It is common for a key employee to be offered an opportunity to purchase equity of the employer.  Often the key employee can personally finance such purchase.   And sometimes the employer will help the key employee finance the purchase by providing him or her with a loan equal to the purchase price.  The purpose of this Tip of the Week is to remind readers that a substantial part of the loan should be recourse.

• Risk Associated with 100% Non-Recourse Note - Key Employee Received an Option.   If the loan is 100% non-recourse (meaning the key employee has no personal assets at risk other than the underlying equity securing the loan), then the IRS could take the position that: (i) NO transfer of property occurred at the time of purchase, (ii) at the time of purchase the key employee only received an option (i.e., the key employee has optionality because he or she can walk away from the loan with no personal risk),  and (iii) the tax transfer actually occurred later in time when the loan was repaid by the key employee.  If such IRS position were successful and the fair market value of the underlying equity increased from the date the equity was purchased until the date the loan was repaid, then the key employee would have compensatory ordinary income equal to the spread between the purchase price and the fair market value of the underlying stock when the loan was repaid.  The employer would have a corresponding withholding obligation.
• Applicable Rules.  The Treasury Regulations provide that if the amount paid for the equity is an indebtedness secured by the transferred property, and there is no personal liability to pay "all or a substantial part of such indebtedness," then such transaction could be in substance the same as the grant of an option and taxed accordingly.  See Treas. Reg. Section 1.83-3(a)(2).  This Treasury Regulation further provides that the determination of the substance of the transaction will be based upon all the facts and circumstances.
• Only a "Substantial Part" is Required to be Recourse, the Test Is Not "Substantially All."  According to a plain reading of Treas. Reg. Section 1.83-3(a)(2), only a "substantial part" is required to have personal liability.  What is a "substantial part"?  90% recourse?  75% recourse?  50% recourse?  If 30% of the loan was recourse, could that percentage be considered a "substantial part" of the whole (i.e., keeping in mind that "substantial" is different and can be less than a "significant" standard)?

The Internal Revenue Code and Treasury Regulations do not provide how much of the loan must be recourse in order to satisfy the "substantial part" test.  But a conservative approach, assuming there are supporting facts, is that at least 50% of the loan must be recourse in order to avoid the IRS successfully treating the purchase as the receipt of an option.