Taxing the Promise to Pay
60 Pages Posted: 2 Apr 2005
The IRS recently disclosed that it has identified more than 100 executives at 42 leading public corporations that participated in a tax shelter designed to defer the recognition of income from the exercise of stock options. While the agency thus far has identified approximately $700 million in unreported gains from these shelters, it predicts that the revenue loss to the government will ultimately exceed $1 billion. Compared to most tax shelters, this particular transaction (commonly known as the "Executive Compensation Strategy" or "ECS") is remarkably simple. Rather than exercise the options individually, a participating executive instead transfers the options to a family limited partnership in exchange for the partnership's 30-year unsecured balloon promissory note. Very shortly thereafter, the partnership exercises the options, sells the underlying shares, and invests the proceeds in other investments. Pro-moters of the shelter claim that the partnership takes a cost basis in the options, resulting in little or no gain to the partnership upon exercise. Meanwhile, promoters assert, the executive does not realize income until principal payments are made the on the note 30 years in the future.
This shelter can be attacked from a variety of perspectives. Commentators who have previously examined the shelter have focused on whether the sale of the options to the partnership is made at arm's length. If the sale does not constitute an "arm's length transaction," regulations under IRC Section 83 effectively disregard the sale, causing the executive to recognize income when the partnership exercises the option and defeating the purpose of the shelter. Unfortunately, because the arm's length issue is inherently dependent upon the unique facts and circumstances of each transaction, it is not an ideal "silver bullet" issue for attacking the shelter. Another way to attack the shelter is to argue that the mere receipt of the partnership's promise to pay constitutes a taxable event for the executive, thereby undermining completely the goal of the shelter. This Article analyzes this issue, concluding that, because the partnership's promise constitutes a third-party compensatory promise (i.e., one made by a party external to the service relationship), it is immediately taxable to the executive upon receipt. In discussing this issue, the Article examines the origin and development of the economic benefit doctrine, as well as the history and purpose of IRC Section 83. The Article closes with an explanation of why limiting tax deferral to the second-party promise context comports with sound tax policy.
Suggested Citation: Suggested Citation