rr-04-37.pdf

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Part I

Section 83.--Property Transferred in Connection with Performance of Services

26 C.F.R. 1.83-4: Special rules.
(Also §§ 108, 3121, 3306, 3401, 1.1001-3)

Rev. Rul. 2004-37

ISSUE

If an employee issued a recourse note to his or her employer in satisfaction of
the exercise price of an option to acquire the employer’s stock and the employer and
employee subsequently agree to reduce the stated principal amount of the note, does
the employee recognize compensation income under § 83 of the Internal Revenue
Code?
FACTS
In Year 1, Employer, a corporation, grants a nontransferable, nonstatutory option
to its Employee to purchase 1,000 shares of Employer common stock at an exercise
price of $75 per share, the fair market value of a share of Employer stock at the time the
option is granted. Employee may exercise the option only during employment with
Employer or within 90 days after cessation of employment.
On January 1 of Year 2, when the fair market value of 1,000 shares of Employer
stock is $100,000, Employee exercises the option and purchases 1,000 shares of
Employer stock in exchange for a nontransferable recourse note ("Note") secured by
the stock Employee receives on the exercise of the option. The Note has a stated
principal amount of $75,000, which is payable at maturity on December 31 of Year 11.

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The Note also provides for payments of interest on December 31 of each year the Note
is outstanding. The interest rate is one-year LIBOR (determined as of January 1 of
each year the Note is outstanding) plus 25 basis points. The interest rate on the Note is
not less than the appropriate applicable Federal rate (AFR) on the date the Note is
issued. The stock is not subject to a substantial risk of forfeiture within the meaning of
§ 83(c).
In Year 2, Employee includes $25,000 as compensation income under § 83(a).
Employer reports $25,000 of compensation income on the Form W-2 issued to
Employee for Year 2 and claims a corresponding deduction in Year 2 under § 83(h).
In Years 2 and 3, Employee makes the required interest payments under the
Note. On January 1 of Year 4, the fair market value of the Employer stock has declined
to $50,000 and Employer and Employee agree to reduce the stated principal amount of
the Note from $75,000 to $50,000. The interest rate on the Note is not less than the
appropriate AFR on the date the Note is modified.
LAW
Section 83(a) provides that if, in connection with the performance of services,
property is transferred to any person other than the person for whom such services are
performed, the excess of the fair market value of the property at the first time that the
rights to the property are either transferable or not subject to a substantial risk of
forfeiture ("substantially vested"), whichever occurs earlier, over the amount paid for the
property is included in the gross income of the service provider in the first taxable year
in which the rights to the property are substantially vested.
Section 83(e)(3) provides that § 83 does not apply to the transfer of an option
without a readily ascertainable fair market value.
Section 83(h) provides that, in the case of a transfer of property to which § 83
applies, the person for whom were performed the services in connection with which the
property was transferred is allowed a deduction in an amount equal to the amount

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included under § 83(a), (b), or (d)(2) in the gross income of the person who performed
the services. Such deduction is allowed for the taxable year of such person in which or
with which ends the taxable year in which such amount is included in the gross income
of the person who performed such services.
Section 1.83-3(a)(1) of the Income Tax Regulations provides that a "transfer" of
property occurs when a person acquires a beneficial ownership interest in the property.
A person acquires a beneficial ownership interest in property when he or she has been
transferred both the right to share in an increase in the value of the property and the
obligation to share in the risk of loss in its value. Whether a transfer has in fact
occurred is based on all the facts and circumstances.
Section 1.83-3(g) provides that the term "amount paid" refers to the value of any
money or property paid for the transfer of property to which § 83 applies. For this
purpose, value does not include any stated or unstated interest.
Section 1.83-4(c) provides that, if an indebtedness that has been treated as an
"amount paid" for purposes of § 83 is subsequently cancelled, forgiven, or satisfied for
an amount less than the amount of such indebtedness, the amount that is not, in fact,
paid is includible in the gross income of the service provider for the taxable year in
which such cancellation, forgiveness, or satisfaction occurs.
Section 1.83-7(a) provides that the grant of a nonqualified stock option is taxable
to the extent that the option has a readily ascertainable fair market value, determined in
accordance with § 1.83-7(b). Under § 1.83-7(b), an option that is not traded on an
established market does not have a readily ascertainable value at the time of grant
unless certain specific conditions are all satisfied (including the option being
transferable, the option not being subject to a condition that has a significant effect on
the fair market value of the option, and the fair market value of the option privilege being
readily ascertainable). Under § 1.83-7(a), if the option does not have a readily
ascertainable value at the time of grant, §§ 83(a) and 83(b) apply at such time as the

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option is exercised or otherwise disposed of, even though the fair market value of such
option may have become readily ascertainable before such time.
Section 61(a)(12) provides that, in general, gross income includes income from
the discharge of indebtedness.
Section 108(a)(1)(B) provides an exclusion from gross income for any amount
that would be includible in gross income by reason of the discharge of indebtedness of
the taxpayer if the discharge occurs when the taxpayer is insolvent.
Under § 108(e)(5), for solvent and non-bankrupt taxpayers, if debt owed by a
purchaser to a seller is reduced, the reduction is a purchase price adjustment and not
income from discharge of indebtedness. Under § 108(e)(5)(C), § 108(e)(5) only applies
to reductions that, but for the application of § 108(e)(5), would be treated as income to
the purchaser from the discharge of indebtedness.
Not every indebtedness that is cancelled results in the debtor realizing gross
income by reason of discharge of indebtedness within the meaning of §§ 61(a)(12) and
108(a). “Debt discharge that is only a medium for some other form of payment, such as
a gift or salary, is treated as that form of payment, rather than under the debt discharge
rules.” S. Rep. No. 1035, 96th Cong., 2d Sess. 8 n.6 (1980), 1980-2 C.B. 620, 624 n.6.
Section 1.1001-3 provides rules to determine whether a modification of the terms
of a debt instrument results in an exchange of the original debt instrument for a modified
instrument that differs materially either in kind or in extent. If the modification results in
an exchange, the adequacy of the interest rate on the modified debt instrument
generally is retested under the applicable Code section, such as § 483.
Under § 1.1001-3(b), a modification of a debt instrument results in an exchange
for purposes of § 1.1001-1(a) if the modification is significant. Under § 1.1001-3(c), a
modification means any alteration, including any deletion or addition, in whole or in part,
of a legal right or obligation of the issuer or a holder of a debt instrument, whether the
alteration is evidenced by an express agreement (oral or written), conduct of the parties,

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or otherwise.
Section 1.1001-3(e) provides rules for determining whether a modification is
"significant." Under § 1.1001-3(e)(2), a change in the yield of a debt instrument is a
significant modification if the yield computed under § 1.1001-3(e)(2)(iii) varies from the
annual yield on the unmodified debt instrument (determined as of the date of the
modification) by more than the greater of 1/4 of one percent (25 basis points) or 5
percent of the annual yield of the unmodified debt instrument (.05 x annual yield).
Sections 3101 and 3111 impose Federal Insurance Contributions Act (FICA)
taxes on “wages,” as that term is defined in § 3121(a). FICA taxes consist of the Old-
Age, Survivors and Disability Insurance tax (social security tax) and the Hospital
Insurance tax (Medicare tax). These taxes are imposed both on the employer under
§ 3111(a) and (b) and on the employee under § 3101(a) and (b). Section 3102(a)
provides that the employee portion of FICA tax must be collected by the employer of the
taxpayer by deducting the amount of the tax from the wages as and when paid. Section
31.3102(a)-1(a) of the Employment Tax Regulations provides that the employer is
required to collect the tax, notwithstanding that wages are paid in something other than
money. The term “wages” is defined in § 3121(a) for FICA purposes as all
remuneration for employment including the cash value of all remuneration (including
benefits) paid in any medium other than cash, with certain specific exceptions. Section
3121(b) defines “employment” for FICA purposes as any service, of whatever nature,
performed by an employee for the person employing him, with certain specific
exceptions.
Rules similar to the FICA rules apply with respect to Federal Unemployment Tax
Act (FUTA) tax under §§ 3301, 3306(b), and 3306(c).
Section 3402(a), relating to income tax withholding, generally requires every
employer making a payment of wages to deduct and withhold upon these wages a tax
determined in accordance with prescribed tables or computational procedures. Section

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3401(a) provides that “wages” for income tax withholding purposes means all
remuneration for services performed by an employee for his employer, including the
cash value of all remuneration (including benefits) paid in any medium other than cash,
with certain specific exceptions. Under § 31.3402(a)-1(c), an employer is required to
deduct and withhold income tax notwithstanding that the wages are paid in something
other than money (for example, wages paid in stock or bonds) and to pay over the tax in
money. If the wages are paid in property other than money, the employer should make
necessary arrangements to insure that the amount of the tax required to be withheld is
available for payment in money.
Sections 31.3121(a)-1(e), 31.3306(b)-1(e), and 31.3401(a)-1(a)(4) provide that in
general the medium in which the remuneration is paid is immaterial. It may be paid in
cash or other than in cash. Remuneration paid in any medium other than cash is
computed on the basis of the fair market value of such items at the time of payment.
Sections 31.3121(a)-1(i), 31.3306(b)-1(i), and 31.3401(a)-1(a)(5) provide that, unless
specifically excepted, remuneration for employment constitutes wages even though at
the time paid the relationship of employer and employee no longer exists between the
person in whose employ the services were performed and the individual who performed
the services.
In Rev. Rul. 79-305, 1979-2 C.B. 350, a corporation transferred common stock to
an employee subject to a substantial risk of forfeiture. The ruling holds that, under § 83,
the fair market value of the stock at the time the risk lapses is includible in the
employee’s gross income for the year in which risk lapses. The ruling also holds that
the fair market value of the stock at the time the risk lapses is wages for purposes of
§§ 3121(a), 3306(b), and 3401(a).
ANALYSIS
Under § 1.83-7(b), the option granted to Employee did not have a readily
ascertainable fair market value at the time of grant. Therefore, § 83 applies when the

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option is exercised and stock is transferred to Employee.
Employee acquired beneficial ownership of the shares of Employer stock in Year
2 because, at that time, Employee acquired both the right to enjoy any increase in the
value of the shares and the risk of a decline in the value of the shares. Accordingly, for
purposes of § 83, the shares were transferred to Employee in Year 2. Employee’s
Note, with an issue price of $75,000, constituted the amount paid by Employee for the
shares under § 1.83-3(g) in Year 2. Employee included $25,000 in gross income under
§ 83(a) in Year 2, the excess of the fair market value of Employer stock at the time of
transfer over the amount paid.
Under § 1.83-4(c), if an indebtedness that has been treated as an "amount paid"
for purposes of § 83 is subsequently cancelled, forgiven, or satisfied for an amount less
than the amount of such indebtedness, the amount that is not, in fact, paid is includible
in the gross income of the service provider for the taxable year in which such
cancellation, forgiveness, or satisfaction occurs. Thus, if the reduction of the stated
principal amount of the Note is a cancellation, forgiveness, or satisfaction of the
indebtedness for an amount less than the amount of such indebtedness, the reduction
of the stated principal amount is a medium for payment of compensation by Employer to
Employee, and any income resulting from the reduction is not income to Employee from
the discharge of indebtedness subject to the provisions of section 108. Accordingly, the
tax consequences of the reduction are governed by § 83 and § 1.83-4(c), and not
by § 108(a)(1)(B) or § 108(e)(5).
Whether the reduction of the stated principal amount of the Note is a
cancellation, forgiveness, or satisfaction for an amount less than the amount of the
Note, and, thus, whether an amount is includible in income under § 1.83-4(c), is
determined in accordance with § 1.1001-3. Under § 1.1001-3(e)(2), if a modification to
the stated principal amount of a note produces a significant change in the note’s yield,
the modification is significant. A significant modification results in an exchange of the

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unmodified note for the modified note, which, depending on the issue price of the
modified note and the adjusted issue price of the unmodified note, may have tax
consequences for both the issuer and holder of the note.
In this case, the reduction in the stated principal amount of the Note is a
significant modification under § 1.1001-3(e)(2). As a result, there is an exchange of the
unmodified Note for the modified Note between Employee and Employer and a
satisfaction of the original indebtedness. Under § 1.83-4(c), the amount that is not, in
fact, paid, and thus the amount includible as compensation by Employee, is the excess
of the adjusted issue price of the unmodified Note over the issue price of the modified
Note.
The modified Note has adequate stated interest under § 483. Under
§ 1273(b)(4), the modified Note has an issue price of $50,000. The adjusted issue price
of the unmodified Note is $75,000. See § 1.1275-1(b). As a result, under § 1.83-4(c),
Employee recognizes compensation income of $25,000 (the excess of the adjusted
issue price of the unmodified Note ($75,000) over the issue price of the modified Note
($50,000)). This amount is recognized in Year 4, the taxable year in which the
modification occurred.

HOLDING
If an employee issued a recourse note to his or her employer in satisfaction of
the exercise price of an option to acquire the employer’s stock and the employer and
employee subsequently agree to reduce the stated principal amount of the note, the
employee generally recognizes compensation income under § 83 at the time of the
reduction. Thus, under the facts described above, Employee recognizes $25,000 of
compensation income on January 1 of Year 4 under § 1.83-4(c). If Employer and
Employee instead were, for example, to reduce the interest rate on the Note or change
the Note from recourse to nonrecourse, that modification also generally would result in

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compensation income for Employee.
In addition, the compensation is wages for purposes of FICA, FUTA, and income
tax withholding.
DRAFTING INFORMATION
The principal authors of this revenue ruling are Jean M. Casey of the Office of
the Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities)
and Rebecca Asta of the Associate Chief Counsel (Financial Institutions and Products).
For further information regarding § 83, contact Ms. Casey at (202) 622-6030 and for
further information regarding § 1.1001-3, contact Ms. Asta at (202) 622-3940 (not toll-
free calls).