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[Ed note: this post is nothing more than me asking questions based on what I know about tax…and what I DON’T know about SEC law. If I’m charging down an incorrect path — or if you happen to be an SEC attorney — please let me know.]

As Facebook grew during its formative years, to avoid reaching a shareholder limit that would have forced them to report their financial statements as if they were a public company, the tech giant switched from issuing stock options to Restricted Stock Units (RSUs) to compensate its employees. As of December 2011, Facebook had 378,772,184 shares of RSUs outstanding.

The granting of restricted stock units — as opposed to the granting of restricted stock — does NOT involve the issuance of actual shares of stock at the time of grant. Rather, after the recipient employee reaches certain pre-determined vesting bogeys, either shares of company stock or cash can be used to “settle” the employee’s right to receive the value of the RSUs. For the remainder of this post, let’s assume all Facebook RSUs will indeed be settled with Facebook stock.

This much I’m certain of: under I.R.C. § 83, when the employee vests in the underlying RSUs and actual shares are issued, the employee recognizes ordinary income equal to the value of the shares less any amounts paid by the employee for the RSUs. In order for an employee to vest in the RSU, the Facebook S-1 provides:

Pre-2011 RSUs granted under our 2005 Stock Plan vest upon the satisfaction of both a service condition and a liquidity condition. The service condition for the majority of these awards is satisfied over four years. The liquidity condition is satisfied upon the occurrence of a qualifying event, defined as a change of control transaction or six months following the completion of our initial public offering.

Assuming most employees have met the service condition (and the S-1 seems to indicate they have), all employees who received pre-2011 RSUs will vest and receive their Facebook stock six months after the IPO date of Friday, May 18th.  Each employee will recognize compensation income at that time equal to the FMV of the shares less any amount paid for the stock.

Here’s where my SEC knowledge may be leading me astray.

Under  Rule 144, once Facebook has been subject to public company reporting requirements for at least 90 days, any person who is not deemed to have been an “affiliate” for purposes of SEC law at any time during the 90 days preceding a sale and who has beneficially owned the shares proposed to be sold for at least six months, is free to sell those shares. The Facebook S-1 further provides:  

The shares of common stock that were not offered and sold in our initial public offering as well as shares underlying outstanding RSUs will be upon issuance, “restricted securities,” as that term is defined in Rule 144 under the Securities Act. These restricted securities are eligible for public sale only if they are registered under the Securities Act or if they qualify for an exemption from registration under Rule 144 or Rule 701 under the Securities Act, which are summarized below.

Putting this all together, does this mean that the RSUs issued to employees upon vesting six months after the IPO date cannot be sold for another six months?

This is an important question, because based on my understanding of the relevant case law and underlying congressional reports, the Rule 144 restriction is not considered a restriction on transferability worthy of postponing the recognition of income under Section 83. As a result, the employees would be required to recognize compensation income upon receipt of the stock on November 18, 2012, even though they cannot sell it pursuant to Rule 144 for an additional six months. This would lead to two problems:

 1. The employees would not be able to sell the stock in order to pay the tax on the compensation income recognized upon vesting. It appears this concern is being mitigated by Facebook’s decision to net-settle the RSUs, selling enough stock to cover the employee’s tax burden and only issuing the “net” shares to the employee.

2. There is a risk that the value of the stock on the vesting date will exceed the value six months later, when the shares can be freely traded. If that is the case, the employees will have recognized ordinary income to the extent of the higher value, with an offsetting capital loss which may provide no immediate tax benefit — or only a 15% benefit by offsetting long-term capital gains.

Understand, I don’t think this is what’s going to happen, but I can’t be certain. It appears based on discussions on the Internet — and when have anonymous web comments ever led us astray?  — that the vested RSUs will be free to be sold immediately upon vesting in November, so the issues I identified may be completely moot. It’s completely dependent on the application of Rule 144, which is where my comfort level dissipates.

So please, if you can add some clarity to the topic, do so in the comments.

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Perhaps we’re looking into this a bit too much, but we found the Tax Court’s decision this Thursday in Kilker v. Commissioner, 2011-250 to be a bit curious.

In Kilker, the taxpayer (Kilker) was the owner and operator of Allegra Print and Imagining, a printing shop. Kilker was Allegra’s CEO during 2003 and 2004. In 2003, in exchange for providing Zap Corp. (Zap) with printing services, Kilker received 73,529 shares of Zap stock. The stock was restricted stock pursuant to SEC rule 144, meaning Kilker could not sell or transfer the stock for at least 1 year. In 2004, at the end of the 1-year holding period, Kilker sold 30,000 shares for a total of $90,290.

Kilker failed to file a tax return for 2004. The IRS recreated Kilker’s 2004 tax return, and reported the $90,290 as capital gain. The Tax Court agreed:

Section 61(a) defines gross income as all income from whatever source derived. Section 61(a)(3) specifically includes in income gains derived from dealings in property. Respondent argues that petitioner received $90,290 from the sale of 30,000 shares of Zap stock in 2004. To satisfy his initial burden of production with respect to petitioner’s capital gain income of $90,290, respondent provided the Court with a Form 1099-B, Proceeds From Broker and Barter Exchange Transactions, and trade confirmations from Edward Jones confirming the information reported on the Form 1099-B. Petitioner has failed to present any evidence to dispute she received this amount or any evidence of her basis in the shares of stock. Accordingly, we sustain respondent’s determination with respect to the capital gain income.

Seems simple enough. But here’s what we’re wondering: Why didn’t the IRS and the Tax Court include the income related to the Zap stock in Kilker’s 2003 tax year,when it was received in 2003, rather than when it was sold in 2004?

When a taxpayer receives stock in exchange for services, the inclusion of the value of the stock in the income of the recipient is governed by Section 83. Generally, stock received in exchange for services is taxable upon receipt for an amount equal to its FMV less any amount paid by the taxpayer for the stock. However,  if the stock received is 1) subject to a substantial risk of forfeiture, and 2) not freely transferable, Section 83 defers the taxation of the stock until the stock is no longer subject to a substantial risk of forfeiture and is freely transferable.

In Kilker, the taxpayer received the Zap stock in 2003 subject to SEC Rule 144, which prohibits the sale of the unregistered stock on the public market for 1 year. Now, it may sound like this is a sufficient restriction on transferability to defer income recognition on the receipt of the Zap stock from 2003 (when the stock was granted) until 2004 (when the restriction lapsed under Rule 144 and the stock was sold). However, the District Court of California and the Ninth Circuit have recently held that the restriction on transferability under Rule 144 does not constitute a significant enough restriction to defer income under Section 83, echoing the position tax advisors have adhered to for years based on the general structure and language of Section 83.

In Gudmundsson v. U.S.,107 AFTR 2d 2011-852 (634 F.3d 212), 02/11/2011, the taxpayer (Gudmundsson) received stock options on July 1, 1999 that were subject to several constraints. The Ninth Circuit discussed the Rule 144 element of the constraints as follows:

First, these were “restricted securities” under Securities and Exchange Commission (“SEC”) Rule 144 meaning they were acquired directly from the issuer and not in a public offering, id. Under Rule 144, the Stock could not be sold on a public exchange until the expiration of a holding period that, in Gudmundsson’s case, ended on July 1, 2000. The Stock could, however, be disposed of in a private placement sale or pledged as security or loan collateral.

The Ninth Circuit ultimately concluded that the options were taxable on July 1, 1999, the date of receipt, despite the fact that Rule 144 barred the sale of the options on the public market until July 1, 2000:

The Stock was not subject to a substantial risk of forfeiture on July 1, 1999, and although this is enough for income recognition under  Section 83, we briefly address plaintiffs’ arguments regarding the transferability of the Stock, as well. Plaintiffs assert, however, that the Stock was not transferable because “in reality, … [t]he various restrictions imposed by law and agreement made [the Stock] impossible to sell.” Regardless of whether this is true, the argument misunderstands what Section 83 requires. Transferability is not just a question of marketability. In fact, even if sales are prohibited for a period of time, property may be transferable if it can be pledged or assigned.

To summarize, the district court was correct to recognize the Stock as income on July 1, 1999, as the Stock was transferable and not subject to a substantial risk of forfeiture on that day. This conclusion was correct under Section 83(a) and in general, as income in whatever form is taxable in the year in which it is received.

This begs the question: with authority like Gudmundsson out there, why didn’t the Tax Court in its decision in Kilker inlcude the income generated from the receipt of Zap stock in 2003 when it was received? Why did it wait until the stock was sold in 2004?

Clearly, under the principles established in earlier case law, the mere presence of the Rule 144 restriction on the sale of the Zap stock should not have prevented the IRS from including the FMV of the Zap stock in Kilker’s income in 2003. Perhaps there was some other substantial risk of forfeiture that was stipulated between the two parties and was not disclosed in the court documents. Or perhaps by the time the IRS caught wind of Kilker’s failure to file her 2004 tax return, the statute had run on the 2003 return, which apparently was filed. Otherwise, it would seem the IRS missed an opportunity to tax the income in 2003, and potentially increase the amount included in Kilker’s income if the stock price was higher upon receipt in 2003 that upon sale in 2004.

Any thoughts?

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