Taxpayer may deduct service warrants when they are exercised

Plain-English summary

A corporate taxpayer issued stock warrants to two companies in connection with services provided under long-term purchasing agreements. The warrants had no readily ascertainable fair market value when granted and became exercisable only if the service obligations were performed. The IRS ruled that the taxpayer could recognize the tax consequences when the warrants were exercised, not when they merely became exercisable. At exercise, section 83 determines the service providers' income and allows the taxpayer a corresponding deduction under its accounting method and sections 446 and 461.

Ruling snapshot

• Question: When could the taxpayer recognize the tax consequences of warrants issued for services?
• Outcome: Approved for recognition when the warrants are exercised.
• Key authorities: IRC §§ 83, 162, 446, and 461; Treas. Reg. §§ 1.83-6, 1.83-7, and 1.461-1

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201610006                                              [Third Party Communication:
Release Date: 3/4/2016                                         Date of Communication: Month DD, YYYY]
Index Number: 461.00-00
                                                               Person To Contact:
------------------                                             ----------------------, ID No. -------------
------------------------------------------------------------   Telephone Number:
---------                                                      ---------------------
--------------------------------------------                   Refer Reply To:
------------------------                                       CC:ITA:B03
 -------------------------------------------------------       PLR-122710-15
                                                               Date:
                                                               November 23, 2015




TY: -------

LEGEND:

Taxpayer = -------------------------------------------
Taxpayer’s Subsidiary = ---------------------------------------------------
Company A= --------------------
Company B = -----------------------------
Company C = ---------------------------------------------------------------
Products = -----------------------------------
Date 1 = ----------------------
Date 2 = --------------------
Date 3 = ----------------------
Date 4 = ----------------------------
Date 5 = ----------------------
Date 6 = ----------------------------
Year 1 = -------
Year 2 = -------
D = ---
E = ---------------
$X = ---------
$Y = ---------
$Z = ---------

Dear -----------------:

This is in response to the letter sent by your authorized representatives dated -------------
-------. In the letter, your representatives requested a ruling that the tax consequences
of the warrants Taxpayer issued on Date 1 be recognized as an expense when they
become exercisable by their owners, the subsidiaries of Company A and Company B.
PLR-122710-15                                             2

The request is based on sections 1.461-1(a)(2) and 1.83-7(a) of the Income Tax
Regulations.

FACTS

Taxpayer is a United States corporation which is the parent company of a consolidated
group for U.S. federal income tax purposes, which includes a wholly owned subsidiary,
Taxpayer’s Subsidiary, as well as other U.S. subsidiaries. Taxpayer and its subsidiaries
use the accrual method of accounting for U.S. federal income tax purposes and their
taxable year ends on Date 2 of each year.

One of the businesses in which Taxpayer is engaged is the business of purchasing and
distributing Products to a variety of providers. Taxpayer’s ability to obtain these
products from manufacturers in necessary volume and with favorable pricing is critical
to satisfying its customers.

On Date 1, Taxpayer and Taxpayer’s Subsidiary entered into several contracts with
Company A, a domestic corporation, Company B, a foreign corporation, and Company
C, a foreign corporation owned by Company A and B. The goal of these contracts was
to increase the purchasing power of the parties involved with an objective to realize
improved pricing for Products. Central to the new relationship was the execution of a D
year purchasing services agreement ----------------------------------------------whereby
Taxpayer, through Taxpayer’s Subsidiary, ------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
----------------------------------. Taxpayer remained responsible -------------------------------------
----------------------------------------------------------- in the various contracts mentioned above.
In addition, Company C was required to ---------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
-----------------------------------. Company C also agreed to -------------------------------------------
---------------------------------------------------------------. In addition to requiring performance of
the above services, ------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------.

As part of the agreements, Taxpayer granted contingent equity rights, or warrants,
subject to the performance requirements stated above, to each of Company A and
Company B (via their respective subsidiaries) to acquire E shares in Taxpayer between
Date 3 and Date 4 of Year 1 at $X per share and to each company to acquire another E
shares in Taxpayer between Date 5 and Date 6 of Year 2 at $Y per share. At the time
the warrants were issued, the warrants did not have an ascertainable fair market value
as defined in Section 1.83-7(b) of the Income Tax Regulations because, among other
things, they were not actively traded on an established market and were not exercisable
immediately in full by the recipient. The shares acquired pursuant to the exercise of the
warrants will not be subject to a substantial risk of forfeiture, and therefore, will be
substantially vested within the meaning of section 1.83-3(b) of the Income Tax
Regulations at the time of exercise of the warrants.
PLR-122710-15                                  3

Taxpayer granted the stock warrants when Company A, Company B, and
Company C signed a contract for Company C to perform services. At the time of the
grant, the then price of Taxpayer’s stock was $Z, less than the exercise prices of the
warrant tranches under the agreements. Taxpayer’s goal was to provide appropriate
long-term incentives for Company C to perform its duties under the agreement
effectively. The agreements provided that if Company C failed to perform its duties
under the agreements in a satisfactory and successful manner, Taxpayer had the right
under the agreements to terminate them and cancel the warrants granted to Company
A and Company B. Thus, the warrants would only become exercisable in Year 1 and
Year 2 if Company C had fully complied with the terms of the agreements, including the
performance of the required services, up to the applicable points in time.

LAW AND ANALYSIS

Section 162(a) of the Code allows a deduction for the ordinary and necessary expenses
paid or incurred during the taxable year in carrying on any trade or business. Section
162(a)(1) includes a reasonable allowance for salaries or other compensation for
personal services actually rendered as an ordinary and necessary business expense.

Section 1.461-1(a)(2)(i) of the Income Tax Regulations provides in part that under an
accrual method of accounting, a liability is incurred, and is generally taken into account
for federal income tax purposes, in the taxable year in which: (1) all the events have
occurred that establish the fact of the liability, (2) the amount of the liability can be
determined with reasonable accuracy, and (3) economic performance has occurred with
respect to the liability.

Section 1.461-4 of the Regulations provides rules for determining when economic
performance occurs with respect to liabilities arising out of the performance of services,
the transfer of property, or the use of property, interest on debt, assumption of liabilities
in connection with the sale of a trade or business, and certain other liabilities.

Section 1.461-4(d)(2)(i) of the Regulations generally provides that if the liability of a
taxpayer arises out of the providing of services or property to the taxpayer by another
person, economic performance occurs as the services or property is provided.

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 such property over the amount (if any)
paid for such property, shall be included in the gross income of the person who
performed such services in the first taxable year in which the rights of the person having
the beneficial interest in such property are transferable or are not subject to a
substantial risk of forfeiture, whichever is applicable.
PLR-122710-15                                4

Section 1.83-3(b) of the Regulations provides that property is substantially vested when
it is either transferable or not subject to a substantial risk of forfeiture.
Section 1.83-3(f) of the Regulations provides that property transferred in recognition of
the performance of, or the refraining from performance of, services is considered
transferred in connection with the performance of services within the meaning of section

83. The section also provides that the transfer of property is subject to section 83
whether such transfer is in respect of past, present, or future services.

Section 83(e)(3) provides that section 83 does not apply to a stock option (which is
equivalent to a stock warrant) without a readily ascertainable fair market value.

Section 1.83-7(a) of the Regulations states that if section 83(a) does not apply to the
grant of an option because the option does not have a readily ascertainable fair market
value at the time of grant, sections 83(a) and 83(b) shall apply at the time the option is
exercised or otherwise disposed of, even though the fair market value of such option
may have become readily ascertainable before such time. If the option is exercised,
sections 83(a) and 83(b) apply to the transfer of property pursuant to such exercise, and
the employee or independent contractor realizes compensation upon such transfer at
the time and in the amount determined under section 83(a) or 83(b).

Section 83(h) provides that the service recipient may take a deduction in an amount
equal to the amount included under section 83 in the gross income of the person who
performed such services. Furthermore, the deduction is allowed only 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 1.83-6(a)(3) provides that where property is substantially vested upon transfer,
the deduction shall be allowed to such person in accordance with his method of
accounting (in conformity with sections 446 and 461).

Thus, when a service provider exercises a stock option (or stock warrant) for
substantially vested stock, pursuant to section 83, the fair market value of the stock
(minus the exercise price) is included in the service provider’s gross income. Pursuant
to section 1.83-6(a)(3), the service recipient may take a deduction for the amount
included in the service provider’s gross income upon the service provider’s exercising
the stock option (or stock warrant) in accordance with his method of accounting (in
conformity with sections 446 and 461).

Under section 1.461-1(a)(2)(i), all events have not occurred that establish the fact of the
liability and determine it with reasonable accuracy until the contingencies surrounding
the issuance of the warrants have lapsed. In contrast, economic performance will have
occurred by the time the contingencies lapse because services by then will have
already been provided to Taxpayer. Thus, the only question is whether the contingency
lapse occurs when the warrants become exercisable or exercised. The warrants are
PLR-122710-15                                         5

subject to section 83 because Taxpayer granted the stock warrants to Company A and
Company B in connection with the performance of services -------------------------------------
-------------------------------------------------------------------------------------------------for Taxpayer
on an ongoing basis. Therefore, section 83 determines the timing of the contingency
lapse.

The warrants did not have an ascertainable fair market value on the date of grant.
Thus, under section 1.83-7(a) of the Regulations, sections 83(a) and 83(b) do not apply
on the issuance of the warrants or when they become exercisable, but become
applicable only upon the warrants’ exercise. Pursuant to sections 83(h) and 1.83-
6(a)(3), Taxpayer may claim a deduction in accordance with its method of accounting
(in conformity with sections 446 and 461) when the substantially vested E shares are
transferred to Company A and/or Company B, as applicable, upon exercise of the stock
warrants.

CONCLUSION

Taxpayer may recognize the tax consequences of the warrants issued to Company A
and/or Company B, as applicable, when they are exercised.

Except as expressly provided herein, no opinion is expressed or implied concerning the
federal income tax consequences of any aspect of any transaction or item discussed or
referenced in this letter.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representative.

A copy of this letter must be attached to any income tax return to which it is relevant.
Alternatively, taxpayers filing their returns electronically may satisfy this requirement by
attaching a statement to their return that provides the date and control number of the
letter ruling.
PLR-122710-15                               6


The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.



                                     Sincerely,



                                     Robert Casey
                                     Senior Technician Reviewer, Branch 3
                                     (Income Tax & Accounting)




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