with respect to these transactions. Affected executives should promptly consider what action, if any, to take in light of this settlement initiative. There is only a limited period of time to act - parties who desire to participate in this settlement initiative only have until May 23, 2005 to notify the IRS. Set forth below is a brief summary of some of the key aspects of the settlement initiative and a link to an IRS website announcing this initiative.

What type of transactions are covered by the settlement initiative?

A sale of stock options (or restricted stock) to a family limited partnership (or other related person to the executive) for a long term (15 to 30 year) unsecured loan. The purported tax benefits from these transactions included deferral of the executive's tax on built in option gains upon exercise and the conversion of post sale stock appreciation into long term capital gains for the family limited partnership. The IRS position is that gains realized upon exercise of the stock option by the family limited partnership (or vesting of the restricted stock) are taxable compensation to the executive.

Why is the IRS targeting the stock option sale to family limited partnership transaction?
It is likely that there are more executive officers at public companies who have not yet been identified by the IRS. It was not uncommon before Sarbanes-Oxley for some auditors to issue tax opinion letters on this transaction opining that there "should be" no tax to the executive on the exercise of the stock option by the family limited partnership. In addition to the potential tax revenue, the IRS has made it a point to express its concerns about auditor independence and corporate governance. The Chair of the SEC and PCAOB have issued public statements supporting the initiative.

Who is able to participate in the settlement?

Executives and family limited partnership (or other related person to the executive) and the company, but only if (1) the executive transferred the option to the family limited partnership by July 2, 2003 (i.e., when the IRS identified this transaction as a "tax shelter"), and (2) the person is not already in a court proceeding to determine the tax treatment of this transaction. A company may participate in this settlement initiative without the executive. The executive may participate without the company, but must secure the cooperation and participation of the family limited partnership.

What are the terms of the settlement?

Announcement 2005-19 sets forth the settlement terms, which are fairly complex in nature. In general, executives must pay income and FICA taxes with respect to the gain on the option exercise (or vesting of restricted stock) plus a 10% penalty. Interest on deferred payments for the stock option would also be taxable. The gain must be recognized in the year in which the family limited partnership sold the option stock. Parties will be allowed to deduct "out of pocket transaction costs" (i.e., the promoters fee). The settlement terms do not affect the application of gift, estate and generation skipping taxes.

How might public companies react to this settlement initiative?
Affected public companies will face sensitive legal issues. The settlement initiative provides an affected public company the opportunity to accelerate potentially valuable tax deductions. Questions may exist whether the company complied with securities laws when disclosing this transaction to stock holders. If the executive is unable to pay the taxes associated with the settlement offer, the executive's ability to lead the company may be impaired. The Wall Street Journal previously reported in 2003 that a large public company fired two of its senior executives as a result of their inability to settle these tax issues promptly on audit.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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