US Tax Treatment of ESOP Funded by a Nonrecourse Loan

Typical Scenario -

Given the explosion in entrepreneurial activity and commensurate startups, options are a hot topic.  Here's a scenario to consider. An employee is granted restricted shares in company X at a Y% discount to value of ordinary shares. These shares will be funded by a non-recourse loan. Shares will only vest after Z years, after which time they will become ordinary shares and be valued at the then prevailing market value.

1. What are the US tax consequences to the US exposed employee?

  • Employers sometimes finance their employees’ stock purchases or their exercised options. How these loans are structured, whether they qualify as “recourse” or “non-recourse” loans—has accounting and, therefore, tax consequences. If the employer has recourse only to the stock purchased and not to the employee’s other assets, the loan is considered to be “nonrecourse.”
  • In contrast, a “recourse” loan gives the employer the legal right to foreclose on the employee’s other assets in the event of default. Significant judgment and analysis may be necessary to determine whether an arrangement is a recourse or nonrecourse. The purchase of stock through a nonrecourse loan is effectively the same as granting an option to buy stock.
  • A non-recourse loan arrangement for purchasing stock or exercising options is, in substance, an option and should be accounted for accordingly.
  • The general rule that nonqualified compensatory options are not taxed until exercised has appeared in treasury regulation section 1.421-6 since 1961. They are taxing compensatory options when they are exercised, rather than when they are granted or vest, reflects a long-standing Treasury practice.

2. How is a non recourse loan cancellation treated in the event that shares do not vest - and have a value lower than the loan balance?

  • If a stock is purchased or an option is exercised using a nonrecourse note, the value of the underlying shares decreases below the loan’s amount. In that case, an employee can return the stock instead of repaying the loan. Put another way, and the employee is in the same position as if the stock purchase or option exercise had never occurred.

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