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If purchasing stock shares of a company via a promissory note, Sec. 1.83-3(a)(2) states that "if the amount paid for the transfer of property is an indebtedness secured by the transferred property, on which there is no personal liability to pay all or a substantial part of such indebtedness, such transaction may be in substance the same as the grant of an option" (see https://www.law.cornell.edu/cfr/text/26/1.83-3).

Having the transaction not be treated as an option grant is important because then the long term capital gains holding period doesn't start which can result in a much higher tax paid if the shares appreciate and are sold eventually.

What percentage of the indebtedness must be secured personally to count as "substantial"?

Is there any case law or regulation that authoritatively establishes that definition in this context that someone could point to, or if not, how is this percentage arrived at?

Back in January 2010 when http://www.thetaxadviser.com/issues/2010/feb/unexpectedtaxconsequencesofbuyingemployerstockwithloanproceeds.html was written, it discussed there being no clear guidance with some practitioners saying 50% and some saying higher and some saying lower, but I wonder if either that was incorrect or if things have become clarified since then. What's ironic is that the IRS uses a far lower number for "substantial" when it's in the context of a person or entity not paying taxes.

  • It would be appropriate to note that you are referring to the Treasury Regulations issued pursuant to the Internal Revenue Code of the United States, as opposed to state or non-U.S. law. – ohwilleke Nov 26 '16 at 15:16
  • In the context you cite to "substantial" probably means anything more than nominal. Keep in mind that any transaction involving "non-recourse debt" is highly suspicious and should generally be avoided. A true debt involves personal liability or the economic equivalent of personal liability. – ohwilleke Nov 26 '16 at 15:21
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If there is no definition in the statute then "substantial" means what it means in English:

Of real worth and importance; of considerable value; valuable. Belonging to substance; actually existing; real; not seeming or imaginary; not illusive; solid; true; veritable.

It is likely that the IRS or a court would look at all of the percentage, the dollar value and the proportion it represents of the taxpayers liability. Substantial to an individual is unlikely to be substantial to CitiBank.

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