The IRS will soon be publishing Revenue Procedure 2002-29, which will add some clarity to the risks of making a I.R.C. § 83(b) election while also providing some helpful sample language. Let’s get right to the Q&A:
Q: Remind me what I.R.C. § 83 says?
A: That’s really not a question, it’s more of a directive, but fine. We’ve covered it here and here, but in general, I.R.C. § 83 provides that if you provide services for someone (whether past, present, or future) and that person compensates you by paying you in property, the excess of the FMV of the property over the amount you paid to acquire it is taxed as compensation income.
Example 1: You provide services for your employer. Your employer, in turn, pays you in unrestricted, freely transferable stock valued at $100 and requires you to pay $0 to obtain the stock. Under I.R.C. § 83, you will recognize ordinary income of $100 upon the receipt of the stock.
Q: So then what’s a Section 83(b) election?
A: Here’s the catch. Under I.R.C. § 83, the service provider (you) are only taxed on the property you receive when that property is EITHER:
1. no longer subject to a substantial risk of forfeiture, or
2. freely transferable.
This is a concept that confuses many tax advisers. Property must be subject to BOTH conditions in order for the recipient to defer the recognition of taxable income. The moment the property either becomes transferable or no longer subject to a substantial risk of forfeiture, the recipient must recognize taxable income.
Q: So you get to defer the income? Isn’t that a good thing?
A: Contrary to popular opinion, income deferral — like Radiohead and Johnny Depp – isn’t always great. Here’s the thing…under the general rule of I.R.C. § 83, when the property becomes either freely transferable or no longer subject to a substantial risk of forfeiture, the service recipient (you) will be taxed on the FMV of the property at that time. Thus, if the value has increased substantially from the date it was first granted to you until the date the restrictions lapse, you will pay for your deferral with an increased income recognition.
Example 2: If the $100 in stock in Example 1 was subject to a substantial risk of forfeiture — i.e., you were required to remain employed for 2 years in order to “vest” in the property — you would not be taxed upon receipt of the $100 in stock in year 1. Instead, your income would be deferred until you vested in year 3. At that point, if the value of the stock had increased to $400, you would be required to recognize $400 of compensation income, as opposed to the $100 in the previous example.
Q: So where does the election come in?
A: Section 83(b) and Treas. Reg. § 1.83-2(a) permit the service provider (you) to elect to include the excess of the FMV of the property at the time of transfer over the amount paid for the property as compensation for services at the time of the transfer, rather than when the restrictions lapse. Thus, in Example 2, even though the stock did not vest until year 3, you could elect under I.R.C. § 83(b) to include the $100 in income in year 1.
Q: Why would you choose to accelerate income?
A: Because in some situations, as illustrated above, if you don’t make the election, you will recognize more ordinary income when the property vests if the FMV of the property increases. In other words, when you make an I.R.C. § 83(b) election, you are betting that the value of your nonvested property will increase. By making the election, you are capping your ordinary income at the FMV on the date of transfer. Any subsequent appreciation will only be recognized upon a subsequent disposition of the property, likely as capital gain.
Q: You said something in the intro about risks. What’s the downside?
A: The downside is obvious, and quite painful. If you make an I.R.C. § 83(b) election to include the FMV of restricted property in income at the date of grant and the value subsequently decreases, well…then you just voluntarily accelerated more income than necessary. It is, as I said, a gamble.
Q: Any other risks?
A: There sure are. Say you don’t actually vest in the property; for example, you don’t put in the two years required to vest in the stock in the illustration above. The regulations provide that you don’t get a deduction for the amount you voluntarily took into income; rather, you may recognize a loss equal to the amount paid for the property less any amount realized on the sale.
To illustrate just how painful this can be, assume you made the election to include the stock worth $100 in income in year 1, expecting the value to increase before you vested in year 3. You decide to leave the company in year 2, however, and never vest, forfeiting the property back to your employer for no consideration. Your loss is limited to $0 (the amount you paid for the stock), even though you included $100 in taxable income. Ouch.
Q: When/How do I make the election?
A: An election made under I.R.C. § 83(b) must be filed with the Internal Revenue Service no later than 30 days after the date that the property is transferred to the service provider. This is done so as not to give you the benefit of too much in the way of hindsight as to the change in value of the restricted property.
The election is made by filing a copy of a written statement with the Internal Revenue Service office with which you file your return. In addition, you’re required to submit a copy of such statement with your income tax return for the taxable year in which such property was transferred. The statement must be signed by the person making the election and must indicate the election is being made under I.R.C. § 83(b). The statement must include the following information: the name, address and taxpayer identification number of the taxpayer; a description of each property with respect to which the election is being made; the date or dates on which the property was transferred and the taxable year for which such election is being made; the nature of the restriction or restrictions to which the property is subject; the fair market value at the time of transfer of each property with respect to which the election is being made; the amount, if any, paid for such property; and a statement to the effect that copies have been furnished to other persons as provided in Treas. Reg. § 1.83-2(d).
Q: So what did Revenue Procedure 2012-29 add?
A: Not much. The RP added some clarity, but mostly provided sample language that can be used in making the election, likely because the IRS has read your Facebook status updates and realized that rudimentary writing skills have gone the way of the dodo.
For text of the sample election, click RP 2012-29.
Excellent Radiohead, J. Depp and F-book references….
My experience with this election has been in most circumstance I cannot see the advantage in recognizing income before it is vested. Unless it is a start-up company situation and the fair-market value is diddly squat. If anyone has a different take on it or had it work for them I would love to hear it. I have never had a taxpayer that would have benefitted if the election would have been made.
I do not like this election personally, I feel if you recognize income you should have “basis” and therefore a loss if you do not vest – if you do vest then you use the income recognized as basis so why doesn’t it work in reverse. I know the concept of for every tax benefit there is a tax detriment but I still don’t like it, it seems too punitive to my tiny brain.
I have not read the new rev proc and now that you have explained that there is not much to it I won’t bother reading it until I have to – so thanks for saving me some valuable time
I’m thinking of making the 83(b) election since I have expiring foreign tax credits in my general limitation income basket. Assume I have $100 of deferred compensation next year which will be subject to foreign tax when it vests in 3 years. If I make the 83(b) election, the $100 of deferred compensation is currently taxed in the US. Assuming I have additional $300 income taxed at an average rate of 40% ($120 tax), this brings my average foreign tax rate down to 30% on my overall $400 foreign source income. In turn, this would allow me to soak up some otherwise expiring foreign tax credits so I don’t have any residual US tax.
The downside discussed above (no tax deduction if the deferred compensation doesn’t vest) doesn’t really apply since I’m not paying more tax in the current year. The upside is obviously capital gains tax rates on any increase in value on the underlying deferred compensation amount (held in stock).
Also would be interesting if the future 40% foreign tax on any increase in value of the deferred comp (say from $100 to $150) could be used as a FTC against my lower taxed foreign capital gains. This would reduce the build-up of general limit basket excess FTCs in future years, which will occur at vesting.
I’ve not researched this in detail but seems like a potential interesting use of my otherwise expiring FTCs.
[...] so well received as a means to understanding challenging concepts such as carried interests and Section 83(b) elections, I figure it’s also the best way to communicate my particular brand of parenting [...]