IRS Ruling Produces Unfavorable Tax Affect with Nonqualified Stock Options

When companies partially compensate employees with nonqualified stock options, they commonly allow the worker to give the company a personal note to pay for the exercise of the option (i.e. the purchase of the underlying stock).  If the company reduces the face value of the note after several payments on the note, what is the tax result?

Many taxpayers thought that there would be no tax effect.  They were relying on a section of the Internal Revenue Code dealing with cancellation of indebtedness and a specific subsection stating that reductions in qualifying purchase-money debt do not generate taxable income.  Earlier this year, the Internal Revenue Service ruled that the reduction in the amount due from the employee would produce compensation income that would be deductible by the employer.  In addition to the employee having to pay income taxes, according to the IRS' approach, the amount of "income" would be subject to Social Security and Medicare tax which is imposed on employees and employers.

To discuss options as part of a compensatory package, please contact Lawrence Lipoff or your Perelson Weiner Partner .