Property received for services.

A general proposition of individual income tax planning is to delay the recognition of taxable income for as long as possible, thus delaying the tax as well. A second proposition is to try to convert ordinary income to long-term capital gain to get both a more favorable rate and possibly use capital losses, further reducing the tax cost of the income.

In the "property for services" arena these dual goals are very difficult to accomplish. Due to the unique nature of the rules in this area, it is often advantageous to recognize ordinary income at the earliest possible date in order to maximize the portion that will be reportable as long-term capital gain later. A recent case demonstrates that with the right facts, a favorable result can be obtained.

Sec. 83 and the regulations thereunder govern the tax treatment of the receipt of property for services. Not surprisingly, the general rule is that such a transaction generates ordinary income taxable on receipt of the property. A significant exception to this rule is Sec. 83(a), which postpones the recognition of income on property received for services that is subject to restrictions on transferability or substantial risk of forfeiture until the restrictions lapse or the property vests in the taxpayer.

Example: If an employer gives employee E a bonus of 1,000 shares of stock with a fair market value (FMV) of $20,000, the employee is taxed on $20,000 of ordinary income on receipt of the shares. Suppose instead that E is "given" the stock, but can only dispose of 500 shares immediately, with the balance being forfeited if he does not remain with the employer for one year. In that case, E must report $10,000 of ordinary income on receipt of the shares. With respect to the other 500 "restricted" shares, E will report income at the end of one year in an amount equal to the FMV of the shares at that time.

Another significant exception is Sec. 83(e)(3), which provides that the receipt of an option to acquire property is not immediately taxable unless the option has a readily ascertainable FMV. Regs. Sec. 1.83-7(b) defines options with readily ascertainable FMVs as those actively traded on an established market or other options in which the FMV can otherwise be measured with reasonable accuracy. In practice, this provision delays taxation until the option is exercised and the amount of income is measured by the excess of the value of the property received over the option's exercise price. Since most people do not exercise options until they are "in the money," there will usually be ordinary income on exercise. (Note that there are other rules for incentive stock options, which are governed by Sec. 422 and are generally exempt from Sec. 83.)

The recently decided case of Theophilos, 9th Cir., 5/31/96, illustrates these rules and the substantial difference in tax treatment that can result. In this case, the taxpayer agreed to work for GSM in late 1985 with the promise that he would receive 40% of the company. After several months of negotiations (including discussions concerning the use of options to achieve the desired result), an agreement was reached in April 1986 to allow the taxpayer to purchase all of GSM's Class B shares for $10,000. The shares were actually issued in December 1986. The taxpayer left GSM in late 1987 and after a prolonged negotiation received a payment in April 1989 for $1.75 million in full redemption of his shares. The taxpayer did not report any income on his 1985, 1986 or 1987 returns from these transactions.

On audit, the Service determined that the receipt of the shares in December 1986 was a taxable event, and asserted a deficiency based on a value of$3.52 million for the shares. The Tax Court agreed with the IRS as to the time of taxability, but revalued the stock at $2.35 million.

On appeal, the Ninth Circuit determined that the property the taxpayer received was a contractual right to acquire the shares, which was reduced to writing in April 1986. In the court's view, that was the triggering event for income reporting purposes. The court distinguished this contractual right from an option, stating that the contract unconditionally obligated the taxpayer to make a payment to acquire shares while an option did not create any obligation until its exercise.

The court's analysis discussed the enforceability of the agreement under state (California) law, and reviewed whether a contractual right to acquire stock was "property." (See Doran, 296 F2d 27 (9th Cir. 1961), in which such a right was held to be a capital asset.) The Service argued that, since the shares were not paid for or issued at the time of the April 1986 agreement, it was effectively an option and should be taxed under Sec. 83. The court rejected this reasoning, in part due to testimony that the parties in their negotiations had considered and rejected the use of options.

The taxpayer's victory was not complete. The case was remanded back to the Tax Court to determine the value of the taxpayer's contractual right to acquire stock in April 1986, and the taxpayer must recognize ordinary income on any excess of that value over his $10,000 purchase price. A capital gain or loss for the difference between the April 1986 value and the $1.75 million he ultimately received must also be recognized in 1989.

One interesting aspect of this case is the way the IRS became involved. After the taxpayer received the proceeds from the stock redemption in 1989, GSM issued an amended 1986W-2 Form to the taxpayer, increasing his wages by the $3.52 million value the company placed on the stock at that time. It also filed an amended corporate income tax return to claim this deduction. Of course, these filings triggered the Service's review.

From Elliot Glass, CPA, J.D., Feldman, Radin & Co., PC., New York, N.Y.