GT Alert

IRS Hearing on Compensation Plans for Tax-Exempt Organizations; Sponsored Regulations Do Not Extend to Periodical Acknowledgements

September 2002
By Harry J. Friedman, Greenberg Traurig, Phoenix Office

  View or download the PDF version of this Alert here.

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 tax–exempt 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), IRS Finalized 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 Regulation’s 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 were common.

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.

Periodical Acknowledgements

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 organization’s 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 Service’s attempt in the early 1990’s to tax contributions to tax-exempt organizations made by corporations in exchange for the use of the corporation’s 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 public’s 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 sponsorship payments.

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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