IRS Confirms Tax Consequences of New Vesting Restrictions on Fully Vested Stock
The IRS recently issued Revenue Ruling 2007-49, which provides guidance on the tax consequences of certain transactions involving new vesting restrictions on fully vested stock. This update provides a brief background on Section 83 of the Internal Revenue Code, summarizes the key highlights from the revenue ruling and offers practical tips.
Tax Consequences Under Section 83 of the Internal Revenue Code
Under Section 83(a), when property is transferred in connection with the performance of services, the service provider must recognize ordinary compensation income equal to the excess, if any, of the fair market value of the property over the amount paid for the property, commonly referred to as the “spread.” Section 83(a) requires the service provider to recognize income at the time that the property is either transferable or not subject to a substantial risk of forfeiture, such as vesting. With respect to unvested property, Section 83(b) allows a taxpayer to recognize any spread as income in the year of the transfer by filing an 83(b) election within 30 days of the transfer.
Revenue Ruling 2007-49 Addresses Three Situations
The revenue ruling addresses three scenarios: (1) the imposition of vesting restrictions on fully vested stock, (2) the exchange of fully vested stock for unvested stock of an acquiring corporation in a tax-free reorganization, and (3) the exchange of fully vested stock for unvested stock of an acquiring corporation in a taxable exchange.
New Vesting Restrictions on Fully Vested Stock – Scenario 1. The revenue ruling confirms the IRS's prior analysis in private letter rulings that there is no transfer of property for purposes of Section 83 when vesting restrictions are imposed on fully vested stock, causing the stock to become unvested. The vesting restrictions are entirely ignored for purposes of Section 83, and the service provider does not need to file an 83(b) election to avoid compensation income as the shares vest.
Fully Vested Stock Exchanged for Unvested Stock – Scenarios 2 and 3. The revenue ruling also provides that an exchange of fully vested stock for unvested stock of an acquiring corporation, whether the exchange is a tax-free reorganization or a taxable exchange, constitutes a transfer of property subject to Section 83. In these situations, the service provider must file an 83(b) election to avoid the potential recognition of compensation income in the future as the shares vest. However, the revenue ruling confirms that the spread will be zero, and, accordingly, there should be no downside to the service provider resulting from the 83(b) election.
- Service providers who agree to the imposition of vesting restrictions soon after the issuance of vested stock should exercise caution in relying on the revenue ruling, in particular if the transactions are related. In that situation, service providers may want to file an 83(b) election within 30 days of the original transfer of the stock as a protective measure.
- Where there is an exchange of vested stock for unvested stock, the service provider will almost certainly want to file an 83(b) election to avoid any potential compensation income in the future. Issuers should be sure to adequately disclose the tax consequences of the exchange and the advantages of the 83(b) election to the service provider to best avoid claims by a service provider who fails to timely file an 83(b) election.
- In situations the revenue ruling does not address, such as exchanges of stock in connection with recapitalization or reincorporation transactions (which in many cases will be very similar to the first scenario) and conversions of stock or indebtedness, service providers will generally want to file 83(b) elections. The revenue ruling confirms that there should not be any downside to filing an election.
- Although the revenue ruling describes transactions involving stock, its guidance should generally apply to other types of property transferred in connection with the performance of services, such as interests in partnerships and limited liability companies.
This update is only intended to provide a general summary of Revenue Ruling 2007-49. You can read the full text of Revenue Ruling 2007-49 at http://www.irs.gov/pub/irs-drop/rr-07-49.pdf. You can find discussions of other recent cases, laws, regulations and rule proposals of interest on our website.