In an Internal Legal Memorandum (ILM), the IRS has taken the position that it can seize and sell stock options held by a taxpayer, even though the taxpayer was restricted from transferring or selling the options. Dated Jan. 9, 2009, ILM 200926001 was only recently made public. An ILM is a memorandum prepared by the legal counsel staff in the IRS national office that does not have the force of law. It indicates, however, the current enforcement position of the IRS.
Transfer restrictions are common in compensatory option programs. A corporation can avoid registration of options with the Securities and Exchange Commission if the options are granted to employees and cannot be transferred. There is a narrow exception in this registration exemption for transfers of nonqualified stock options to family members in connection with estate planning. Incentive Stock Options (ISOs) have additional restrictions under section 422 of the Internal Revenue Code (Code). A transfer of an ISO may only occur in the event of death or divorce. These restrictions on transfers reflect recent SEC pronouncements to end abusive practices in which promoters could potentially rely on the exemption for compensatory options to circumvent registration of securities sold in a public offering.
In the ILM, the executive had both nonqualified options and ISOs. The IRS cited authority to establish that the contractual restrictions on transferring nonqualified options are overridden by the IRS's broad powers under section 6334 of the Code to levy on all property rights belonging to the taxpayer. The ILM next concludes that the Code restrictions on transferring ISOs are also overridden by the IRS's power to levy under section 6334 of the Code. Section 6334 allows the IRS to levy on property or property rights without regard to any other law of the United States, including any other provision of the Code. The ILM further notes that this position is consistent with and similar to the rights of the IRS to levy on retirement benefits held in an ERISA-covered retirement plan, regardless of ERISA's general protections of retirement plan participants against creditors.
The ability of the IRS to levy on stock options under section 6334 of the Code seems well-supported in the ILM. The ILM, however, cites no authority and provides no rationale for eliminating transfer restrictions once the levy is completed. In other words, the authority of section 6334 is sufficient to give the IRS the ability to levy on stock options and acquire the property subject to the same restrictions on transfer that applied to the taxpayer. The IRS, however, seems to reach the conclusion that the transfer restrictions are somehow eliminated through the levy process, giving the IRS greater property rights than were held by the taxpayer. We are not aware of any authority to support the position taken in the ILM that the IRS may sell or transfer stock options to a third party following the levy.
Stock options are frequently assumed or purchased in corporate mergers and acquisitions. Often, as in a cash merger, option holders may be offered cash at closing in lieu of exercise. The facts involved in the ILM are incomplete but suggest that corporate transaction was pending. To the extent the taxpayer in the ILM could have received a cash payment for the options, the IRS would hold those rights and be able collect the payment. It is not apparent that the IRS was expecting to receive cash in exchange for the options in the transaction, however. The language in the ILM went much further than stating that the IRS would stand in the shoes of the taxpayer in that transaction. It assumes that the IRS has the right to sell or transfer the property that was never granted to the taxpayer.
The collateral tax consequences on the seizure and sale of the option are not discussed in the ILM and, to some extent, are uncertain. With respect to the ISO, the transfer of the option from the taxpayer to the IRS may or may not trigger tax. IRS regulations provide a transfer of an ISO pursuant to a qualified domestic relations order, for example, causes an ISO to lose its ISO status and is treated as a non-qualified option. The tax treatment of transferring nonqualified options, however, is not addressed in the IRS regulations. Potentially, the seizure of the option by the IRS could be characterized as a taxable disposition of the option by the taxpayer for value.
It seems impractical for the IRS to levy on stock options and then seek to sell them to a third party. For most companies, there generally is not an active market for trading stock options. The troubling aspect of the ILM is that the reasoning assumes that the IRS can have greater rights in property that it seizes through levy than were held prior to the seizure.
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