Rev. Proc. 2002-69: A Tax Safe Harbor for Stock Options

A tax safe harbor exists for when a parent company provides its own stock to compensate the employees of a subsidiary. Without this guidance, such transactions could create unexpected tax liabilities for the subsidiary. The rules are designed to prevent a tax outcome known as the “zero basis” problem.

This issue arises because a subsidiary has no cost basis in its parent’s stock. When the subsidiary uses that stock to pay its employees, it could be treated as a disposition of property with a zero basis, forcing it to recognize a taxable gain equal to the full market value of the stock.

Conditions for Safe Harbor Treatment

To qualify for the safe harbor, a transaction must satisfy several conditions. The stock used must be from the parent company and transferred to a subsidiary’s employee as compensation for services. The subsidiary must immediately transfer the parent company’s stock to its employee. This rule prohibits the subsidiary from holding the stock for any period, as this could be viewed as an investment. A subsidiary cannot claim a deduction for any parent stock it does not transfer immediately.

The subsidiary also must not have paid for the stock in a way that would give it a cost basis. If the subsidiary purchased the stock at fair market value, it would already have a basis, and these safe harbor provisions would not be necessary.

Tax Consequences of Applying the Rules

When the safe harbor conditions are met, the transaction is recast into a series of deemed steps for tax purposes, following Treasury Regulation § 1.1032-3. First, the parent corporation is treated as making a non-taxable contribution of its stock to the subsidiary’s capital. Immediately after, the subsidiary is treated as transferring the stock to its employee as compensation.

This recasting leads to two main tax outcomes. First, the subsidiary recognizes no gain or loss on the transfer of the parent’s stock, as it is treated as having a basis in the stock equal to its fair market value.

Second, the parent company increases its basis in the subsidiary’s stock. This basis increase is equal to the fair market value of the stock transferred to the subsidiary’s employee.

Application for Disregarded Entities

The rules differ when the subsidiary is a “disregarded entity.” For federal tax purposes, a disregarded entity like a single-member LLC is not treated as separate from its owner, and its activities are reported on the owner’s tax return.

When a parent corporation transfers stock to an employee of its disregarded entity, the income tax treatment is simplified. The employee is treated as an employee of the parent corporation. The transfer is therefore a direct grant, avoiding the zero basis problem without needing the recasting rules.

For employment tax purposes, however, the disregarded entity is treated as a separate entity. This means the LLC is responsible for reporting and paying employment taxes on the compensation using its own employer identification number (EIN).