CUNA Comment Letter

Option Plans for Employees of Tax-Exempt Organizations

August 6, 2002

CC:ITA:RU (REG-105885-99)
Room 5226
Internal Revenue Service
POB 7604
Ben Franklin Station
Washington, D.C. 20044

RE: Proposal Regarding Eligible Deferred Compensation Plans

Dear Sir or Madam:

The Credit Union National Association (CUNA) appreciates the opportunity to comment on the IRS’ proposed regulations concerning eligible deferred compensation plans. CUNA represents over 90% of our nation's more than 10,500 state and federal credit unions. We appreciate the IRS’ efforts to provide guidance with clear standards for the administration and operation of eligible deferred compensation plans under Section 457 of the Internal Revenue Code (Code), which requires that deferred compensation (other than so-called “eligible-- plans) will be taxable to the employee in the first year in which the employee’s right to the deferred compensation is not subject to a substantial risk of forfeiture. However, CUNA is very concerned that these proposed regulations would effectively eliminate the use of option plans offered by credit unions and other not-for-profit entities.

Deferred compensation plans provided by tax-exempt organizations are generally governed by Section 457 of the Internal Revenue Code (Code). For some executives with very old deferred compensation arrangements (perhaps included in employment contracts), this “risk of forfeiture-- provision has created unanticipated significant tax liability (perhaps without the cash to pay the liability), and has led to them trying to find alternatives. Section 457(f) includes a specific exception for transfers of property in connection with performance of services “described in-- Section 83 of the Code. For this reason, many credit unions and other tax-exempt organizations have looked to Section 83 in designing option plans under which they grant executives options to purchase certain property (such as mutual fund shares) at discounted prices at a future date. An option is called a discounted option when the exercise price is below the market value of the underlying shares on the date of the option grant. These option plans are sometimes used to supplement retirement income for executives because 401(k) plans generally limit the contributions for these executives, including particularly those who are close to retirement age. These option plans do not have to be limited to executives but can be offered to rank-and-file employees as well.

Under current regulations, an option plan is not taxable until exercised if at the time of the grant the option has no readily ascertainable value. Upon exercise, option plans are taxed on the difference between the price paid for the option and the exercise price. (CUNA supports the view that the transfer of property in option plans takes place at the time of the exercise of the option, not at the time of the grant.) An increasing number of credit unions and other tax-exempt employers have been issuing nonqualified options to executives at discounted prices – for example, offering for $50,000 options that would be worth $100,000 at the time of exercise – and mandating that the options cannot be exercised until a certain date in order to retain the executive until that time. The format allows those executives to foresee the exact point in time at which they will take a tax “hit-- on the option. Many credit unions have found these types of option programs to be a good tool for retaining talented executives.

The proposed changes to the rules on option plans would probably end the use of nonqualified options by tax-exempt employers. The proposed regulations suggest that Section 457(f) limitations would now apply to options for employees of tax-exempts. These limitations result in the elimination of tax deferral by the employee and the inclusion of deferred compensation in the gross income of the employee for the first taxable year in which there is no “substantial risk of forfeiture-- of the rights to the deferred compensation. There is no substantial risk of forfeiture in instances where the options are not conditioned on the future performance of services of the employee or similar conditions. For example, if a credit union agrees on December 1, 2002, to pay an executive a specified amount on January 15, 2005, and there is no substantial risk of forfeiture, the present value of the payment is includible in the individual’s gross income for 2002. When the payment is made on January 15, 2005, the amount includible at that time is the excess of the fair market value of the property paid, less the amount that was includible in gross income in 2002. If, however, the arrangement included a substantial risk of forfeiture until payment in 2005, the property would not be included in the executive’s income until 2005.

CUNA is strongly opposed to this proposal for several reasons, the primary one being the issue of fairness. If taxable entities are allowed to provide their key employees options on a tax-deferred basis, tax-exempt entities should also be given this same treatment. The practical effect of the proposed regulations is a tax increase on certain employees of tax-exempt entities. Those employees are the ones who will bear the brunt of this different treatment. The IRS has not provided an explanation as to why an employee of a tax-exempt entity should not be given the same benefit (via tax treatment) that is given to an employee of a taxable entity. In our view, this action by the IRS appears to be overreaching, as the proposed regulations represent a fundamental change in tax law. Prior to the issuance of the proposed regulations, options were taxed under Section 83; and Section 457 provides that property taxed under Section 83 should not be taxed under Section 457. These regulations, if issued in final form, would produce a result that is not mandated by Section 457. In fact, some credit unions are waiting until this matter is settled to consider the adoption of a new option program. This cannot be a good outcome for employees.

Option plans have served as a valuable tool for credit unions and other tax-exempt employers in designing compensation packages to attract and retain key executives and employees. Compared to deferred compensation plans, option plans provide more diversity and flexibility. Many credit unions and other tax-exempt organizations are concerned that if the proposed regulations effectively eliminate options, it will make it difficult for them to compete for talented executives because they lose the ability to offer them similar option programs that are available in the taxable entity world. CUNA firmly believes that credit unions should continue to have this tool available for employee recruitment and retention.

For tax-exempts that have implemented an option plan, the proposed regulations would create two classes of employees: one class that would be grandfathered as of May 8, 2002, and allowed to retain the options granted to them prior to this date and a second class that would be barred from participation. This inability to grant new options to current and future employees would result in similarly situated employees having materially different compensation arrangements and has the potential for creating significant compensation management issues. For participants who were granted options prior to May 8, 2002, options granted after that date should be grandfathered as well.

In recent years, the employee benefits marketplace has become more sophisticated. Especially in the current economic climate, employees are interested in comprehensive benefit packages. Furthermore, there is increased competition to attract and retain qualified employees. Credit unions and other tax-exempt organizations have certainly have not been immune from this trend. Many tax-exempt employers find themselves competing against for-profit employers for management and employee talent. Taxable entities would not be hindered by these proposed regulations in designing their deferred compensation plans as tax-exempt entities would be. Ideally and in light of no statutory directive to the contrary, employees of for-profit and tax-exempt employers should be treated equally under the Code. Therefore, we urge the IRS to reconsider the proposal relative to coordination between Sections 457(f) and 83 in order to afford fairness to credit unions and other tax-exempt employers.

Thank you for the opportunity to share our comments. If you have any further questions, please contact Mary Dunn ( or Catherine Orr ( at our e-mail addresses or at (202) 638-5777.


Mary Mitchell Dunn
Associate General Counsel

Catherine Orr
Senior Regulatory Counsel