Sec. 83 in the Context of Contract Manufacturing

By Lori C. Lincolnhol, CPA, and Mark A. Walkotten, CPA, Grand Rapids, MI

Editor: Frank J. O’Connell Jr., CPA, Esq.

Sec. 83, which provides rules for the taxation of property transferred in connection with the performance of services, generally is considered in the context of an employer-employee relationship. However, Sec. 83 has applications outside this conventional framework. As illustrated in the following scenario, Sec. 83 may be applied to successfully defer and possibly reduce taxable compensation to independent contractors, including contract manufacturers.

Example: Company A entered into a comanufacturing agreement with Company B to produce widgets on behalf of B. As part of the agreement, B will place a significant amount of equipment (widget manufacturing assets) at A’s manufacturing facility, which A will use to manufacture the widgets on behalf of B. In addition to the co-manufacturing contract, the parties have also entered into a no-charge lease agreement for the widget manufacturing equipment. At the end of the term of the co-manufacturing contract, B will transfer the ownership of the widget manufacturing equipment to A for a nominal price. During the term of the two agreements, A is responsible for the maintenance, insurance, and all property taxes associated with the equipment. However, B will retain title and will transfer title only upon successful completion of the contract period. How should the receipt of the widget manufacturing equipment by A be treated for tax purposes, and when should income, if any, be recognized?

Application of Sec. 83

To determine the tax treatment of the receipt of the widget manufacturing equipment, both the language in the documents and the overall intent of the parties involved must be examined. In this example, A and B have entered into an arrangement whereby A will provide a service to B. As part of that arrangement, B is providing the equipment necessary for A to provide that service. The bargain purchase of the widget manufacturing equipment was intended to both compensate A and encourage it to complete the full term of the contract.

Regs. Sec. 1.61-2(d)(2) provides that

if property is transferred to an independent contractor, as compensation for services, for an amount less than its fair market value, then regardless of whether the transfer is in the form of a sale or exchange, the difference between the amount paid for the property at the time of transfer and the amount of its fair market value at the time of the transfer is compensation and shall be included in the gross income of the independent contractor.
Thus, under the general rule of Sec. 61, the receipt of the widget manufacturing equipment should be considered additional compensation for services provided. However, as part of the agreement, title to the assets does not transfer from B to A until the end of the term of the co-manufacturing contract. Hence, the transfer of title and full ownership is predicated on the successful completion of the contract, so a substantial risk of forfeiture exists with regard to A’s absolute ownership of the widget manufacturing equipment.

The rules under Sec. 83 must be considered when property is transferred in connection with the performance of services subject to a substantial risk of forfeiture. Under Sec. 83, income resulting from the transfer is not required to be included in gross income until the first tax year in which the rights of the person having the beneficial interest in the property are transferable or are not subject to a substantial risk of forfeiture, whichever is applicable. There are five key statutory requirements in order to invoke treatment under Sec. 83 (versus immediate recognition under Sec. 61):

  1. The transfer must be in connection with the performance of services. Regs. Sec. 1.83-3(f) provides that Sec. 83 applies whenever property is transferred in recognition of the performance of, or the refraining from performance of, services. While Sec. 83 treatment is most often applied in situations in which there is an employer-employee relationship, the language of the section specifically includes independent contractors in a service relationship. Hence, A would meet the first requirement because the co-manufacturing contract forms a service relationship between A and B.
  2. The “property” must be transferred. Regs. Sec. 1.83-3(e) provides that “for purposes of section 83 and the regulations thereunder, the term ‘property’ includes real and personal property other than either money or an unfunded and unsecured promise to pay money or property in the future.” In this case, the items to be transferred are considered property under Sec. 83 because they are machinery and equipment.
  3. The property must be “transferred.” Regs. Sec. 1.83-3(a)(1) defines a transfer as a transaction in which a person acquires a beneficial ownership interest in property. The focus of the term “transfer” is whether a person obtains ownership rights in the property; however, it is obvious that full ownership is not required because then there would be no delay in the taxable event. Under the co-manufacturing and lease agreements, A bears all the benefits and burdens of ownership but lacks absolute ownership because it does not have title to the equipment.
  4. The ultimate ownership of the property must be subject to a substantial risk of forfeiture. Regs. Sec. 1.83-3(c) provides that “[a] substantial risk of forfeiture exists where rights in property that are transferred are conditioned, directly or indirectly, upon the future performance (or refraining from performance) of substantial services by any person, or the occurrence of a condition related to a purpose of the transfer, and the possibility of forfeiture is substantial if such condition is not satisfied.” The classic substantial risk of forfeiture situation is one that predicates full ownership of the transferred property upon the future performance of substantial services. Due to the real possibility that the recipient of the property might not perform the future services, the presence of such an earn-out restriction will normally postpone taxation under Sec. 83 until the restriction lapses. In this scenario, A must perform services for the contract period before full ownership (transfer of title) will occur. Hence, it must provide substantial future services before it will meet the conditions for the transfer of title.
  5. The property must be nontransferable in the recipient’s hands. Regs. Sec. 1.83- 3(d) provides that “the rights of a person in property are transferable if such person can transfer any interest in the property to any person other than the transferor of the property, but only if the rights in such property of such transferee are not subject to a substantial risk of forfeiture.” Hence, if recipients have the ability to transfer the property, they have substantially vested in the property and a substantial risk of forfeiture does not exist. In the present scenario, the property is nontransferable because A does not have title to the widget manufacturing equipment.

Based on this analysis, the transfer of the equipment between B and A would fall under the provisions of Sec. 83. As such, no taxable event with regard to the widget manufacturing equipment occurs until the substantial risk of forfeiture lapses and the title transfers from B to A. Upon the transfer of title, the equipment will need to be appraised to determine its fair market value. A will recognize additional service income to the extent that the fair market value exceeds the nominal amount paid for the assets. Ultimately, B was able to allow A to use the assets for the contract term and, upon completion, transfer those assets to A at a value that is in all likelihood significantly reduced based on the estimated life of most machinery and equipment.


Frank O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, IL.

Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.

For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or

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