Having procured a document scanner, IRS has eliminated the requirement that taxpayers enclose Internal Revenue Code Section 83(b) elections with their income tax returns. When a taxpayer receives property (such as stock or LLC interests in an employer) in exchange for services, the taxpayer normally recognizes the fair market market value of the property as ordinary (regular tax rate) income in the year the property is transferable or is vested (i.e., not subject to forfeiture). A taxpayer can, however, accelerate recognition of income by filing a Section 83(b) election with IRS within thirty days of receiving the property. By doing so, the taxpayer can recognize the property’s value as ordinary income when first granted (when the value may be low) and start his or her long-term capital gain holding period sooner (so the taxpayer is more likely to recognize lower-tax-rate long-term capital gain on a larger portion of gain when the property is later sold). Previously, a Section 83(b) election was valid only if a copy was enclosed with the taxpayer’s income tax return for the year of the election, in addition to filing the election within thirty days of receiving the property. IRS required this because they could not match originally-filed elections with taxpayer tax returns. The absolute rule unfortunately proved a frequent trap for unorganized taxpayers who forgot to include the elections with their tax returns, even though they timely filed original elections. In recent years, some commercial electronic tax filing services had difficulty creating a means for their customers to include Section 83(b) elections with electronically filed returns. This caused some taxpayers to file paper income tax returns just to make sure their Section 83(b) elections were valid. In response to concerns surrounding this issue, IRS created a document scanning process that enables the agency to better match Section 83(b) elections with taxpayer returns, obviating the need to include the elections with taxpayers’ income tax returns. Document scanning is not a new technology. It is disappointing that common sense did not prevail long ago. The taxpayer “trap” has existed for years, but the “fix” only came about when the process became an administrative hassle for IRS. Nevertheless, the new approach is a positive step in tax administration, and we welcome the change. Here is a link to the Proposed Treasury Regulations, effective January 1, 2015: http://www.gpo.gov/fdsys/pkg/FR-2015-07-17/pdf/2015-17530.pdf
Treasury recently finalized Regulations under Code Section 83, which governs the taxation of the transfer of property (such as shares of stock, partnership interests, options, or warrants) to persons in exchange for services. Under these rules, the taxable event to the recipient generally occurs upon the earlier of the property being transferrable or when the property is not subject to a substantial risk of forfeiture. The final regulations modify Section 1.83-3(c) to clarify that a substantial risk of forfeiture may be established “only” through a service condition or a condition related to the purpose of the transfer. In determining whether a substantial risk of forfeiture exists, both the likelihood that the forfeiture will occur and the likelihood that the forfeiture will be enforced must be considered. Also, a transfer restriction that provides for the forfeiture or disgorgement of all or a portion of the property in the event of a violation of the restriction generally does not create a substantial risk of forfeiture. Finally, the final regulations incorporate the holding of Revenue Ruling 2005-48 by providing that the only provision of the securities law that would delay taxation under Code section 83 would be if a sale of the property could subject the seller to liability under Section 16(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) (which generally prevents corporate insiders from purchasing and selling corporate securities within 6 months). The final regulations add examples illustrating that a substantial risk of forfeiture is not created solely as a result of potential liability under Rule 10b-5 of the Exchange Act (relating to fraud or insider trading) or as a result of a lock-up agreement.
If you have questions regarding the final regulations or the tax treatment of granting equity interests in corporations or tax partnerships or options to acquire equity interests in exchange for services, please contact: