Disallowance of deduction for failure of employer to withhold on stock disputed.

The treatment of property transferred to an employee, as governed by Sec. 83 requires the value of property transferred by an employer to an employee in connection with the performance of services to be included in income when the property first becomes transferable or not subject to a substantial risk of forfeiture. The employer is allowed a deduction in its tax year with which or within which ends the recipient's tax year in which the income is included.

Employers are subject to the additional requirement to withhold income tax on the amount of compensation in accordance with Sec. 3402. Considerable controversy has arisen over the withholding requirement, which was not included in regulations until after the public comment period and does not appear to be supported by the statute's legislative history.

Now it appears that the validity of the withholding regulation will be tested in court. K-H Corporation and Subsidiaries has filed a petition in Tax Court stating that the company paid compensation in the form of restricted stock to two of its officers. The company also paid its officers dividends on the restricted stock in 1985 and 1986. The restrictions on the stock lapsed in 1986. The company deducted the dividends paid in 1985 and 1986, and deducted the value of the stock when the restrictions lapsed in 1986. Income taxes were never withheld for the dividends or the value of the stock, but in 1986 the company did report the amounts paid or credited to the officers on W-2 statements.

The IRS disallowed the deductions for the dividends and the value of the stock at the time of the lapse, citing the company's failure to withhold these amounts.

It should be noted that the Service had addressed this issue earlier in Letter Ruling (TAM) 8403005, in which several employees of a corporation exercised stock options, for which the corporation issued Forms 1099-MISC, Miscellaneous Income, but did not withhold in the year of exercise with respect to the stock transferred. Although the cmployees properly reported the income, the corporation was denied the deduction because of its failure to comply with the withholding requirement under the regulations.

In spite of this ruling, it was the experience of many practitioners that the IRS often conceded this issue, presumably out of concern that the regulation could not be successfully defended. The Service did issuc a proposed regulation that slightly softened the position of the final regulation, but this proposed regulation has ncver been finalized.

Arguably, the dividends are deductible without regard to Sec. 83(h), which governs only the transfer of property. In other words, because dividends are paid in the form of cash, and cash payments are not governed by Sec. 83, the denied deduction provision of Regs. Sec. 1.83-6(a)(2) should not apply.

From Bill Dunn, CPA, and Julie Rabinowitz, Esq., Washington, D.C.