Executive Compensation

Late in June, the IRS released a memorandum from the Office of the Chief Counsel, declaring that the IRS can seize and sell executive stock options held by a taxpayer regardless of restrictions on the transferability of the options.

The taxpayer had received and held both Incentive Stock Options (ISOs) and Non-Incentive Stock Options (NISOs). His Employer's Stock Plan and the Option Award Agreements unambiguously provided that the Options:

• could not be transferred except by will, the laws of descent or distribution, or pursuant to a qualified domestic relations order (QDRO)*, and
• during the taxpayer's life, could only be exercised by the taxpayer, his guardian or legal representative, or the Taxpayer's transferee pursuant to a QDRO.

The taxpayer terminated employment with all options fully vested, and the IRS served a Notice of Levy on Wages, Salary and Other Income (Form 668-W) on the Employer about that time. The IRS easily found that (i) a federal tax lien that arises upon assessment of the tax and notice and demand for payment attaches to all of the taxpayer's property and rights to property. Code §§ 6321 and 6322, and (ii) Congress broadly defined "property" to reach every interest a taxpayer might have in property.

Regarding the NSOs, the IRS quickly concluded that contractual restrictions on transferability (e.g., in the Plan or Award documents) do not bar the IRS from seizing and selling property under the procedures of Code Sec. 6335. Regarding the ISOs, the IRS acknowledged that to be a qualified ISO, the option by its terms must not be "transferable by such individual otherwise than by will or the laws of descent and distribution. . . ." (Code Sec. § 422(a)(5)). However, the IRS also concluded here that it "is not bound by the restrictions on transferability applicable to the Taxpayer and levy may be enforced by the sale of the incentive stock options to a third party."

Obviously, it is good to be the King (or the IRS). What are employers to do? I welcome (and will post) readers' comments, but there appears to be a range of possible choices, including the following:

1. Accept the IRS' opinion and honor any Notice of Levy on Wages, Salary and Other Income (Form 668-W) it receives in the future.

2. Refuse to honor any Notice of Levy on Wages, Salary and Other Income (Form 668-W), at least as a preliminary matter, and force the IRS into a settlement agreement, which receives official sanction by a court (to protect the employer from a claim by the employee/taxpayer).

3. Amend its Plan and Option Award Agreement documents (as some have done) to explicitly provide that any Notice of Levy or other attempt to transfer the options will result in the immediate forfeiture of the options. This may offer the employer the satisfaction of sticking it to the IRS, but may increase its risk of liability without rendering and benefit at all to the employee (at least the transfer of options would reduce his tax liability somewhat).

*A requirement of ISOs, but often written into the Plan documents for NISOs, as in this case.