CUNA Regulatory Comment Call


July 12, 2002

Changes to IRS Rules on Discounted Option Plans for Employees of Tax-Exempt Organizations

EXECUTIVE SUMMARY

  • The Internal Revenue Service (IRS) has issued proposed regulations that would provide guidance on deferred compensation plans. Deferred compensation plans provided by tax-exempt organizations are generally governed by Section 457 of the Internal Revenue Code (Code). Section 457 requires that deferred compensation (other than so-called “eligible” plans) will be taxable to the employee in the first year in which the employee’s right to the deferred compensation is not subject to a substantial risk of forfeiture. For some executives with very old deferred compensation arrangements (perhaps included in employment contracts), this “risk of forfeiture” provision has created unanticipated significant tax liability (perhaps without the cash to pay the liability), and has led to them trying to find alternatives. Section 457(f) includes a specific exception for transfers of property in connection with performance of services governed by Section 83 of the Code. For this reason, many tax-exempt organizations have looked to Section 83 in designing discounted option plans under which they grant executives options to purchase certain property (such as mutual fund shares) at discounted prices at a future date. These plans are sometimes used to supplement retirement income for executives because 401K plans generally limit the contributions for these executives, including particularly those who are close to retirement age. An option is called a discounted option when the exercise price is below the market value of the underlying shares on the date of the option grant.

  • Under current regulations, discounted options (nonqualified plans) are not taxable until exercised, when they are taxed on the difference between the price paid for the option and the exercise price. Tax-exempt employers, such as hospitals, and an increasing number of credit unions, have been issuing nonqualified options to executives at bargain prices – for example, offering for $50,000 options that would be worth $100,000 at the time of exercise – and mandating that the options cannot be exercised until a certain date in order to retain the executive until that time. The format allows those executives to foresee the exact point in time at which they will take a tax “hit” on the option. Many tax-exempt organizations have found this mechanism for delaying taxation on deferred compensation to be a good tool for retaining talented executives.

  • The wording used in the proposed changes to the rules on discounted option plans probably puts an end to tax-exempt employers using nonqualified options. The proposed regulations suggest that Section 457(f) limitations would now apply to discounted options for employees of tax-exempts. These limitations result in the elimination of tax deferral by the employee and the inclusion of deferred compensation in the gross income of the employee for the first taxable year in which there is no “substantial risk of forfeiture” of the rights to the deferred compensation. There is no substantial risk of forfeiture in instances where the options are not conditioned on the future performance of services of the employee or similar conditions. For example, if a credit union agrees on December 1, 2002, to pay an executive a specified amount on January 15, 2005, and there is no substantial risk of forfeiture, the present value of the payment is includible in the individual’s gross income for 2002. When the payment is made on January 15, 2005, the amount includible at that time is the excess of the fair market value of the property paid, less the amount that was includible in gross income in 2002. If, however, the arrangement included a substantial risk of forfeiture until payment in 2005, the property would not be included in the executive’s income until 2005.

  • Whether the regulations have the effect of quashing the use of nonqualified options by tax-exempt organizations is conditioned on whether the property is defined as the exercised option, in which case Section 83 would still apply to discounted options, or is defined as the specific assets underlying the options that will lead to the exercised option, in which case Section 457(f) would apply.

  • There has been concern expressed that if the proposed regulations effectively eliminate discounted options, it will make it difficult for many tax-exempt organizations to compete for talented executives because they lose the ability to offer them similar deferred compensation arrangements that are available in the taxable entity world. In addition, for tax-exempts that have implemented a discounted option plan, the proposed regulations would create two classes of employees: one class that would be grandfathered as of May 8, 2002, and allowed to retain the options granted to them prior to this date and a second class that would be barred from participation. This has the potential of creating significant compensation management issues.

  • Taxable entities are not hampered by these proposed regulations in designing their deferred compensation plans. The IRS appears to have singled out tax-exempt organizations for this treatment.

  • Comments are due to the IRS by August 6, 2002. Responses can be sent directly to the IRS at: CC:ITA:RU (REG-105885-99), Room 5226, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, D.C. 20044; comments may also be sent electronically via the IRS Internet site at www.irs.gov/regs. Please send your comments to CUNA by July 31, 2002. Please feel free to fax your responses to CUNA at 202-638-7052; e-mail them to Associate General Counsel Mary Dunn at mdunn@cuna.com or to Senior Regulatory Counsel Catherine Orr at corr@cuna.com; or mail them to Mary or Catherine in c/o CUNA's Regulatory Advocacy Department, 601 Pennsylvania Avenue, NW, 6th Floor - South Building, Washington, DC 20004. You may obtain a copy of the proposed regulations here, at the IRS Internet site referenced above, or by contacting us.

QUESTIONS REGARDING THE PROPOSED REGULATIONS

  1. Does your credit union offer discounted options?

    Yes ______ No ______

    If yes, please describe your plan.









  2. Have you investigated the possibility of offering a discounted option plan?

    Yes ______ No ______

    If so, what was the outcome of your study?









  3. Do you believe the proposed changes would have the effect of eliminating discounted option plans for tax-exempt organizations?

    Yes ______ No ______

    If so, please elaborate.









  4. The proposed changes appear to grandfather existing discounted options that have been granted and to prohibit any new ones after May 8, 2002. If this is correct, do you believe that this inability to grant new options to current and future employees would result in similarly situated employees having materially different compensation arrangements?

    Yes ______ No ______

    Please explain.









  5. Do you have recommendations on the coordination of Section 457(f) and Section 83 under the proposed regulations?

    Yes ______ No ______









    If so, what are those recommendations?











  6. There are many differences between taxable entities and tax-exempt organizations. Do you believe that employees of tax-exempt entities (like credit unions) should be denied this tool to defer taxes until income is received?

    Yes ______ No ______

    Please explain.









  7. Other comments?









Eric Richard • General Counsel • (202) 508-6742 • erichard@cuna.com
Mary Mitchell Dunn • SVP & Associate General Counsel • (202) 508-6736 • mdunn@cuna.com
Jeffrey Bloch • Assistant General Counsel • (202) 508-6732 • jbloch@cuna.com
Catherine Orr • Senior Regulatory Counsel • (202) 508-6743 • corr@cuna.com
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