Restricted property and section 83(b) elections.

Employers are continually looking for new ways to reward and keep valued employees. Often this will take the form of stock or some other non-monetary compensation in return for employee services.

RESTRICTED PROPERTY

A popular compensation method is the restricted stock plan, which involves the transfer of stock that, when received, is subject to certain restrictions affecting its value. This type of plan has two goals: It allows the employee to defer tax on the property until the restriction lapses and gives him or her a stake in the employer's business.

Questions then arise about the tax treatment of such property, both as to when the income must be included in the employee's income and how much. (The amount that can be deducted by the employer also hinges on this determination.)

Generally, the employee is taxed for the restricted property's full value when ownership of the property is no longer subject to a substantial risk of forfeiture. Such a risk exists if the employee's right to full enjoyment of the property is conditioned on the future performance of substantial services by any individual (for example, required employment for a specified period of time from receipt of the property).

Section 83(b) election. Internal Revenue Code section 83(b) provides an exception to this general rule: An employee can elect to have the restricted property's value (over his cost) taxed to him in the year it is received, rather than when the restrictions have been lifted. To be timely, the election must be made within 30 days after the property is transferred and cannot be revoked without Internal Revenue Service consent.

Note: Section 83 applies to all property received in connection with the performance of services. Therefore, it applies to property for which full fair market value was paid; that is, the transfer was made solely to motivate the employee and the amount paid equaled its fair market value without regard to any restrictions. An employee who pays full fair market value (or close to it) for restricted property should seriously consider a section 83(b) election. Since the tax is paid when the property is originally transferred, no further tax on the property will be due, even if its value later increases significantly.

Revocation. While a revocation of this election is possible, it is granted only when there has been a mistake of fact in the underlying transaction; a mistake in value (or decline in value) of the property involved will not be enough. With this as the standard, revocations have been extremeley rare.

IRS LETTER RULING

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In March 1990, a company offered to transfer restricted stock to each of its employees and to pay cash bonuses sufficient to cover the taxes for each employee who would make a timely section 83(b) election. In April, the employees accepted this stock and executed these elections.

In July, the company learned the effects of this stock transfer would result in a charge to the company's earnings that was more than six times higher than originally estimated. As a result, the company, with full agreement of all the employees involved, rescinded the original agreements, required the return of the stock transferred and refused to pay the bonuses.

IRS ruling. Because the stock grant was rescinded within the same tax year in which it was made, the IRS also allowed the section 83(b) elections to be rescinded. Since the parties were in the same positions at the end of the tax year as they were before the sale, the original sale was disregarded. And since the effect of this rescission voided the transfer on which the section 83(b) elections were based, the elections had no effect and the employees did not have to recognize any income.

Analysis. Given the service's attitude toward revocation of section 83(b) elections, this result is surprising. Key to this decision were

* The company (rather than an individual employee) initiated the rescission.

* Both the transfer and the rescission occurred within the same tax year (so the employees could be restored to the same positions they would have been in had no transfer been made).

For a discussion of this letter ruling and other related matters, see "Current Developments in Employee Benefits (Part I)," by Deborah Walker, in the November 1991 issue of The Tax Adviser.