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.

Additional Information

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.