It is common for key employee shareholders to retain an interest in the target business following either a taxable or tax-free acquisition. In many cases, the key employees’ stock is either converted into or exchanged for stock that vests over time based upon the shareholders’ continued employment with the target or the acquirer. Such stock is commonly referred to as “restricted” or “substantially nonvested” stock. The receipt of restricted stock is generally treated as a taxable event under Sec. 83 when the transfer is made in connection with the performance of services.
For many years, the application of Sec. 83 to an employee’s conversion or exchange of “fully vested” or “unrestricted” shares for restricted shares has been unclear. For example, has a transfer been made in connection with the performance of services when a restriction is placed on previously unrestricted shares? What about when restricted shares are received in exchange for unrestricted shares in a taxable or tax-free reorganization, particularly when other shareholders receive unrestricted stock of an equal value (ignoring discounts)? Rev. Rul. 2007-49 provides much-needed guidance and some answers to the questions raised above; however, many still remain unanswered. Specifically, the ruling is conspicuously silent as to the larger issues that may affect the overall impact of restricted stock exchanges in tax-free reorganizations.
Sec. 83 treats a transfer made in connection with the performance of services as an exchange of property (e.g., restricted stock) for the performance of services and requires the recipient to recognize ordinary income equal to the amount by which the fair market value (FMV) of the property received exceeds the amount paid (Sec. 83(a)). In the case of restricted property, the timing and amount of income recognition is dependent on whether a Sec. 83(b) election is made. If no election is made, the exchange is taxed and the property is valued at the time the restrictions lapse. The recipient’s basis in the property will equal its FMV at that time; similarly, the property’s holding period does not begin until the restrictions lapse.
Without a Sec. 83(b) election, the recipient is not deemed the owner of the property for federal income tax purposes until the restrictions lapse (Regs. Sec. 1.83-1(a)(1)), despite the fact that in many cases restricted stock has equal voting and dividend rights to that of unrestricted stock. If a Sec. 83(b) election is made, the recipient is considered the owner of the property upon transfer; however, the exchange is taxed on the day of the property transfer, rather than on the day the restrictions lapse. The recipient’s basis is then equal to the FMV of the property upon transfer, and the holding period likewise begins on the transfer date. While the recipient takes obvious risks in making a Sec. 83(b) election, assuming future appreciation, it effectively defers income recognition on the appreciation until disposal of the stock and replaces future ordinary income with capital gain.
In Connection with the Performance of Services
For Sec. 83 to apply to a transaction, the property must be transferred in connection with the performance of services, as determined by all the facts and circumstances. The courts cast the Sec. 83 net broadly and do not limit its application to compensatory grants. Any relationship between the services performed and the property transferred generally indicates that a compensatory transfer has occurred, and the placement of buyback restrictions on the stock, which are contingent on employment, may be sufficient by itself to establish this (see Montelepre Systemed, Inc.,TC Memo 1991-46, aff’d, 956 F2d 496 (5th Cir. 1992); Alves, 734 F2d 478 (9th Cir. 1984), aff’g 79 TC 864 (1982); Regs. Sec. 1.83-2(a)).
Further, a compensatory transfer can occur regardless of whether the employee pays fair value for the stock (Alves; Regs. Sec. 1.83-2(a)). However, the regulations provide that the existence of other persons (e.g., nonemployee shareholders) entitled to buy stock on the same terms and conditions indicates that Sec. 83 does not apply (Regs. Sec. 1.83-3(f)). Based on Sec. 83’s broad application, it is easy to understand how the conversion or exchange of unrestricted shares for restricted shares may be considered to fall within the statute, especially when restrictions are contingent on employment. Clearly there are no easy answers.
Issues Arising from Tax-Free Exchanges
If one presumes that a tax-free exchange was made in connection with the performance of services and Sec. 83 applies, significant collateral issues arise. For example, as noted above, Sec. 83 provides specific rules for determining a stock’s basis and holding period. However, the tax-free reorganization provisions have similarly specific rules. In a tax-free reorganization described in Sec. 368(a), a shareholder’s exchange of stock is tax free under Sec. 354, the stock received has a carryover basis under Sec. 358, and the holding period of the exchanged stock is tacked onto that of stock received in the exchange under Sec. 1223. Clearly the two sets of rules are at odds, and a balanced approach is needed. What is the proper mix of carryover basis and step-up related to income recognition and between the historical holding period and the new period beginning with vesting? Despite numerous reasonable methods put forth by practitioners and commentators, no guidance has been provided by Treasury or the IRS. (See, e.g., Levin, Rocap, and Ginsburg, “Surprising Tax Issues for Shareholder-Execs Receiving Unvested Stock for Vested Stock in Reorg,” 89 Tax Notes 1289 (12/4/00).)
The confusion of Sec. 83’s application to tax-free exchanges is further exacerbated by restricted stock’s effect on continuity of proprietary interest (COI). A fundamental principle in tax-free reorganizations, COI requires target shareholders to receive significant qualifying consideration (i.e., stock or securities) in the acquiring corporation. The IRS and Treasury announced in the preamble to the final COI regulations issued in September 2005 that they were continuing to consider the appropriate treatment of restricted shares in determining COI (TD 9225). Why the uncertainty? With respect to COI, the key question is whether the restricted shares are outstanding and can therefore count toward continuity.
The IRS’s practice is to generally treat restricted stock for which a Sec. 83(b) election is in place as outstanding. (See, e.g., Letter Ruling 9712029 and Chief Counsel Advice 199944001 in the consolidated group context; but see Letter Ruling 9422048 with respect to a Sec. 382 ownership change.) However, it seems perfectly reasonable to count restricted stock toward continuity when restricted shares have identical voting rights and dividend rights as non-restricted shares. Certainly the holders of restricted shares have a proprietary interest in the acquirer if they can vote and receive dividends. But what if the restricted shares never vest and the holders never acquire “true” ownership rights? Thus, the confusion.
Rev. Rul. 2007-49 addresses some of the issues raised above and specifically addresses Sec. 83 in three different scenarios. The first considers the placement of restrictions on previously unrestricted shares. The final two scenarios consider the exchange of unrestricted shares for restricted shares in a taxable and a tax-free transaction, respectively. The following examples address each scenario in turn.
Example 1—Restrictions on unrestricted shares: A private equity group (PEG) invests in the target corporation. A condition of the investment is that certain management shareholders agree to subject their unrestricted shares to restrictions that result in the shares’ becoming substantially nonvested. The ruling holds that subjecting unrestricted stock to a restriction is not a transfer of property; therefore, Sec. 83 cannot apply to the conversion. This conclusion is consistent with Letter Ruling 200212005, in which the IRS ruled on a similar transaction.
Example 2—Receipt of restricted stock in exchange for unrestricted stock in a taxable transaction: A PEG or strategic buyer acquires a target corporation in a fully taxable transaction. In exchange for his fully vested shares with a basis of $10, shareholder X, an executive of the target, receives restricted shares valued at $100. Other nonemployee shareholders receive fully vested shares. The restrictions placed on X’s shares enable the acquirer to buy back the restricted shares if X’s employment is terminated for any reason within three years. The buyback price is the lesser of $100 or the stock’s value on the day of the buyback. X completes three years of service. The value of the shares when the restrictions lapse is $200. Two years after vesting, X leaves the company and sells his shares for $400.
Rev. Rul. 2007-49 holds that the exchange described above was made in connection with the performance of services, so Sec. 83 applies. This conclusion was reached despite X’s receiving the same consideration as a nonemployee shareholder. Regardless of the application of Sec. 83, each shareholder’s initial exchange is taxable under Sec. 1001. X recognizes capital gain to the extent the FMV of property received ($100) exceeds X’s basis in the shares sold to the purchaser ($10). Therefore, X recognizes capital gain on the exchange of $90. When the restrictions lapse, X recognizes compensation under Sec. 83 equal to the amount by which the restricted shares’ value upon vesting ($200) exceeds the value of the amount paid (i.e., the value of the target shares given up in return for the restricted shares ($100)). Therefore, X recognizes compensation of $100 ($200-$100) when the restrictions lapse. When the shares are sold two years later, X recognizes capital gain equal to the amount realized ($400) over X’s basis in the shares (i.e., the value upon vesting ($200)). As such, X’s capital gain is $200.
If X makes a Sec. 83(b) election, the answer is decidedly better. He would recognize income on the day of transfer to the extent the value of the restricted stock ($100) exceeds the amount paid (i.e., the value of the stock transferred ($100)). This is of course zero, and X does not recognize any compensation with respect to the restricted stock. X recognizes no income at vesting and will recognize a capital gain upon disposal of the shares of $300 ($400 received over the amount paid for the shares of $100). By making the Sec. 83(b) election, X eliminated the ordinary income recognition of $100 and was taxed on all future appreciation at preferential capital gain rates.
Alternatively, if the stock had depreciated, X would not have been in a worse position than if no Sec. 83(b) election had been made because no additional income was recognized. The example demonstrates that the Sec. 83(b) election has no apparent downside on such a transaction.
Example 3—Receipt of restricted stock in exchange for unrestricted stock in a tax-free reorganization: Assume the same facts as above except that the target corporation is acquired in a tax-free Sec. 368(a) reorganization, X receives restricted shares worth $100, and X makes a Sec. 83(b) election.
Not surprisingly, the ruling holds that this transfer was also made in connection with the performance of services to which Sec. 83 applies. However, in this case no gain is recognized on the exchange. The ruling provides that the exchange of target stock for restricted stock is tax free to X and no gain or loss is recognized. The Sec. 83(b) election also does not result in income recognition because the FMV of the restricted shares on the day of transfer ($100) is equal to the amount paid (i.e., the value of shares given up ($100)). The ruling further states that upon ultimate sale, capital gain is recognized based on the shareholder’s basis in the stock given up. The basis in the stock is not stepped up to the FMV due to the Sec. 83(b) election but remains $10. There is again no apparent downside in making a Sec. 83(b) election because the carryover basis insulates the shareholder from any risk associated with the election.
The examples from the ruling demonstrate a number of key points. First, consistent with previous guidance, a restriction placed on already fully vested shares is not a Sec. 83 event. Second, an exchange of unrestricted shares for restricted shares in either a taxable or tax-free transaction can be subject to Sec. 83. The third key point is that there is no downside to making a Sec. 83(b) election in such a transaction. A timely election (when applicable) is essential, as the tax situation of the recipient is substantially improved with the making of a valid election.
The transferring shareholder in a tax-free reorganization has a carryover basis in the newly received restricted shares when a Sec. 83(b) election is made (see Example 3 above). One can assume that the restricted stock is received in an exchange under Sec. 368(a), for which Secs. 354 and 358 must then apply. Basis in the shares is not stepped up to the FMV of the shares on the day of transfer under Sec. 83(a) but is carried over presumably under Sec. 358. If the restricted stock is received tax free, it is also reasonable to assume that the stock is qualifying consideration for purposes of determining whether the tax-free reorganization meets the various requirements, including COI. However, the ruling does not state this specifically, and the facts in the ruling do not provide enough information to conclude that the restricted stock is counted in determining COI for the reorganization. Even more uncertain is the result if no Sec. 83(b) election is made and whether restricted shareholders can contribute to COI if they are not treated as owners of the shares for federal tax purposes. Can a restricted share contribute to COI if the recipient is not treated as owner of the share for federal tax purposes? With or without a Sec. 83(b) election, is the stock “good consideration” upon receipt, and, if so, is COI tested again upon the forfeiture of the stock?
Rev. Rul. 2007-49 provides valuable guidance in determining whether Sec. 83 applies to the receipt of restricted stock in taxable and tax-free reorganizations. However, many questions remain unanswered. Until further guidance is received, it would be wise to structure tax-free reorganizations in a manner that satisfies COI without relying on the restricted shares as good consideration.
Nick Gruidl, CPA, MBT, Managing Director, National Tax Department, RSM McGladrey, Inc., Minneapolis, MN
Unless otherwise indicated, contributors are members of RSM McGladrey, Inc.
If you would like additional information about these items, contact Mr. Gruidl at (952) 893-7018 or firstname.lastname@example.org.