IRS Addresses Tax Consequence of Vested Stock Becoming Novested Due to Corporate Changes

Scott E. Vincent
Vincent, Fontg & Hansen, L.L.C.
Kansas City

Revenue Ruling 2007-49, 2007-31 IRB, was recently issued by the Internal Revenue Service to address tax consequences of vested stock becoming nonvested under Internal Revenue Code Section 83. The revenue ruling addresses the effects of corporate changes in the context of an employee who had been granted stock in exchange for services. The examples include new restrictions on the employee’s stock imposed by the company’s financing, merger and sale transactions. Each “situation” referenced in the revenue ruling results in the employee’s vested stock becoming nonvested under Section 83.

Background Facts and Applicable Law

The three situations outlined in Revenue Ruling 2007-49 all address the same basic factual background:

Investors form Corporation X in 2004, by contributing $1,000 each to Corporation X in exchange for 100 shares of Corporation X stock. In exchange for Individual A’s agreement to perform services for Corporation X, Corporation X issues 100 shares of its stock to A. The fair market value of the Corporation X stock on that date is $10 per share. The shares of Corporation X stock transferred to A are “substantially vested” within the meaning of Section 1.83-3(b) of the Income Tax Regulations. For the 2004 taxable year, the amount included in A’s income under Section 83(a) is $1,000 (the fair market value of the stock ($10 x 100 shares) less the amount paid ($0). A’s basis in the stock is $1,000.

Section 83 provides that property transferred in connection with the performance of services is included in the service provider’s gross income for the first taxable year for which the rights to the property are either transferable or not subject to a substantial risk of forfeiture. Treasury Regulations Section 1.83-3(f) further provides the existence of other persons entitled to buy stock on the same terms and conditions as an employee, whether pursuant to a public or private offering, may indicate that a transfer to the employee is not in recognition of performance of, or refraining from performance of, services.

Situation One – Financing

The first situation described in the revenue ruling addresses financing from an investor who imposes restrictions on Individual A’s shares:

In connection with its plan to start a new business venture, Corporation X seeks financing from Investor M on July 9, 2007. Investor M agrees to invest funds in Corporation X in exchange for a specified number of shares and the further requirement that A agree to subject A’s shares to a restriction that will cause the stock to be “substantially nonvested” within the meaning of Section 1.83-3(b). Under this restriction, if the employment of A with Corporation X terminates before July 9, 2009, A must sell the shares to Corporation X in exchange for the lesser of $150 per share (the fair market value of Corporation X stock on July 9, 2007) or the fair market value at the time of forfeiture. In addition, the shares are nontransferable before that date. A remains employed with Corporation X, and on July 9, 2009, the fair market value of Corporation X stock is $250 per share.

The IRS concludes that there is no transfer of substantially nonvested stock subject to Section 83 where restrictions on substantially vested stock result in the stock becoming substantially nonvested. The IRS reasons that A already owned the shares for Section 83 purposes, and that there is not a “transfer” under Section 83. As a result, the imposition of new restrictions on the substantially vested shares has no effect. Further, the substantial vesting of A’s shares on July 9, 2009 does not cause A to recognize compensation income under Section 83, and his tax basis in the shares continues to be $1,000.

Situation 2 – Merger

The second situation addressed in Revenue Ruling 2007-49 involves a merger pursuant to which Individual A’s shares are exchanged for new shares that are subject to a restriction:

Corporation Y, a corporation unrelated to Corporation X, agrees to acquire all of the stock of Corporation X. Accordingly, on August 9, 2010, Corporation Y causes Corporation Z (a newly formed wholly-owned subsidiary of Corporation Y) to merge into Corporation X in a transaction that qualifies as a reorganization described in Section 368(a). In the merger, the shareholders of Corporation X receive solely Corporation Y voting stock in exchange for their Corporation X stock. The fair market value of the Corporation X stock on August 9, 2010, is $310 per share.

In the merger, A’s 100 shares of substantially vested Corporation X stock are exchanged for 100 shares of Corporation Y stock subject to a restriction that will cause the stock to be “substantially nonvested” within the meaning of Section 1.83-3(b). Under this restriction, if A’s employment with Corporation X is terminated for any reason before August 9, 2013, A must sell the substantially nonvested Corporation Y shares to Corporation Y in exchange for the lesser of $310 per share (the fair market value of the shares on August 9, 2010) or the fair market value at the time of forfeiture. In addition, the shares are nontransferable before that date. No other shareholder of Corporation X receives Corporation Y stock subject to a restriction.

A timely files an election under Section 83(b) with respect to the substantially nonvested Corp-oration Y stock A receives in the merger. A continues to be employed by Corporation X until August 9, 2013 at which time the fair market value of the stock is $500. A sells the stock on October 31, 2014 when the fair market value of the stock is $550 per share.

The IRS determines in situation two that the exchange of substantially vested Corporation X stock for Corporation Y stock that is subjected to a restriction causes the new shares to be substantially nonvested, transferred in connection with the performance of services, and subject to Section 83. A’s Section 83(b) election results in him becoming the owner of the shares.

The “amount paid” for the stock on the transfer of the substantially nonvested shares is the fair market value of the substantially vested Corporation X stock exchanged for the substantially nonvested Corporation Y stock ($31,000) on the exchange date of August 9, 2010. Effective on A’s Section 83(b) election, $31,000 is treated as the amount paid for the Corporation Y stock. A’s tax return for 2010 does not include taxable income from the transfer of the Corporation Y stock under the Section 83(b) election because the fair market value of the stock is offset by the amount paid. A does not have taxable compensation income in the 2013 tax year when the stock becomes substantially vested because of the prior Section 83(b) election. A’s basis in the Corporation Y stock continues to be $1,000, and the sale of the shares in 2014 results in a capital gain for A of $54,000, which is the 2014 fair market value of $55,000 less A’s basis in the shares of $1,000.

Situation 3 – Taxable Stock Acquisition

The third situation described in Revenue Ruling 2007-49 addresses the same facts as the merger in situation two but includes a share exchange and cash payment:

Assume the same facts as in Situation Two except that in the merger half of the Corporation X stock is exchanged for cash and half is exchanged for Corporation Y stock, the transaction is fully taxable, and all of A’s Corporation X stock is exchanged for Corporation Y stock.”

In this situation, the IRS treats A’s exchange of substantially vested Corporation X stock with a basis of $1,000 for substantially nonvested Corporation Y stock with a fair market value of $31,000 as a taxable exchange to which Section 1001 applies. As a result, A recognizes capital gain of $30,000 on the disposition of Corporation X stock, and A’s basis in the Corporation Y stock is $31,000. Because the Corporation X stock is exchanged for Corporation Y stock subject to a restriction causing the shares to be “substantially nonvested,” the Corporation Y shares are subject to Section 83 as a transfer in connection with the performance of services.

As in Situation Two, the “amount paid” for the stock under Section 83 is $31,000, and A’s Section 83(b) election avoids additional income for the 2010 tax year because the fair market value of the stock is offset by the amount paid for the stock. A also does not have taxable compensation income for the 2013 tax year because of the prior Section 83(b) election, and A’s basis in the Corporation Y stock is $31,000.

Notably, the IRS points out that “if A had not made an election under Section 83(b) with respect to the Corporation Y stock, when the stock becomes substantially vested on August 9, 2013, A would include $19.000 in gross income as compensation under Section 83(a). This is the amount by which the fair market value of 100 Corporation Y shares ($50,000 or $500 per share) exceeds the amount paid for those shares ($31,000).” This income would increase A’s basis in the Corporation Y stock to $50,000 and thereby reduce A’s capital gain to $5,000 on his subsequent sale of the shares for $55,000.

Conclusions

Revenue Ruling 2007-49 highlights the issues that can arise when new restrictions are imposed on substantially vested stock interests. The revenue ruling provides helpful examples to illustrate the effects in financing and both nontaxable and taxable stock acquisitions. These examples and the effects of stock restrictions should be carefully considered in connection with any transaction, and a Section 83(b) election should always be considered to affect the timing of the ultimate tax effects.