The IRS has ruled that in a tax-able merger of corporations or a merger of corporations that qualifies as a tax-free reorganization, Sec. 83 applies to an employee’s transfer of stock in his or her employer corporation in return for stock in the remaining corporation that is subject to employment-related restrictions.
In both of the following scenarios, in exchange for A’s agreement to perform services for Corporation X, in 2004, X issues 100 shares of its stock to A at a fair market value (FMV) of $10 per share. The shares of X stock transferred to A are “substantially vested” within the meaning of Regs. Sec. 1.83-3(b). For the 2004 tax year, the amount included in A’s income under Sec. 83(a) is $1,000 (the FMV of the stock ($10 × 100 shares) less the amount paid ($0)). A’s basis in the stock is $1,000.
Scenario 1: In the first scenario, on August 9, 2010, Corporation Y causes Corporation Z (a newly formed wholly owned subsidiary of Y) to merge into X in a transaction that qualifies as a tax-free Sec. 368(a) reorganization. In the merger, the X shareholders each receive solely 100 shares of Y voting stock in exchange for their X stock, which on that date has an FMV of $310 per share. The shares of Y stock are subject to a restriction that will cause the stock to be “substantially non-vested” within the meaning of Regs. Sec. 1.83-3(b). Under this restriction, if A’s employment with X is terminated for any reason before August 9, 2013, A must sell the Y shares to Y in exchange for the lesser of $310 per share or their FMV at the time of forfeiture. In addition, the shares are nontransferable before that date. No other X shareholder receives Y stock subject to a restriction.
A timely files an election under Sec. 83(b) with respect to the Y stock received in the merger. A continues to be employed by X until August 9, 2013, at which time the FMV of the stock is $500. A sells the stock on October 31, 2014, when the FMV of the stock is $550 per share.
Scenario 2: In the second scenario, the facts are the same as in the first scenario, except that in the merger, half of the X stock is exchanged for cash and half is exchanged for Y stock, the transaction is fully taxable, and all of A’s X stock is exchanged for Y stock.
Sec. 83 provides that if, in connection with the performance of services, property is transferred to any person other than the service recipient, the excess of the property’s FMV, on the first day that the rights to the property are either transferable or not subject to a substantial risk of forfeiture, over the amount paid for the property, is included in the service provider’s gross income. Regs. Sec. 1.83-3(f) provides that property transferred to an employee or independent contractor (or beneficiary thereof) in recognition of the performance of, or the refraining from performance of, services is considered transferred in connection with the performance of services within the meaning of Sec. 83. In addition, subjecting stock to a restriction that will cause it to be substantially nonvested (within the meaning of Regs. Sec. 1.83-3(b)) indicates that the property is transferred in connection with the performance of services, even if the employee pays fair value for the stock. See Alves, 734 F2d 478 (9th Cir. 1984), aff’g 79 TC 864 (1982).
Regs. Sec. 1.83-1(a)(1) provides that property transferred in connection with the performance of services is not taxable under Sec. 83(a) until it becomes substantially vested (within the meaning of Regs. Sec. 1.83-3(b)) in the person to whom the property is transferred. However, Sec. 83(b) provides that any person who receives transferred property in connection with the performance of services may elect to include in gross income, for the tax year in which such property is transferred, the excess of such property’s FMV at the time of transfer (determined without regard to any restriction other than a restriction that by its terms will never lapse) over the amount paid for such property.
Regs. Sec. 1.83-2(a) provides, in part, that the fact that the transferee has paid full value for the property transferred does not preclude a Sec. 83(b) election. If this election is made, the substantial vesting rules of Sec. 83(a) and the regulations thereunder do not apply with respect to such property. An employee who makes an election under Sec. 83(b) is considered to be the owner of the property. See Rev. Rul. 83-22, 1983-1 CB 17.
Scenario 1: In the first scenario, A receives 100 shares of Y stock. Because that stock is subject to an employment-related restriction that causes it to be substantially nonvested, the shares are treated as having been transferred in connection with the performance of services and therefore are subject to Sec. 83. As a result of the Sec. 83(b) election, A becomes the owner of those shares.
The amount paid for the stock under Sec. 83 on the transfer of the Y shares is the FMV of the X stock exchanged ($31,000) on the exchange date, August 9, 2010. On A’s Sec. 83(b) election, $31,000 is treated as the amount paid for the Y stock for purposes of Sec. 83. Therefore, A does not report any taxable income in 2010 from the transfer of the Y stock because the FMV of the stock less the amount paid is $0. A does not include any amount in compensation income in the 2013 tax year when the stock becomes substantially vested because of his prior Sec. 83(b) election. A’s basis in the Y stock continues to be $1,000. On the sale of the shares in 2014, A recognizes a capital gain of $54,000, the amount by which $55,000 ($550 FMV of the stock × 100 shares) exceeds his $1,000 basis in the shares.
Scenario 2: In the second scenario, A exchanges substantially vested X stock for substantially nonvested Y stock with an FMV of $310 in a taxable transaction. Because A disposed of the X stock in exchange for Y stock in a taxable exchange, A recognizes a $30,000 capital gain on the disposition of the X stock ($31,000 FMV of the Y stock ($310 per share × 100 shares) less $1,000 basis in the X stock). A’s basis in the Y stock is $31,000.
For the same reasons as in the first scenario, the Y stock is subject to Sec. 83, and the amount paid for it is $31,000. If A makes an election under Sec. 83(b), he does not report any additional amount of income for the 2010 tax year as a result of the election and does not include any amount in compensation income in the 2013 tax year when the stock becomes substantially vested. A’s basis in the Y stock continues to be $31,000. On the sale of the 100 shares in 2014, A will recognize a capital gain of $24,000, the amount by which $55,000 ($550 sale price × 100 shares) exceeds his $31,000 basis in the shares.
If A had not made a Sec. 83(b) election with respect to the Y stock, when the stock became substantially vested on August 9, 2013, he would include $19,000 in gross income as compensation under Sec. 83(a). This is the amount by which the FMV of 100 Y shares ($50,000, or $500 per share) exceeds the amount A paid for those shares ($31,000). Consequently, A’s basis in the Y stock would be increased by $19,000 to $50,000, per Regs. Sec. 1.83-4(b). On the sale of the 100 shares, A would recognize a capital gain of $5,000, the amount by which $55,000 ($550 sale price × 100 shares) exceeds A’s basis of $50,000 in the shares.
In Rev. Rul. 2007-49, the determination of whether the transfers are subject to Sec. 83 is based primarily on the decision in Alves, above, in which the Ninth Circuit held that in a stock transfer to an employee subject to an employment-related restriction that made it substantially nonvested (within the meaning of Regs. Sec. 1.83-3(b)), Sec. 83 applied to the stock even though the employee had paid the employer FMV for the stock. Although the reorganization-related transfers in Rev. Rul. 2007-49 seem on their face to be quite different from the transfer at issue in Alves, they too involve a stock transfer subject to employment-related restrictions and a payment of FMV for stock (the stock received is “paid for” with the stock transferred), so applying Sec. 83 to reorganization-related transfers based on Alves is not unjustified. Based on this ruling, it seems clear that until the IRS is successfully challenged, it will continue to expand the reach of Sec. 83 to any transaction that its broad language can plausibly be said to cover.
From a practical standpoint, Rev. Rul. 2007-49 also shows the radically different tax consequences that can occur in a transfer subject to Sec. 83 if a transferee taxpayer makes the Sec. 83(b) election (which essentially negates the effect of Sec. 83(a) and makes the transfer subject to tax at the time it occurs). Whether or not a Sec. 83(b) election is appropriate depends on the facts and circumstances of the taxpayer and the transfer, but the effects of making or not making the election should always be analyzed to ensure the proper decision is made. A Sec. 83(b) election must be made no later than 30 days after the transfer date, so practitioners should carefully consider any property transfer that is related in any way to a taxpayer’s employment (as an employee or as an independent contractor) either before or immediately after the transfer occurs to determine what the potential tax results will be if it is subject to Sec. 83. REV. RUL. 2007-49, 2007-31 IRB 239 (7/6/2007).