Can the IRS Seize and Sell Your Company's Stock Options?

On June 29, 2009, the Internal Revenue Service (IRS) issued a ruling stating that it can seize and sell executive stock options regardless of contractual restrictions on transferability of the options. This could present significant issues for public and private companies in the event their executives become subject to an IRS levy.

In the ruling, the IRS concluded that contractual restrictions on transferability of the options do not bar the IRS from seizing and selling options. They reasoned that the Internal Revenue Code specifically lists certain types of property that are exempt from levy. That list does not include stock options, and the IRS refused to recognize any exemptions not included in the statutory list. Further, the IRS stated that the contractual transferability restrictions are specifically overridden by the terms of the Internal Revenue Code, regardless of the fact that the Internal Revenue Code itself requires incentive stock options to contain transferability restrictions.

The ruling analogized the seizure and sale of stock options to the seizure and sale of benefits under an ERISA-qualified plan. An ERISA-qualified plan is required to provide that benefits under the plan may not be assigned or alienated. Nevertheless, the IRS may levy upon those benefits despite the anti-alienation provisions. Similarly, the IRS reasoned, although the contractual restrictions exist and are even required by the Internal Revenue Code for incentive stock options, the IRS may seize and sell stock options.

However, the IRS failed to recognize the critical distinction between rights to benefits under a plan and rights to acquire stock pursuant to an option. The transferability restrictions of a stock option are an inherent part of the right represented by that option. Particularly in the case of private companies, the ability to limit who becomes an owner, and thus exercises control over the company through voting rights, is essential. Generally, private companies would not issue stock options if they were transferable to third parties. The ruling as written is so broad that it would allow the IRS to sell a private company's options to anyone, including one or more of the company's competitors. That cannot be the intended result. Clearly, the IRS did not consider all of the implications of its decision in this case.

In addition, it is not at all clear that such an option would be exercisable by the third party. Stock option plans generally require surrender or immediate exercise of options upon termination of employment and therefore do not even contemplate exercise by any person who is not an employee. Moreover, the ruling could call into question the validity of transfer restrictions in shareholders' agreements as well. If the IRS can seize an option which is non-transferable by its terms, then it can certainly seize shares of stock that are subject to transfer restrictions. If that's the case, the transfer restrictions could even be deemed unenforceable in a broader context.

There may be some ways to draft around this issue. First, the option could be drafted so that it was immediately and automatically rendered null and void if the IRS served any kind of notice of levy on the option holder. Second, the plan and agreement could be drafted so that the company has an automatic buy-out right or right of first refusal if the IRS serves notice of levy upon the option holder or shareholder. Because of the broadness of the recent ruling, which effectively negated transfer restrictions regardless of purpose, content or context, it cannot be certain that the IRS would respect these arrangements. The IRS may choose to disregard all contractual arrangements designed to prevent levy on a taxpayer's assets. As a result, companies should be aware of the issue and take steps to address the issue when a stock or option holder encounters the possibility of an IRS levy.

For further information, or to discuss the implications of this new IRS ruling, please contact Janice Wilken of Ice Miller's Business Group.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice.  The reader must consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.