US Government Bans Executive Stock Option Manoeuvre

by Leroy Baker, Tax-News.com, New York

27 February 2004

The US Treasury Department and the IRS on Wednesday issued a revenue ruling that would shut down an aggressive transaction involving the exercise of stock options by corporate insiders using debt financing provided by the corporation.

In these transactions, typically the corporate insider will exercise options he or she holds by giving the company a promissory note. If the value of the stock later falls below the face amount of the note, the company may agree to reduce the insider’s debt. Certain individuals have claimed that this debt reduction does not result in taxable income.

Revenue Ruling 2004-37 provides that reduction of debt in these circumstances does result in taxable income to the insider. By forgiving part of the purchase price, the company has increased the amount of stock that the insider has received without paying for the stock. If the stock was not paid for by the insider, they will be treated as receiving compensation.

Commenting on the ruling, Acting Assistant Secretary for Tax Policy Greg Jenner stated: “Once again, we have made it clear that everyone has to play by the same rules. A corporate insider whose compensation is increased because the company reduces the purchase price on stock the insider has already purchased must pay tax on that increased compensation.”

The ruling also provides that a reduction in the interest rate under the note, or a change in the note so that the executive no longer has personal liability, also would result in compensation income.

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