rr-05-39.pdf

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Part I

Section 280G.—Golden Parachute Payments

26 CFR 1.280G-1: Golden parachute payments.
(Also § 83)

Rev. Rul. 2005-39

ISSUES

1) In determining whether a corporation has experienced a change in
ownership or control under § 280G(b)(2)(A)(i) of the Internal Revenue Code, are
unvested shares of restricted stock for which an election under § 83(b) has been
made treated as outstanding stock?

2) In determining the amount of stock held by a shareholder for purposes
of testing whether the shareholder is a disqualified individual under §1.280G-1,
Q/A-17 of the Income Tax Regulations, are unvested shares of restricted stock
for which an election under § 83(b) has been made treated as outstanding stock?

FACTS

Corporation X and Corporation Y are unrelated publicly-held companies.
Both Corporation X and Corporation Y maintain restricted stock plans and option
plans for their respective employees. Immediately prior to the merger described
below, without considering any outstanding options or restricted stock, the
shareholders of Corporation X own stock with a total fair market value of $105x
and the shareholders of Corporation Y own stock with a total fair market value of
$105x.

Employees of Corporation X hold restricted Corporation X stock that is not
substantially vested but with respect to which elections under § 83(b) have been
made. They also hold vested options to purchase vested stock of Corporation X.
The fair market value of this Corporation X restricted stock and the Corporation X
stock subject to these options is $3x.

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Employees of Corporation Y hold restricted Corporation Y stock that is not
substantially vested but with respect to which elections under § 83(b) have been
made. They also hold vested options to purchase vested stock of Corporation Y.
The fair market value of this Corporation Y restricted stock and the Corporation Y
stock subject to these options is $2x.

Certain employees of Corporation X and Corporation Y also hold restricted
stock that is not substantially vested with respect to which no election under
§ 83(b) has been made and vested options to purchase substantially nonvested
stock.

On February 20, 2005, Corporation X merges into Corporation Y, with
Corporation Y as the surviving corporation. In the merger, the shareholders of
Corporation X receive Corporation Y stock in exchange for their Corporation X
stock. The holders of nonvested restricted Corporation X stock receive
nonvested restricted Corporation Y stock in exchange for their nonvested
restricted Corporation X stock. The holders of options to acquire Corporation X
stock receive options to acquire Corporation Y stock in exchange for their options
to acquire Corporation X stock. After the merger, Corporation Y stock (vested or
nonvested, as applicable) will be issued on the exercise of all outstanding
options.

LAW

Section 83(a) provides that the excess of the fair market value of property
transferred in connection with the performance of services over the amount (if
any) paid for the property is included in the gross income of the person
performing the services in the first taxable year in which the rights of the person
having the beneficial interest in such property are transferable or are not subject
to a substantial risk of forfeiture, whichever occurs earlier.

Section 83(b) permits any person performing services in connection with
which property is transferred to elect to include in gross income for the taxable
year in which the property is transferred the excess of its fair market value at the
time of transfer (determined without regard to lapse restrictions) over the amount
(if any) paid for the property.

Section 1.83-1(a) provides that property transferred to an employee in
connection with the performance of services by such employee is not taxable
until the employee acquires a beneficial ownership interest in such property and
it has become substantially vested (as defined in § 1.83-3(b)) in such employee.
Until such property becomes substantially vested, the transferor is regarded as
the owner of such property, and any income from such property received by the
employee is included in the gross income of such employee as additional
compensation for the taxable year in which such income is received.

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Section 1.83-3(b) provides that property is substantially nonvested if it is
subject to a substantial risk of forfeiture and is nontransferable.

Section 1.83-2(a) provides that the employee providing the services may
elect to include in gross income under § 83(b), as compensation for services, the
excess (if any) of the fair market value of the property at the time of transfer
(determined without regard to any lapse restrictions) over the amount (if any)
paid for such property. If this election is made, the substantial vesting rules of
§ 83(a) and the regulations thereunder do not apply with respect to such
property. Thus, property with respect to which this election is made is includible
in gross income as of the time of transfer, and no compensation will be includible
in gross income when such property becomes substantially vested.

In Rev. Rul. 83-22, 1983-1 C.B. 17, an employee who received restricted
stock made an election under § 83(b) and later earned dividends on the
restricted stock. The ruling provides that the regulations under § 83(b) treat
stock transferred to an employee in connection with the performance of services
as substantially vested when the employee makes an election under § 83(b), and
the employee is considered the owner of the stock. Accordingly, the ruling holds
that a dividend paid to the employee who has made a § 83(b) election is not
additional compensation to the employee, but retains its character as a dividend
in the hands of the employee.

Section 280G denies a deduction for any excess parachute payment.
Section 4999 imposes a nondeductible 20-percent excise tax on the recipient of
any excess parachute payment, within the meaning of § 280G(b).

An excess parachute payment is defined in § 280G(b)(1) as an amount
equal to the excess of any parachute payment over the portion of the disqualified
individual's base amount that is allocated to such payment.

Section 280G(b)(2)(A) defines a parachute payment as any payment in
the nature of compensation to (or for the benefit of) a disqualified individual if (i)
such payment is contingent on a change in the ownership of a corporation, the
effective control of a corporation, or the ownership of a substantial portion of the
assets of a corporation (a change in ownership or control), and (ii) the aggregate
present value of the payments in the nature of compensation which are
contingent on such change equals or exceeds an amount equal to 3 times the
base amount.

Section 1.280G-1, Q/As-27 and 29, provides guidance concerning
whether a corporation is considered to have undergone a change in ownership or
control in a merger.

Section 1.280G-1, Q/A-27(a), provides that a change in the ownership of a
corporation occurs on the date that any one person, or more than one person

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acting as a group (as defined in Q/A-27(b)), acquires ownership of stock of the
corporation that, together with stock held by such person or group, possesses
more than 50 percent of the total fair market value or total voting power of the
stock of such corporation. Section 1.280G-1, Q/A-27(b), provides that persons
will not be considered to be acting as a group merely because they happen to
purchase or own stock of the same corporation at the same time, or as a result of
the same public offering. However, persons will be considered to be acting as a
group if they are owners of a corporation that enters into a merger, consolidation,
purchase or acquisition of stock, or similar business transaction with the
corporation.

Section 1.280G-1, Q/A-27(c), provides that § 318(a) applies to determine
stock ownership. Section 1.280G-1,Q/A-27(c), also provides that stock
underlying a vested option is considered owned by an individual who holds the
vested option (and the stock underlying an unvested option is not considered
owned by an individual who holds the unvested option). For purposes of the
preceding sentence, however, if the option is exercisable for stock that is not
substantially vested (as defined in § 1.83-3(b) and (j)), the stock underlying the
option is not treated as owned by the individual who holds the option.

Section 1.280G-1, Q/A-29, provides that a change in the ownership of a
substantial portion of a corporation’s assets occurs on the date that any one
person, or more than one person acting as a group (as defined in Q/A-29(c)),
acquires (or has acquired during the 12-month period ending on the date of the
most recent acquisition by such person or persons) assets from the corporation
that have a total gross fair market value equal to or more than one-third of the
total gross fair market value of all of the assets of the corporation immediately
prior to such acquisition or acquisitions. For this purpose, gross fair market value
means the value of the assets of the corporation, or the value of the assets being
disposed of, determined without regard to any liabilities associated with such
assets.

Section 1.280G-1, Q/A-29(b)(1), provides that there is no change in
ownership or control under Q/A-29(a) when there is a transfer to an entity that is
controlled by the shareholders of the transferring corporation immediately after
the transfer, as provided in Q/A-29(b).

Section 1.280G-1, Q/A-29(c), contains the same language as § 1.280G-1,
Q/A-27(b), concerning when persons will be considered to be acting as a group.
Section 1.280G-1, Q/A-29(d), refers to Q/A-27(c) for purposes of determining
stock ownership.

For purposes of determining when a payment in the nature of
compensation under § 280G(b)(2)(A) has been made, § 1.280G-1, Q/A-12(b),
provides that an election made by a disqualified individual under § 83(b) with
respect to the transferred property does not apply. A payment in the nature of

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compensation for purposes of that determination is generally considered made
(or to be made) when the property is transferred to, and becomes substantially
vested in, such individual. The § 280G regulations, however, are silent for
purposes of determining whether restricted stock subject to an election under
§ 83(b) is outstanding when determining whether there has been a change in
ownership or control.

The position in § 1.280G-1, Q&A-12(b) was adopted, in part, because the
legislative history provides that all transfers of property are to be valued for
purposes of the golden parachute rules. See H.R. Conf. Rep. No. 98-861, 98
th

Cong. 2d Sess. at 851 (1984), 1984-3 C.B. (Vol. 2) 851; Joint Committee on
Taxation Staff, General Explanation of the Revenue Provisions of the Deficit
Reduction Act of 1984, 98
th
Cong. 2d Sess. (1984) at 203. The vesting of
payments contingent on a change in control frequently provides substantial
benefits to an individual without regard to whether an election under § 83(b) has
been made. This concern, however, is not present when determining whether a
change in ownership or control has occurred.

ANALYSIS

The regulations under § 280G have generally adopted objective rules to
determine whether a change in ownership or control has occurred. Pursuant to
§ 1.280G-1, Q/A-27(c), vested stock underlying a vested option is considered
owned by the individual who holds the vested option. Thus, the vested shares
subject to vested options held by the former Corporation X employees and the
Corporation Y employees are considered outstanding for purposes of
determining whether a change in ownership or control occurred. However, the
substantially nonvested shares underlying vested options held by the former
Corporation X employees and the Corporation Y employees are not considered
outstanding for purposes of determining whether a change in ownership or
control occurred.

In determining whether a change in ownership or control has occurred,
§ 1.280G-1, Q/A-27(c) generally implements an expansive rule for determining
the shares treated as owned by an individual, treating, for example, shares
subject to a vested option as owned by the holder of the option. Accordingly, an
employee should be considered the owner of unvested shares of restricted stock
for which an election under § 83(b) has been made for purposes of § 1.280G-1,
Q/A-27 because the regulations under § 83(b) treat stock transferred to an
employee in connection with the performance of services as substantially vested
when the employee makes an election under § 83(b), and the employee is
considered the owner of the stock for that purpose. However, restricted stock
with respect to which an election under § 83(b) has not been made is not
considered outstanding for purposes of determining whether a change in
ownership or control occurred.

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Consequently, the shareholders of Corporation X and Corporation Y,
along with the employees holding vested options to receive vested stock and
holding restricted stock that has been subject to an election under § 83(b), will be
treated as acting as a group with respect to their acquisition of stock or assets.
Applying the above-described rules, the Corporation X shareholders acquired
ownership of Corporation Y stock ($108x) that has more than 50 percent of the
total fair market value of the Corporation Y stock ($215x) outstanding
immediately after the merger. Thus, there is a change in control of Corporation Y
under § 1.280G-1, Q/A-27.

Turning to Corporation X, all of the assets of Corporation X were
transferred to Corporation Y in exchange for Corporation Y stock. Because more
than 50 percent of the fair market value of the outstanding stock of Corporation Y
is owned by the former shareholders of Corporation X (immediately after the
exchange), the transfer of assets to Corporation Y is not a treated as a change in
ownership of a substantial portion of the assets of Corporation X under § 1.280G-
1, Q/A-29(b)(1).

Additionally, for purposes of determining the amount of stock owned by an
individual under §1.280G-1, Q/A-17, the same rule as described above applies.
Thus, an individual who holds restricted stock with respect to which an election
under § 83(b) has been made is considered to hold the outstanding stock under
§ 1.280G-1, Q/A-17.

HOLDINGS

1) In determining whether a corporation has experienced a change in
ownership or control under § 280G(b)(2)(A)(i) of the Internal Revenue Code,
unvested shares of restricted stock for which an election under § 83(b) has been
made are treated as outstanding stock.

2) In determining the amount of stock held by a shareholder for purposes
of testing whether the shareholder is a disqualified individual under §1.280G-1,
Q/A-17 of the Income Tax Regulations, unvested shares of restricted stock for
which an election under § 83(b) has been made are treated as outstanding stock.

DRAFTING INFORMATION

The principal authors of this revenue ruling are Erinn Madden and Jean
Casey of the Office of the Division Counsel/Associate Chief Counsel (Tax
Exempt and Government Entities). However, other personnel from the IRS and
Treasury Department participated in its development. For further information
regarding this revenue ruling, contact Ms. Casey or Ms. Madden at (202) 622-
6030 (not a toll free call).