IRS Hearing on Compensation Plans for Tax-Exempt Organizations; Sponsored
Regulations Do Not Extend to Periodical Acknowledgements
By Harry J. Friedman, Greenberg Traurig,
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Deferred Compensation Plans
Section 457 Requirements
On May 8, 2002, the Internal Revenue Service (the "Service") issued Proposed
Regulations updating the existing Treasury Regulations under Section 457
of the Internal Revenue Code of 1986, as amended (the "Code"). The last
time the Section 457 Regulations were updated was September 23, 1982. The
intent of the Proposed Regulations was to update the Regulations to conform
them to the numerous amendments made to Section 457 by legislation since
1982. In addition, the Proposed Regulations are intended to provide additional
guidance on Section 457 issues not found in the current Treasury Regulations.
|"If Treasury Regulations Section
1.457-11(c) becomes final, tax-exempt organizations will likely
cease to issue stock options."
On August 29, 2002, the Service held a hearing on the Proposed Regulations.
Substantially all of the comments were devoted to the treatment of participants
of "ineligible plans" which involved options to acquire stock and shares
of mutual funds. The remainder of the Proposed Regulations do not appear
to be controversial.
Section 457 deals with deferred compensation plans for employees of governmental
entities and taxĖexempt organizations. Generally, deferred compensation
plans of for-profit employers are governed by a general rule that unfunded
deferred compensation of an employee does not have to be reported until
paid, and the employer is entitled to a deduction only when the employee
recognizes the income for federal income tax purposes. This symmetry of
recognition of the income and the related deduction avoids any tax advantage
from unfunded deferred compensation plans. However, these rules would not
work in the case of an employer such as a tax exempt organization which
does not care about the timing of compensation deductions.
Section 457 provides for a different rule for deferred compensation plans
of governments and tax-exempt organizations. A limited amount of deferred
compensation can escape taxation until paid. Deferred compensation in excess
of the specified amount must be included in income of the employee in the
year it is no longer subject to a risk of forfeiture, generally when the
employee will receive the cash in the future regardless of whether he or
she continues to work for the employer.
The Proposed Regulations describe the revised deferral limitations for
eligible plans enacted with the Economic Growth and Tax Relief Reconciliation
Act of 2001. See, GT Alert (February, 2002),
Intermediate Sanction Regulations; Improvements in Section 457(b) Plans,
for a discussion of these statutory changes. Prior to EGTRRA, a coordination
limitation applied under which the annual limitations were reduced by amounts
excluded for any taxable year under Sections 401(k) or 403(b) plans. Effective
for years beginning January 1, 2002, the requirement that contributions
made to a Section 457(b) Plan be reduced by Section 403(b) or 401(k) plans
contributions made by the employee was repealed. As a result, if a tax-exempt
organization elects to maintain both a Section 403(b) Plan or a Section
401(k) Plan and a Section 457(b) Plan, employees will be able to enjoy a
substantial amount of retirement benefits because they will be able to receive
the maximum contribution amounts under both plans. The Proposed Regulations
provide guidance on the application of these rules.
Treasury Regulations Section 1.457-11 deals with the tax treatment of
participants if the plan is not an "eligible plan" under Section 457(b),
governed by Section 457(f) of the Code. Generally, the Proposed Regulation
provides, as described above, that compensation will be includible in income
when the right to the compensation is no longer subject to a substantial
risk of forfeiture.
The Proposed Regulations provide for a coordination of Section 457(f)
with Section 83 of the Code. Section 457(f) provides that the rules of Section
457(f) do not apply in the case of any plan which "consists of a transfer
of property described in section 83. . ." Generally, Section 83 provides
that an employee is required to recognize income when the property transferred
is no longer subject to a substantial risk of forfeiture. Section 83 and
Treasury Regulation Section 1.83-7 provide that when an employee receives
options to purchase property, including stock, he or she generally does
not recognize current income at the time the option is granted. (Special
rules apply to incentive stock options, which are only options to purchase
employer stock.) Instead, the employee is required to recognize income at
the time the option is exercised. The income that must be recognized is
equal to the difference between the fair market value of the property received
and the exercise price paid by the employee. These rules apply unless the
option has a "reasonably ascertainable value." As a practical matter, it
is rare that an option issued to an employee is deemed to have a reasonably
ascertainable value. As a consequence, generally, stock options issued to
employees do not result in any income, even if vested, until the employee
exercises the option.
Can Tax-Exempt Organizations Use Options?
In recent years, many tax-exempt organizations have been concerned about
losing employees to for-profit entities that can provide stock options as
additional incentive compensation. In order to meet this problem head on,
a number of exempt organizations have provided the equivalent of stock options
to employees by providing an option to purchase an interest in a mutual
fund or other block of stock owned by the tax-exempt organization as a substitute
for employer stock options issued by for-profit companies. See,
GT Alert (March, 2001),
Options Can be Used to Compensate
Tax-Exempt Executives, for a discussion of issues presented by the use
of the option plans for tax-exempt organization employees.
There are a number of issues in connection with these plans, including
whether or not the options are treated as income when vested to the employee
for purposes of Section 457(f). Commentators generally believe that Section
457(f) does not apply to the stock options because they consist of a transfer
of property described in Section 83.
The Proposed Regulations, however, appear to apply Section 457(f) to
these options. The Proposed Regulation provides that "a transfer of property
described in Section 83 means a transfer of property to which Section 83
applies." Section 83 provides that Section 83 does not "apply" to an option
that does not have a reasonably ascertainable value. Because the exclusion
for transfers described in Section 83 is not applicable, transfers of options
would be subject to the rules of Section 457(f), resulting in income inclusion
when the options vest. Proposed Section 1.457-12 clearly evidences this
intent providing that the amendment to Section 1.457-11(c) described above
"does not apply with respect to an option without a readily ascertainable
fair market value that was granted on or before May 8, 2002 (the date the
proposed Regulations were promulgated)."
Several speakers at the Hearing argued that the Proposed Regulationís
interpretation of Section 457 was incorrect, that "described in Section
83" did not mean that Section 83 must "apply". One speaker argued that the
tax treatment of options contained in the Section 83 Regulations predated
the enactment of Section 83 in 1969, which codified the treatment of options
without a reasonably ascertainable value. The enactment of Section 457,
according to that speaker, was not intended to change this result.
Service representatives indicated their concern about deeply discounted
options. One speaker advised in response to a question that exercise price
discounts of 50% to 75% of the fair market value of the underlying property
It is unclear at what point the discount from fair market value of the
exercise price of options becomes so great, and the exercise price so small,
that the employee will be treated as having received the property itself
from the employer. While it is not clear how large a discount from fair
market value may be taken, case law indicates that a substantial discount
from fair market value will not convert an option into a transfer of the
underlying property. Clearly the Service is concerned about the immediate
value received by an employee who receives a deeply discounted option.
If Treasury Regulations Section 1.457-11(c) becomes final in its present
form, tax-exempt organizations will likely cease to issue stock options.
Options that do not have a reasonably ascertainable value under Section
83, would be required to be reported as income by the employee. Organizations
with such programs or contemplating a program should follow future developments
on this subject.
The recent publication in April, 2002 of Final Regulations for corporate
sponsorship payments highlights the fact that Section 513(i) of the Code
does not apply to sponsorship payments allocated to an ad or acknowledgement
of the corporate sponsor support in an exempt organizationís periodical.
See, GT Alert (March, 2000) IRS Issues Corporate Sponsorship Regs
for a discussion of the Treasury Regulations.
The exclusion of acknowledgements for certain corporate sponsorship payments
evolved out of the Serviceís attempt in the early 1990ís to tax contributions
to tax-exempt organizations made by corporations in exchange for the use
of the corporationís name in an event. The Service initially sought to treat
as unrelated trade or business taxable income ("UBIT") payments made by
corporate sponsors to college football bowl games in exchange for naming
rights. The first attack was on the Mobil Cotton Bowl Game; the Service
concluded that payments made by Mobil Oil to the Cotton Bowl were UBTI.
The congressional response to these attempts was fairly quick and negative.
Congress enacted Section 513(i), which defines when payments by corporate
sponsors in exchange for "acknowledgements" would not be treated as advertising
revenues and thus, not UBTI.
Treasury Regulations provide that qualified sponsorship payments, defined
in the Treasury Regulations as payments for which there is no arrangement
or expectation that the corporate sponsor will receive a substantial benefit,
do not constitute UBTI. The acknowledgement may not contain qualitative
or comparative language, price information or other indications of savings
or value, an endorsement or any inducement to purchase the product or services
of the sponsor. Qualified sponsorship payments do not include a payment
if the amount of the payment is contingent upon the level of attendance
at an event sponsored by the exempt organization, broadcast ratings or other
factors that would related to the publicís exposure to the event. Payments
in exchange for "substantial benefits", a benefit other than an acknowledgement
or goods or services with an unsubstantiated value, do not constitute qualified
Specifically excluded from the "safe harbor" are sponsorship payments
allocated to an advertisements or acknowledgement in a periodical of the
exempt organization. A periodical does not include a program or other printed
material associated with a special event. If a payment is, in part, a "qualified
sponsorship payment" and in part, not, the payment must be allocated based
on the value of the "advertising" or other benefit provided to the sponsor.
Acknowledgements contained in a monthly magazine, even if otherwise meets
the requirements of a acknowledgement in the Treasury Regulations may be
treated as a sale of advertising, regardless of its content. Older Revenue
Rulings, predating Section 513(i), do permit acknowledgements involving
a mere list of sponsors on a page.
Since the safe harbor of Section 513(i) does not apply to periodicals,
the general question of what is advertising would apply to acknowledgements
in a periodical. Arguably, a page that merely thanks the sponsor and contains
the sponsors logo may not constitute advertising, even in a periodical.
Revenue Rulings indicate that the determination of the treatment of the
revenues is based on the particular facts, including the expectations of
the business making the payment, the manner in which the periodical is circulated,
the extent to which the readers would be expected to further the interests
of the sponsors, the eligibility of the publishing organization to receive
tax deductible payments, and the manner in which the payments are solicited.
In the absence of any authority on this point, organizations should be careful
in the content of periodical acknowledgements.
© 2002 Greenberg Traurig
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