328 Planning and Forecasting an arrangement would be disastrous to Brad, since the IRS would currently as- sess income tax to Brad on such an arrangement, using the much criticized “eco- nomic benefit” doctrine. Under this theory, monies irrevocably set aside for Brad grant him an economic benefit (presumably by improving his net worth or otherwise improving his creditworthiness) upon which he must pay tax. If Brad were aware of this risk, he might choose another method to pro- tect his eventual payout by requiring the corporation to secure its promise to pay with such devices as a letter of credit or a mortgage or security interest in its assets. All of these devices, however, have been successfully taxed by the IRS under the same economic benefit doctrine. Very few devices have sur- vived this attack. However, the personal guarantee of Morris himself (merely another unsecured promise) would not be considered an economic benefit by the IRS. Another successful strategy is the so-called rabbi trust, a device first used by a rabbi who feared his deferred compensation might be revoked by a future hostile congregation. This device works similarly to the trust de- scribed earlier except that Brad would not be the only beneficiary of the money contributed. Under the terms of the trust, were the corporation to ex- perience financial reverses, the trust property would be available to the cor- poration’s creditors. Since the monies are thus not irrevocably committed to Brad, the economic benefit doctrine is not invoked. This device does not pro- tect Brad from the scenario of his bankruptcy nightmares, but it does protect him from a corporate change of heart regarding his eventual payout. From Morris’s point of view, he may not object to contributing to a rabbi trust, since he was willing to pay all the money to Brad as salary, but he should be aware that since Brad escapes current taxation the corporation will not re- ceive a deduction for these expenses until the money is paid out of the trust in the future. Interest-Free Loans As a further enticement to agree to work for the new ownership of the plant, Morris might additionally offer to lend Brad a significant amount of money to be used, for example, to purchase a new home or acquire an investment port- folio. Significant up-front money is often part of an executive compensation package. While this money could be paid as a bonus, Morris might well want some future repayment (perhaps as a way to encourage Brad to stay in his new position). Brad might wish to avoid the income tax bite on such a bonus so he can retain the full amount of the payment for his preferred use. Morris and Brad might well agree to an interest rate well below the market or even no in- terest at all to further entice Brad to take his new position. Economically, this would give Brad free use of the money for a period of time during which it could earn him additional income with no offsetting expense. In a sense, he would be receiving his salary in advance while not paying any income tax until he earned it. Morris might well formalize the arrangement by reserving the Taxes and Business Decisions 329 right to offset loan repayments against future salary. The term of the loan might even be accelerated should Brad leave the corporation’s employ. This remarkable arrangement was fairly common until fairly recently. Under current tax law, however, despite the fact that little or no interest passes between Brad and the corporation, the IRS deems full market interest pay- ments to have been made and further deems that said amount is returned to Brad by his employer. Thus, each year, Brad is deemed to have made an inter- est payment to the corporation for which he is entitled to no deduction. Then, when the corporation is deemed to have returned the money to him, he real- izes additional compensation on which he must pay tax. The corporation realizes additional interest income but gets a compensating deduction for addi- tional compensation paid (assuming it is not excessive when added to Brad’s other compensation). Moreover, the IRS has not reserved this treatment for employers and em- ployees only. The same treatment is given to loans between corporations and their shareholders and loans between family members. In the latter situation, although there is no interest deduction for the donee, the deemed return of the interest is a gift and is thus excluded from income. The donor receives in- terest income and has no compensating deduction for the return gift. In fact, if the interest amount is large enough, he may have incurred an additional gift tax on the returned interest. The amount of income created for the donor, how- ever, is limited to the donee’s investment income except in very large loans. In the corporation/stockholder situation, the lender incurs interest income and has no compensating deduction as its deemed return of the interest is charac- terized as a dividend. Thus the IRS gets increased tax from both parties unless the corporation has elected subchapter S (see Exhibit 11.4). All may not be lost in this situation, however. Brad’s additional income tax arises from the fact that there is no deduction allowable for interest paid on un- secured personal loans. Interest remains deductible, however, in limited amounts on loans secured by a mortgage on either of the taxpayer’s principal or EXHIBIT 11.4 Taxable interest. Employer Interest income Deductible compensation Nondeductible interest Taxable compensation Employee Employer Interest income Nondeductible compensation Nondeductible interest Dividend income Stockholder Employer Interest income Nondeductible gift (gift tax) Nondeductible interest Nontaxable gift Donee 330 Planning and Forecasting secondary residence. If Brad grants Plant Supply a mortgage on his home to se- cure the repayment of his no- or low-interest loan, his deemed payment of market interest may become deductible mortgage interest and may thus offset his additional deemed compensation from the imaginary return of this interest. Before jumping into this transaction, however, Brad will have to consider the limited utility of itemized deductions described earlier as well as certain limits on the deductibility of mortgage interest. SHARING THE EQUITY If Brad is as sophisticated and valuable an executive employee as Morris be- lieves he is, Brad is likely to ask for more than just a compensation package, de- ferred or otherwise. Such a prospective employee often demands a “piece of the action,” or a share in the equity of the business so that he may directly share in the growth and success he expects to create. Morris may even wel- come such a demand because an equity share (if not so large as to threaten Morris’s control) may serve as a form of golden handcuffs giving Brad addi- tional reason to stay with the company for the long term. Assuming Morris is receptive to the idea, there are a number of different ways to grant Brad a share of the business. The most direct way would be to grant him shares of the corporation’s stock. These could be given to Brad with- out charge, for a discount from fair market value or for their full value, de- pending upon the type of incentive Morris wishes to design. In addition, given the privately held nature of Morris’s corporation, the shares would probably carry restrictions designed to keep the shares from ending up in the hands of persons who are not associated with the company. Thus, the corporation would retain the right to repurchase the shares should Brad ever leave the corpora- tion’s employ or want to sell or transfer the shares to a third party. Finally, in order to encourage Brad to stay with the company, the corporation would prob- ably reserve the right to repurchase the shares from Brad at cost should Brad’s employment end before a specified time. As an example, all the shares (called restricted stock) would be subject to forfeiture at cost (regardless of their then actual value) should Brad leave before one year; two-thirds would be forfeited if he left before two years; and one-third if he left before three years. The shares not forfeited (called vested shares) would be purchased by the corpora- tion at their full value should Brad ever leave or attempt to sell them. One step back from restricted stock is the stock option. This is a right granted to the employee to purchase a particular number of shares for a fixed price over a defined period of time. Because the price of the stock does not change, the employee has effectively been given the ability to share in what- ever growth the company experiences during the life of the option, without paying for the privilege. If the stock increases in value, the employee will exer- cise the option near the end of the option term. If the stock value does not grow, the employee will allow the option to expire, having lost nothing. The Taxes and Business Decisions 331 stock option is a handy device when the employee objects to paying for his piece of the action (after all, he is expecting compensation, not expense) but the employer objects to giving the employee stock whose current value repre- sents growth from the period before the employee’s arrival. Again, the exercise price can be more than, equal to, or less than the fair market value of the stock at the time of the grant, depending upon the extent of the incentive the em- ployer wishes to give. Also, the exercisability of the option will likely vest in stages over time. Often, however, the founding entrepreneur cannot bring herself to give an employee a current or potential portion of the corporation’s stock. Although she has been assured that the block of stock going to the employee is too small to have any effect on her control over the company, the objection may be psy- chological and impossible to overcome. Or, in the case of a subchapter S cor- poration operating in numerous states, the employee may not want to have to file state income tax returns in all those jurisdictions. The founder seeks a de- vice which can grant the employee a growth potential similar to that granted by stock ownership but without the stock. Such devices are often referred to as phantom stock or stock appreciation rights (SARs). In a phantom stock plan, the employee is promised that he may, at any time during a defined period so long as he remains employed by the corporation, demand payment equal to the then value of a certain number of shares of the corporation’s stock. As the cor- poration grows, so does the amount available to the employee just as would be the case if he actually owned some stock. SARs are very similar except that the amount available to the employee is limited to the growth, if any, that the given number of shares has experienced since the date of grant. Tax Effects of Phantom Stock and SARs Having described these devices to Morris and Brad, it is, of course, important to discuss their varying tax impacts upon employer and employee. If Brad has been paying attention, he might immediately object to the phantom stock and SARs as vulnerable to the constructive receipt rule. After all, if he may claim the current value of these devices at any time he chooses, might not the IRS in- sist that he include each year’s growth in his taxable income as if he had claimed it? Although the corporation’s accountants will require that these de- vices be accounted for in that way on the corporation’s financial statements, the IRS has failed in its attempts to require inclusion of these amounts in tax- able income because the monies are not unconditionally available to the tax- payer. In order to receive the money, one must give up any right to continue to share in the growth represented by one’s phantom stock or SAR. If the right is not exercisable without cost, the income is not constructively received. However, there is another good reason for Brad to object to phantom stock and SARs from a tax point of view. Unlike stock and stock options, both of which represent a recognized form of intangible capital asset, phantom stock and SARs are really no different from a mere promise by the corporation 332 Planning and Forecasting to pay a bonus based upon a certain formula. Since these devices are not rec- ognized as capital assets, they are not eligible to be taxed as long-term capital gains when redeemed. This difference is quite meaningful since the maximum tax rate on ordinary income in 2001 is 39.1% and on long-term capital gains is 20%. Thus, Brad may have good reason to reject phantom stock and SARs and insist on the real thing. Taxability of Stock Options If Morris and Brad resolve their negotiations through the use of stock options, careful tax analysis is again necessary. The Code treats stock options in three ways depending on the circumstances, and some of these circumstances are well within the control of the parties (see Exhibit 11.5). If a stock option has a “readily ascertainable value,” the IRS will expect the employee to include in his taxable income the difference between the value of the option and the amount paid for it (the amount paid is normally zero). Measured in that way, the value of an option might be quite small, espe- cially if the exercise price is close or equal to the then fair market value of the underlying stock. After all, the value of a right to buy $10 of stock for $10 is only the speculative value of having that right when the underlying value has increased. That amount is then taxed as ordinary compensation income, and the employer receives a compensating deduction for compensation paid. When the employee exercises the option, the Code imposes no tax, nor does the em- ployer receive any further deduction. Finally, should the employee sell the stock, the difference between, on the one hand, the price received and on the other the total of the previously taxed income and the amounts paid for the op- tion and the stock is included in his income as a capital gain. No deduction is then granted to the employer since the employee’s decision to sell his stock is not deemed to be related to the employer’s compensation policy. This taxation scenario is normally quite attractive to the employee be- cause she is taxed upon a rather small amount at first, escapes tax entirely upon EXHIBIT 11.5 Taxation of stock options. Grant Exercise Sale Readily Ascertainable Value Employee Tax of value No tax Capital gain Employer Deduction No deduction No deduction No Readily Ascertainable Value Employee No tax Tax on spread Capital gain Employer No deduction Deduction No deduction ISOP Employee No tax No tax Capital gain Employer No deduction No deduction No deduction Taxes and Business Decisions 333 exercise, and then pays tax on the growth at a time when she has realized cash with which to pay the tax at a lower long-term capital gain rate. Although the employer receives little benefit, it has cost the employer nothing in hard assets, so any benefit would have been a windfall. Because this tax scenario is seen as very favorable to the employee, the IRS has been loathe to allow it in most cases. Generally, the IRS will not rec- ognize an option as having a readily ascertainable value unless the option is traded on a recognized exchange. Short of that, a case has occasionally been made when the underlying stock is publicly traded, such that its value is read- ily ascertainable. But the IRS has drawn the line at options on privately held stock and at all options that are not themselves transferable. Since Morris’s cor- poration is privately held and since he will not tolerate Brad’s reserving the right to transfer the option to a third party, there is no chance of Brad’s taking advantage of this beneficial tax treatment. The second tax scenario attaches to stock options which do not have a readily ascertainable value. Since, by definition, one cannot include their value in income on the date of grant (it is unknown), the Code allows the grant to es- cape taxation. However, upon exercise, the taxpayer must include in income the difference between the then fair market value of the stock purchased and the total paid for the option and stock. When the purchased stock is later sold, the further growth is taxed at the applicable rate for capital gain. The em- ployer receives a compensation deduction at the time of exercise and no de- duction at the time of sale. Although the employee receives a deferral of taxation from grant to exercise in this scenario, this method of taxation is gen- erally seen as less advantageous to the employee, since a larger amount of in- come is exposed to ordinary income rates, and this taxation occurs at a time when the taxpayer has still not received any cash from the transaction with which to pay the tax. Recognizing the harshness of this result, Congress invented a third taxa- tion scenario which attaches to incentive stock options (ISOs). The recipient of such an option escapes tax upon grant of the option and again upon exercise. Upon sale of the underlying stock, the employee includes in taxable income the difference between the price received and the total paid for the stock and op- tion and pays tax on that amount at long-term capital gain rates. This scenario is extremely attractive to the employee who defers all tax until the last moment and pays at a lower rate. Under this scenario, the employer receives no deduc- tion at all, but since the transaction costs him nothing, that is normally not a major concern. Lest you believe that ISOs are the perfect compensation de- vice, however, be aware that, although the employee escapes income taxation upon exercise of the option, the exercise may be deemed taxable under the al- ternative minimum tax described later in this chapter. The Code imposes many conditions upon the grant of an incentive stock option. Among these are that the options must be granted pursuant to a written plan setting forth the maximum number of shares available and the class of employees eligible; only employees are eligible recipients; the options cannot 334 Planning and Forecasting be transferable; no more than $100,000 of underlying stock may be initially ex- ercisable in any one year by any one employee; the exercise price of the options must be no less than the fair market value of the stock on the date of grant; and the options must expire substantially simultaneously with the termination of the employee’s employment. Perhaps most important, the underlying stock may not be sold by the employee prior to the expiration of two years from the option grant date or one year from the exercise date, whichever is later. This latter requirement has led to what was probably an unexpected con- sequence. Assume that Plant Supply has granted an incentive stock option to Brad. Assume further that Brad has recently exercised the option and has plans to sell the stock he received. It may occur to Brad that by waiting a year to re- sell, he will be risking the vagaries of the market for a tax savings which cannot exceed 19.1% (the difference between the maximum income-tax rate of 39.1% and the maximum capital-gain rate of 20%). By selling early, Brad will lose the chance to treat the option as an incentive stock option but will pay, at worst, only a marginally higher amount at a time when he does have the money to pay it. Furthermore, by disqualifying the options, he will be giving his employer a tax deduction at the time of exercise. An enterprising employee might go so far as to offer to sell early in exchange for a split of the employer’s tax savings. Tax Impact on Restricted Stock The taxation of restricted stock is not markedly different from the taxation of nonqualified stock options without a readily ascertainable value (see Ex- hibit 11.6). Restricted stock is defined as stock that is subject to a condition that affects its value to the holder and which will lapse upon the happening of an event or the passage of time. The Code refers to this as “a substantial risk of forfeiture.” Since the value of the stock to the employee is initially speculative, the receipt of the stock is not considered a taxable event. In other words, since Brad may have to forfeit whatever increased value his stock may acquire, if he leaves the employ of the corporation prior to the agreed time, Congress has al- lowed him not to pay the tax until he knows for certain whether he will be able to retain that value. When the stock is no longer restricted (when it “vests”), EXHIBIT 11.6 Restricted stock tax impact. Grant Restriction Removed Sale Restricted Stock Employee No tax Tax based on current value Capital gain Employer No Deduction Deduction No deduction Restricted Stock 83(b) Election Employee Tax based on value without No tax Capital gain restriction Employer Deduction No deduction No deduction Taxes and Business Decisions 335 the tax is payable. Of course, Congress is not being entirely altruistic in this case; the amount taxed when the stock vests is not the difference between what the employee pays for it and its value when first received by the employee but the difference between the employee’s cost and the stock’s value at the vesting date. If the value of the stock has increased, as everyone involved has hoped, the IRS receives a windfall. Of course, the employer receives a com- pensating deduction at the time of taxation, and further growth between the vesting date and the date of sale is taxed upon sale at appropriate capital gain rates. No deduction is then available to the employer. Recognizing that allowing the employee to pay a higher tax at a later time is not an unmixed blessing, Congress has provided that an employee who re- ceives restricted stock may, nonetheless, elect to pay ordinary income tax on the difference between its value at grant and the amount paid for it, if the em- ployee files notice of that election within 30 days of the grant date (the so- called 83b election). Thus, the employee can choose for herself which gamble to accept. This scenario can result in disaster for the unaware employee. Assume that Morris and Brad resolve their differences by allowing Brad to have an eq- uity stake in the corporation, if he is willing to pay for it. Thus, Brad purchases 5% of the corporation for its full value on the date he joins the corporation, say, $5.00 per share. Since this arrangement still provides incentive in the form of a share of growth, Morris insists that Brad sell the stock back to the corpo- ration for $5.00 per share should he leave the corporation before he has been employed for three years. Brad correctly believes that since he has bought $5.00 shares for $5.00 he has no taxable income, and he reports nothing on his income tax return that year. Brad has failed to realize that despite his paying full price, he has re- ceived restricted stock. As a result, Congress has done him the favor of impos- ing no tax until the restrictions lapse. Three years from now, when the shares may have tripled in value and have finally vested, Brad will discover to his hor- ror that he must include $10.00 per share in his taxable income for that year. Despite the fact that he had no income to declare in the year of grant, Brad must elect to include that nullity in his taxable income for that year by filing such an election with the IRS within 30 days of his purchase of the stock. In situations in which there is little difference between the value of stock and the amount an employee will pay for it (e.g., in start-up companies when stock has little initial value), a grant of restricted stock accompanied by an 83b election may be preferable to the grant of an ISO, since it avoids the alterna- tive minimum tax which may be imposed upon exercise of an ISO. VACATION HOME Morris had much reason to congratulate himself on successfully acquiring the plastics-molding operation as well as securing the services of Brad through an 336 Planning and Forecasting effective executive compensation package. In fact, the only real disappoint- ment for Morris was that the closing of the deal was scheduled to take place during the week in which he normally took his annual vacation. Some years ago, Morris had purchased a country home for use by himself and his wife as a weekend getaway and vacation spot. With the press of busi- ness, however, Morris and his wife had been able to use the home only on oc- casional weekends and for his two-week summer vacation each year. Morris always took the same two weeks for his vacation so he could indulge his love of golf. Each year, during those two weeks, the professional golfers would come to town for their annual tournament. Hotels were always booked far in advance, and Morris felt lucky to be able to walk from his home to the first tee and enjoy his favorite sport played by some of the world’s best. Some of Morris’s friends had suggested that Morris rent his place during the weeks that he and his wife didn’t use it. Even if such rentals would not generate much cash during these off-season periods, it might allow Morris to deduct some of the expenses of keeping the home, such as real estate taxes, mortgage payments, maintenance, and depreciation. Morris could see the ben- efit in that, since the latter two expenses were deductible only in a business context. Although taxes and mortgage interest were deductible as personal ex- penses (assuming, in the case of mortgage interest, that Morris was deducting such payments only with respect to this and his principal residence and no other home), the previously mentioned limits on the use of itemized deduc- tions made the usefulness of these deductions questionable. However, in addition to the inconvenience of renting one’s vacation home, Morris had discovered a few unfortunate tax rules which had dissuaded him from following his friends’ advice. First, the rental of a home is treated by the Code in a fashion similar to the conduct of a business. Thus, Morris would gen- erate deductions only to the extent that his expenses exceeded his rental in- come. In addition, to the extent he could generate such a loss, the rental of real estate is deemed to be a passive activity under the Code, regardless of how much effort one puts into the process. Thus, in the absence of any relief provi- sion, these losses would be deductible only against other passive income and would not be usable against salary, bonus, or investment income. Such a relief provision does exist, however, for rental activities in which the taxpayer is “actively” involved. In such a case, the taxpayer may deduct up to $25,000 of losses against active or portfolio income, unless his total income (before any such deduction) exceeds $100,000. The amount of loss which may be used by such taxpayer, free of the passive activity limitations, is then low- ered by $1 for every $2 of additional income, disappearing entirely at $150,000. Given his success in business, the usefulness of rental losses, in the absence of passive income, seemed problematic to Morris, at best. Another tax rule appeared to Morris to limit the usefulness of losses even further. Under the Code, a parcel of real estate falls into one of three cate- gories: personal use, rental use, or mixed use. A personal use property is one which is rented 14 days or less in a year and otherwise used by the taxpayer and Taxes and Business Decisions 337 his family. No expenses are deductible for such a facility except taxes and mort- gage interest. A rental use property is used by the taxpayer and his family for less than 15 days (or 10% of the number of rental days) and otherwise offered for rental. All the expenses of such an activity are deductible, subject to the passive loss limitations. A mixed use facility is one that falls within neither of the other two categories. If Morris were to engage in a serious rental effort of his property, his oc- casional weekend use combined with his two-week stay around the golf tourna- ment would surely result in his home falling into the mixed use category. This would negatively impact him in two ways. The expenses that are deductible only for a rental facility (such as maintenance and depreciation) would be de- ductible only on a pro rata basis for the total number of rental days. Worse yet, the expenses of the rental business would be deductible only to the extent of the income, not beyond. Expenses which would be deductible anyway (taxes and mortgage interest) are counted first in this calculation, and only then are the remaining expenses allowed. The result of all this is that it would be im- possible for Morris to generate a deductible loss, even were it possible to use such a loss in the face of the passive loss limitations. Naturally, therefore, Morris had long since decided not to bother with at- tempting to rent his country getaway when he was unable to use it. However, the scheduling of the closing this year presents a unique tax opportunity of which he may be unaware. In a rare stroke of fairness, the Code, though deny- ing any deduction of not otherwise deductible expenses in connection with a home rented for 14 days or less, reciprocates by allowing taxpayers to exclude any rental income should they take advantage of the 14-day rental window. Normally, such an opportunity is of limited utility, but with the tournament coming to town and the hotels full Morris is in a position to make a killing by renting his home to a golfer or spectator during this time at inflated rental rates. All that rental income would be entirely tax-free. Just be sure the tenants don’t stay beyond two weeks. LIKE-KIND EXCHANGES Having acquired the desired new business and secured the services of the in- dividual he needed to run it, Morris turned his attention to consolidating his two operations so that they might function more efficiently. After some time, he realized that the factory building acquired with the plastics business was not contributing to increased efficiency because of its age and, more impor- tant, because of its distance from Morris’s home office. Morris located a more modern facility near his main location that could accommodate both opera- tions and allow him to eliminate some amount of duplicative management. Naturally, Morris put the molding facility on the market and planned to purchase the new facility with the proceeds of the old one plus some additional capital. Such a strategy will result in a tax on the sale of the older facility equal . to purchase a new home or acquire an investment port- folio. Significant up-front money is often part of an executive compensation package. While this money could be paid as a bonus, Morris might. return of the interest is charac- terized as a dividend. Thus the IRS gets increased tax from both parties unless the corporation has elected subchapter S (see Exhibit 11.4). All may not be lost. should Brad ever leave the corpora- tion’s employ or want to sell or transfer the shares to a third party. Finally, in order to encourage Brad to stay with the company, the corporation would prob- ably