On Tuesday, the IRS issued proposed regulations that would clarify some key points under I.R.C. § 83 that could affect many taxpayers. As we like to do around here, we’ve summarized the proposed regulations in the ever-popular Q&A format:
Q: What’s the point of I.R.C. § 83?
A: We’ve discussed I.R.C. § 83 before, but allow me to provide a refresher:
If you provide services for someone and get paid in cash, that’s taxable income upon receipt, agreed?
But what if you were paid in property instead, like stock? That should also be taxable to the extent of the value of the property, since it remains remuneration for services, correct?
Continuing along that line of thinking, what if you’re paid in property, but you might have to give that property back in the future if you don’t continue to provide additional services or meet some other condition AND you can’t transfer the property to someone else? In that case, it would seem rather unfair to tax you on the value of the property since it may not remain yours and you can’t even get rid of it.
This is precisely the purpose of I.R.C. § 83, to make sure that when someone who has provided services in the past, or will do so currently or in the future, but is paid in property rather than cash recognizes taxable income on the property received when the time is right.
Q: OK, so when is the time right?
A: With a few exceptions here and there, any property received by a service provider for the provision of past, current, or future services is taxable when EITHER of the following conditions are met:[i]
1. the property is not subject to a substantial risk of forfeiture, or
2. the property is 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: What is the amount and character of the income?
A: In the year that the property first becomes EITHER freely transferable or no longer subject to a substantial risk of forfeiture, the recipient must recognize taxable income equal to the excess of the FMV of the property at that time over any amount paid by the recipient for the property. The excess is taxed as compensation, resulting in ordinary income to the recipient.
Ex: A provides services to X Co. X Co. gives A stock worth $200 in year 1, but the stock is not freely transferable by A, and A must continue to work for X Co. until year 3 in order to retain the stock. In year 3, when A “vests” in the stock, it is worth $400. A must recognize $400 of ordinary income in year 3. [ii]
Q: Alright, that makes sense…but when is property subject to a substantial risk of forfeiture?
A: That’s where the proposed regulations come in. There had been some confusion as to what types of restrictions created a “substantial risk of forfeiture” worthy of deferring income recognition.
In general, the regulations had provided that a substantial risk of forfeiture exists where the recipient’s rights to the property were conditioned upon the future performance (or refraining from performance) of substantial services, or the occurrence of a condition related to a purpose of the transfer, such as the issuer of the property maintaining certain income or revenue levels.
The IRS found that taxpayers were looking to other conditions not contained in the preceding paragraphs as justification for deferral; as a result, the proposed regulations clarify that a substantial risk of forfeiture exists ONLY where there is a service condition present, or another condition related to the purpose of the transfer.
Q: You lost me on the “condition related to the purpose of the transfer” part. Can you explain?
A: Say your employer hires you and gives you stock. The stock is nontransferable, and in order to keep it, the employer’s revenue must remain at 90% of what it was prior to the issuance for the next three years. This type of restriction may qualify as a substantial risk of forfeiture.
Before that determination can be made, however, the proposed regulations clarify that consideration must be given to how likely it is that the condition would not be met. If in the example above, the employer was an established seller of a product and there was no reason to believe revenues would dip, the IRS takes the position that the unlikelihood of having to surrender the stock must be taken into consideration, and thus the condition should not constitute a substantial risk of forfeiture. As a result, the stock would be taxable upon issuance.
Q: OK, I’ve got the “substantial risk of forfeiture part” down. What about transferability restrictions?
A: The proposed regs will clarify a common misconception: transfer restrictions do NOT create a substantial risk of forfeiture. Why is that important? Because of property is not transferable but has no other elements of a substantial risk of forfeiture, then both factors necessary for deferral are not present, and the recipient must recognize income upon issuance, even though the property is not transferable.
Q: What about stock that is not transferable under SEC law, like Rule 144 or Section 16(b)?
A: Great question. Section 83(c) and Rev. Ruling 2005-48 have made clear that the only provision of the securities law that would delay taxation under I.R.C. § 83 is section 16(b) of the SEC law. See Treas. Reg. §1.83-3(j) for more.
Q: You’ve done a thorough and all-around excellent job. One last question: When are these proposed regs effective?
A: You’re too kind. The regulations are proposed to apply as of January 1, 2013, and will apply to property transferred after that date.