In Revenue Ruling 2007-49, the Internal Revenue Service clarified the income tax consequences under section 83 of the Internal Revenue Code if restrictions are imposed on substantially vested stock causing that stock to become substantially nonvested.
Section 83(a) provides that an employee who receives vested property in connection with the performance of services has gross income in an amount equal to the excess of the fair market value of the property over the amount the employee paid for the property. If the property is subject to a substantial risk of forfeiture or transferability restrictions (i.e., nonvested), the employee is not taxed until the property is no longer subject to a substantial risk of forfeiture and the transferability restrictions lapse (i.e., property vests), unless the employee elects to accelerate the taxable event to the time of the transfer by filing a section 83(b) election.
The ruling addresses the following three situations:
- An employee owns vested stock that becomes unvested as a result of the imposition of restrictions in a later taxable year;
- An employee owns vested stock that is exchanged for unvested stock of another corporation in a tax-free reorganization in a later taxable year; and
- An employee owns vested stock that is later exchanged for unvested stock of another corporation in a taxable transaction in a later taxable year.
In the first situation, an investor agrees to invest in Corporation X in exchange for stock and the further requirement that Employee A agrees to subject his Corporation X stock to a restriction that will cause the stock to become nonvested. Because A already owns the vested stock of Corporation X, there is no transfer for purposes of section 83. Thus, (1) the imposition of new restrictions on vested stock has no effect for purposes of section 83; and (2) the employee does not need to file a section 83(b) election. When the nonvested Corporation X stock vests, Employee A does not recognize compensation income.
In the second situation, Employee A exchanges his vested Corporation X stock for nonvested Corporation Y stock in a tax-free reorganization. Because the vested Corporation X stock is exchanged for nonvested stock, the nonvested stock is treated as having been transferred in connection with the performance of services, and thus, is subject to section 83. The "amount paid" for purposes of section 83 is the fair market value of the vested stock on the exchange date. Employee A elects to file a section 83(b) election. On Employee A's tax return for the year of the exchange, Employee A does not report any income from the transfer of Corporation Y stock because (1) the exchange was tax-free; and (2) the fair market value of the stock is equal to the amount paid. When the nonvested Corporation Y stock vests, Employee A will not recognize compensation income because of the prior section 83(b) election. The Revenue Ruling does not address the tax consequences if Employee A does not file a section 83(b) election but presumably Employee A would recognize compensation income when the Corporation Y stock vests to the extent that the fair market value of the Corporation Y stock at that time exceeds the amount paid for the stock.
In the third situation, Employee A exchanges half of his vested Corporation X stock for cash and half for Corporation Y stock in a taxable transaction. Because the exchange is taxable, Employee A recognizes capital gain on the disposition of the Corporation X stock. In addition, because the vested Corporation X stock is exchanged for nonvested stock, the nonvested stock is treated as having been transferred in connection with the performance of services, and thus, is subject to section 83. The "amount paid" for purposes of section 83 is the fair market value of the vested stock on the exchange date. The Revenue Ruling provides that if Employee A files a section 83(b) election, Employee A will neither (1) report any taxable income from the transfer of Corporation Y stock because the fair market value of the stock is equal to the amount paid nor (2) recognize compensation income when the nonvested Corporation Y stock vests. The Revenue Ruling provides that if Employee A did not file a section 83(b) election, Employee A would recognize compensation income when the Corporation Y stock vests to the extent that the fair market value of the Corporation Y stock at that time exceeds the amount paid for the stock.
In short, the Revenue Ruling holds that the imposition of restrictions on vested stock that causes such stock to become nonvested is not subject to section 83 in the absence of an exchange of stock. However, if the vested stock is exchanged for nonvested stock, the nonvested stock is subject to section 83.
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