S-Corp sale - Shareholder options paid over 3 years

Hi, Wiles,

In #48 you said vesting occurred in a prior year. That's a taxable event. To avoid taxation, the option must be nontransferable and subject to a substantial risk of forfeiture. When you say it's vested, that means it is not subject to forfeiture. It just moves the compensation to a prior year. The compensation and later sale result is clearer because the compensation and sale were further apart.

I still don't see why this is difficult to understand. The note was not received from the service recipient, so how could it be compensation (unless, of course, you ignore why the note was issued by the buyer.) Is someone saying the note was actually issued to the target, which then transferred it to the TP as compensation?

I have assumed the goal was to find the correct tax treatment, not to come up with a reason to consider every penny received as compensation.

If that Section doesn’t apply, then 404(a)(5) would).

Actually, I have to think about this some more…

Vesting in an option is not a taxable event.

Please tell me why you think that's not an installment sale!

Because the transaction was an option cancellation payment between the seller and the shareholder. As per Post #35:

It sure feels like Sold Co and the option holder made an exchange to "close out" those options.
Without the liquidation, I believe/assume the buyer would pay Sold Co in Years 2 & 3, and Sold Co would pay option holder and issue the W-2. The same as in Year 1.

In #48 you said vesting occurred in a prior year. That's a taxable event.

No, it’s not. The -7 Reg says as much.

I still don't see why this is difficult to understand. The note was not received from the service recipient, so how could it be compensation (unless, of course, you ignore why the note was issued by the buyer.)

I don’t know what to say about this. The note was received from the seller. And even it it wasn’t, that doesn’t change anything.

I have assumed the goal was to find the correct tax treatment, not to come up with a reason to consider every penny received as compensation.

I don’t know what to say about this either. You have an option issued in connection with the performance of services. And then – ultimately – you have a cash payment made in cancellation of that option. If all cash came at once, and there was no earn out, it would all be compensation right then and there. If there wasn’t a cancellation payment, but rather, an exercise of the option, you end up in the same place, right then and there. For some reason, you propose that the nature of the consideration changes these truths.

The issue here is how the nature of the consideration might change the timing of the income recognition (and any related deduction).

Hi, Jeff,

The difference between us is that I see two transactions and you see one. My view is not dependent on the nature of the consideration, but that yours is. In my view the seller paid for the taxpayer's rights. Viewed by itself, that's a capital transaction, even if taken in the form of a cancellation, rather than a formal transfer. (I think you disagree with that statement.)

Clearly, the compensation was for services performed for the target. Immediately before the closing vesting had not occurred and the taxpayer was still obligated to perform. The employer negotiated a stock sale and the circumstances were such that the taxpayer was able to participate in the closing instead of continuing to be obligated to perform future services. That is, the employer allowed the transfer to happen, thereby triggering section 83.

The amount of compensation was the value of the cash and stock plus the discounted value of the note received -- not because that was the consideration received as compensation, but because the property rights received from target were immediately sold to a third party -- and so there is a presumption that the value of the compensation was equal to the value of the consideration received for the transfer of whatever rights the taxpayer received when 83 was triggered.

As I see it, the difference between us is that you view the notes as received as deferred compensation to be reported as the cash is received. Besides the fact that the taxpayer participated in the closing as a transferor of rights to a third party, I disagree with your viewpoint that it nevertheless was not taxable on receipt -- because the note was not subject to a substantial risk of forfeiture.

It may be that you view receipt of the note as taxable. If so, the note was owned for tax purposes by the taxpayer. It was an asset with a holding period and a basis. And future payments on the note were principal and interest, not additional compensation.

But I'm not sure I understand your position as to whether the FMV of the note was triggered on receipt. My view is that once 83 is triggered 83 ceases to be involved. You seem to be saying the future payments on the note are really compensation payable by the target to be taxed as such as received. That makes no sense to me. The target issued the option. The taxpayer entered into a separate transaction with a third party in which his rights were effectively transferred in exchange for different property rights. That does not mean the target transferred the note to the taxpayer. (The taxpayer had two separate contracts.)

If the payments in years 2 and 3 are compensation, as I think you are asserting, who gets the matching deduction?

But I'm not sure I understand your position as to whether the FMV of the note was triggered on receipt.

…I haven’t really opined on it. I am well aware that if the note triggers Sec 83 income up front, we still have to analyze things from there.

One possibility is that Wiles “client” is taking the position that Sec 83 doesn’t apply, at least initially, to the note on “unfunded and unsecured” grounds. But when note payments are made in cash, we return to Sec 83 and have income at that time. I wonder. It seems to comport with buyer’s plans.

Buyer will show a $35M basis. A deal of this magnitude should be expected to have an allocation agreed to by the taxpayer. So the taxpayer has adverse evidence re reporting compensation income of less than $3.5M. The target stockholders have an incentive to report the entire $3.5M. So I suspect we're discussing a moot point.

I admire your creativity in arguing against application of section 83, but I just don't see it.

BTW, what is an unfunded note?

We're not talking about a contract to pay for services which involved the note. So why does the note enter into your compensation analysis?

Imagine that the target vested the option a month before the closing. Would that alter your view?

Imagine that the target vested the option a month before the closing. Would that alter your view?

The option vested 16 months prior to the closing.

Vesting is a taxable event under 83. That just clarifies my point that there are two taxable events here. The note was not received as compensation. It was received in exchange for the taxpayer's option rights. I have yet to hear a viable counter-argument explaining why there was only one taxable event, let alone a theory explaining why the payments in later years were compensation.

Vesting is not taxable event.

I know there is a special 83 rule re options, but regardless of whether the vesting event triggered 83 recognition 16 months go or at the closing, the option is what is taxed as compensation, not the note. There are two taxable events, even though occurring contemporaneously, and I have not seen an argument as to why there is only one.

I found the article that Diplodok attempted to link in #2:
https://www.robertsandholland.com/siteFiles/News/08-20-15_Decisions%20Tackle%20Corporate%20Equity%20and%20Compensation_(DEK)_(00347026).pdf

The court’s opinion states at various points that Greiner, in 2004, “chose” or “elected” to take the earn-out payments into account under the open transaction approach, rather than by valuing the right and taking it into income as compensation in 2004. Given the treatment in regulations under Code section 83 of an unfunded and unsecured promise to pay money as something other than property <See Reg. § 1.83-3(e)> it is far from clear that the tax law offered such a choice to Greiner or that the closed transaction method in particular would have been a permissible method under the circumstances. However, the court avoided the need to confront this issue by concluding that the open transaction approach followed by Greiner was a method of accounting that could not later be changed unilaterally by the taxpayer.

Another similar article:
https://www.thetaxadviser.com/issues/20 ... aug10.html


Google also brought me here:
https://www.taxnotes.com/research/feder ... tions/ytfy

Finally, commentors requested guidance concerning the treatment of earn-out payments received by option holders in connection with a corporate transaction. Because of the factual nature of these transactions, these final regulations do not address the issues raised by these transactions. However, this area is currently under study and may be the subject of future guidance of general applicability under § 601.601(d)(2).

the option is what is taxed as compensation, not the note.

What is taxed as compensation is the consideration rec’d for the cancellation of the option. That is, the unrestricted property received. Usually, that is Cash only. But not here. It’s Cash plus a Note. We agree the Cash is taxable.

And if an option is exercised, what is taxable is the receipt of unrestricted stock.

Anyway, we all know this stuff already.

There are two taxable events, even though occurring contemporaneously, and I have not seen an argument as to why there is only one.

We know how an option works. All this talk about 1 transaction vs 2 is silly. If you get bought out of an option for cash, that’s 1 transaction. If you get bought out of an option and receive a building, you’re taxed on the value of the building. That establishes basis in the building. We get it. When you sell the building, it’s another taxable transaction. We get it.

Your approach here is ignoring certain stipulated facts. One being that W2’s are forthcoming for Years 2 and 3.

What do you propose to do, Gator? Wiles is preparing the guy’s 1040 (only). Should Wiles say to the guy, “I’m sorry. We need to value the note. Get me that value and I’ll put it on your current year 1040 as wages.”

Tell us, is that your proposal?

Hi, Wiles and Jeff,

The idea that there was an open transaction here strikes me as odd. We have a sale of rights pursuant to a sales contract in exchange for stock, cash and a contingent installment note with a fixed period and a maximum face value. What is about this transaction that makes you think it is an open transaction and not an installment sale?

It also strikes me as odd that the receipt of a note payable by a third party would somehow be treated as if it had been issued by the target instead of what the target actually issued.

Finally, as the plan to issue a W-2, I'm curious as to who is issuing it and who is paying employment tax, etc.?

It is a simple option recognition followed by a sale of the option. You're twisting yourselves in knots trying to avoid the obvious. I only do that when I am trying to find an argument for my client.

The solution is simple. Taxpayer gets the option from the target at the closing and sells it for the cash, stock and note.

The target could report compensation paid as $3.5M minus a valuation discount, but may feel obligated to report it at $3.5M.

The taxpayer's 1040 reports compensation (at the higher or lower value, his choice) and a short-term capital gain installment sale, if the lower value is reported ...

Yes, it’s so simple that:

commentors requested guidance concerning the treatment of earn-out payments received by option holders in connection with a corporate transaction.

But anyway, let’s just keep it simple. Let’s just throw $3.5m of comp on the guy’s current year W2. And we’ll have the corp deduct it. Not quite a symmetry there, to the optionee, with respect to the deduction, unless he already owns 100% of the stock (which he doesn’t). And then when he only collects $2m on the note, I wonder the IRS will say when he files for a claim of right adjustment? What if he is left with a $1.5m capital loss?

Seems to me the “other” shareholders really might want that $3.5m deduction (depending on the Ordinary Income otherwise showing on their K1’s, W2’s, etc.). Fair enough. If they don’t take it now, and liquidate, they may never get that deduction. But that might leave the optionee in a real tenuous position.

Seems we might have competing interests here, but no meeting of the minds.

It does seem, though, that the “shareholders” were already willing to forego the deduction, whether or not they knew it. But then Wiles caught it.

Since Gator speaks of the “client,” if my client is in a position to get a W2 hit in Years2 and 3, I’m not so sure I’d tell him to bring the matter up to his fellow shareholders. Unless, of course, there is some mechanism for him to be made whole in the event he reports $3.5m of compensation income (which his fellow shareholders deduct) and only later collects $2m. What if optionee brings the matter to the other shareholders’ attention, angling for a negotiation in case he loses his ass, but the other shareholders say, “Wow! Thanks for brining it to our attention. We’ll value it at $3.5m. And no, we won’t reimburse you.”

Could there be a shareholder suit if the optionee believes he should report $3.5m, but stays quiet, to protect his own ass, full knowing that a $3.5m deduction might best serve his fellow shareholders?

Well, I suppose the actual reporting in this situation depends on who one represents. But the correct reporting is as I described it. In any event, I have still not seen support for the proposition that the taxpayer received the note as compensation or that the receipt of the note is to be taxed as an open transaction.

It all works out if the taxpayer reports compensation of $3.5M less a valuation discount and an installment sale with no gain.

Well, I suppose the actual reporting in this situation depends on who one represents.

LOL, now you’re catching on.

In any event, I have still not seen support for the proposition that the taxpayer received the note as compensation or that the receipt of the note is to be taxed as an open transaction.

I haven’t seen any support that the note is property for Sec 83 purposes. Your entire argument flows from the assumption that it is.

Quick Google search results:

Publication 537

If the property the buyer gives you is a third-party note (or other obligation of a third party), you’re considered to have received a payment equal to the note's FMV. Because the FMV of the note is itself a payment on your installment sale, any payments you later receive from the third party aren’t considered payments on the sale.

Reg. 1.453-11(c)(3)(2)
Example 2.
(i) A, a cash-method individual taxpayer, owns all of the stock of P corporation, a C corporation. P owns 30 percent of the stock of Q corporation. The balance of the Q stock is owned by unrelated individuals. On February 1, 1998, P adopts a plan of complete liquidation and sells all of its property, other than its Q stock, to B, an unrelated purchaser for cash and an installment obligation bearing adequate stated interest. On March 1, 1998, Q adopts a plan of complete liquidation and sells all of its property to an unrelated purchaser, C, for cash and installment obligations. Q immediately distributes the cash and installment obligations to its shareholders in completion of its liquidation. Promptly thereafter, P liquidates, distributing to A cash, the B installment obligation, and a C installment obligation that P received in the liquidation of Q.
(ii) In the hands of A, the B installment obligation is a qualifying installment obligation. In the hands of P, the C installment obligation was a qualifying installment obligation. However, in the hands of A, the C installment obligation is not treated as a qualifying installment obligation because P owned only 30 percent of the stock of Q. Because P did not own the requisite 80 percent stock interest in Q, P was not a controlling corporate shareholder of Q (within the meaning of section 368(c)) immediately before the liquidation. Therefore, section 453(h)(1)(E) does not apply. Thus, in the hands of A, the C obligation is considered to be a third-party note (not a purchaser's evidence of indebtedness) and is treated as a payment to A in the year of distribution. Accordingly, for 1998, A reports as payment the cash and the fair market value of the C obligation distributed to A in the liquidation of P.

(iii) Because P held 30 percent of the stock of Q, section 453B(d) is inapplicable to P. Under sections 453B(a) and 336, accordingly, Q recognizes gain or loss on the distribution of the C obligation. P also recognizes gain or loss on the distribution of the B and C installment obligations to A in exchange for A's stock. See sections 453B and 336.

My position is that the note was received for the option.

The alternative is muddled at best.