Sec. 83: uncertainty of transfers and nonlapse restrictions.

For purposes of Sec. 83 taxation of property transferred in connection with the performance of services, a "transfer" does not occur unless the transferee acquires a beneficial ownership interest in the property (Regs. Sec. 1.83-3(a)(1)). Generally, this requires that the employee hold the property subject to a risk of loss (Regs. Sec. 1.83-3(a)(6)).

To determine whether a compensatory "transfer" of property has occurred, lapse restrictions (such as risks of forfeiture) are not considered; however, nonlapse restrictions must be considered. Nonlapse restrictions frequently are used by privately held companies to set a formula for establishing the stock's fair market value (FMV) while the company is privately held. Under Sec. 83(d)(1), if a nonlapse restriction allows the transferee to sell the property only at a reasonable price determined under a formula, the price so determined generally is deemed to be the property's FMV, to be used in determining whether a "transfer" has occurred.

A lapse restriction is not considered in determining whether a transfer has occurred. A lapse restriction occurs, for example, when an employer sells stock to an employee, with the restriction that the employee must forfeit the shares if he does not perform two additional years of service. If the employer promises it will return to the employee any amount the employee paid for the stock if he forfeits the shares, this generally is considered part of the lapse restriction, as it lapses on vesting. Accordingly, this refund feature also should be disregarded in determining whether a transfer has occurred.

However, if the employer promises to pay the employee, in any event, the greater of the amount the employee paid for the shares or their FMV at the time of disposition, the provision is a nonlapse restriction and considered in determining whether a transfer has occurred. In this situation, because there is no risk to the employee that the stock will decline substantially in value, no transfer occurs. Thus, no taxable event will occur until the employee disposes of the stock. At that point, the employee recognizes compensatory income on the difference between the amount he received for the stock and the amount he paid for it, and the employer is allowed a corresponding deduction.

Nonlapse Restrictions

A nonlapse restriction must be permanent. Generally, if the recipient of the property has the ability to resell the property later at FMV, rather than the formula price, the formula price is not treated as a nonlapse restriction.

Whether a restriction is considered permanent and thus serves as a nonlapse restriction can be subject to dispute. In Letter Ruling 9308022, the IRS held that an otherwise nonlapse formula price buy-back restriction would not lose its nonlapse status merely because the restriction provided an exception that it would lapse on an initial public offering (IPO). According to the Service, the lapsing of a restriction because of a "highly speculative" event was not inconsistent with a nonlapse restriction, in that Sec. 83(d)(2) anticipates cancellation of nonlapse restrictions. This holding accords with the legislative history, and with Treasury's own regulations.

Legislative history indicates that the type of nonlapse restriction intended to serve as a FMV, non-tax-motivated restriction should be distinguished from restrictions designed to achieve deferral of tax (H. Rep't No. 91-413, 91st Cong., 1st Sess. (1969)). Regs. Sec. 1.83-5(b)(1) explains that cancellation of a restriction when the original purpose of the restriction no longer exists (such as in the case of an IPO) will not be considered compensatory. Thus, it appears that lapsing of an otherwise nonlapse restriction in the event of a highly speculative IPO would not be a compensatory cancellation creating a taxable event.

In contrast, according to Letter Ruling (TAM) 9744001, automatic cancellation of an otherwise nonlapse restriction in the event of certain corporate transactions caused the restriction to be a lapse restriction. As a result, property was considered transferred 10 years earlier than the taxpayer anticipated, and the company's repurchase of the property constituted a nondeductible redemption. Under the facts of the TAM, a privately held corporation required terminating shareholder-employees to sell their vested compensatory stock grants back to the company at the greater of the amount the shareholder-employees paid for the stock or its then formula-based FMV. Considering this restriction to be a nonlapse restriction, the company took the position that no transfer occurred for Sec. 83 purposes at the date of grant, because employees did not assume a risk of loss. Accordingly, repurchase gave rise to income to the employees and a deduction for the company.

However, a shareholders' agreement provided that the restrictions relating to termination of employment would not be effective for any liquidation, merger, acquisition or other reorganization by or affecting the company. For any such transaction, the shareholder-employees had the rights and obligations of the company's common stockholders who were not employees. Without any discussion as to the remoteness of such events, the IRS determined this provision caused the repurchase provision to be a lapse restriction. Because lapse restrictions are disregarded in determining whether a transfer occurs, the Service found that a transfer occurred at grant. Accordingly, the IRS found the corporate deduction could be taken only in the year of grant (a closed year), and the repurchase constituted a nondeductible stock redemption.

It appears that the taxpayer whose deduction was denied in the TAM paid the tax related to its denied deduction and sued for a refund. On Oct. 26, 2000, a U.S. Magistrate Judge concurred with the Service's position and recommended the government be granted summary judgment (Riverton Investment Orb). The judge recognized that the corporate transaction language was related to events beyond the ordinary course of business. However, starting from the position that the language constituted a lapse restriction (rather than the potential cancellation of a nonlapse restriction for valid but highly speculative business purposes), the judge refused to turn the purported lapse restriction into a nonlapse restriction. Responding to the taxpayer's argument based on Letter Ruling 9308022, the court noted the lack of authority accorded letter rulings and distinguished it.

On March 6, 2001, a district court reversed the Magistrate Judge and entered judgment in the taxpayer's favor. Unfortunately, the court did not reverse based on the fact that the language in question represented an allowable exception to a nonlapse restriction permitting the employees later to receive FMV for their shares. In fact, the court concurred that the shareholder agreement language was a lapse restriction, at least for the shareholder-employees' ability to sell the stock. Instead, using parol evidence, the district court found the language did not change the amount shareholder-employees would be permitted to receive on a corporate event, with the result that the formula repurchase price was a nonlapse restriction.

Conclusion

The arguably conflicting rulings in the letter ruling and the TAM raise concern about whether the Service will treat a formula price provision as a lapse restriction when the parties agree that the restriction will be canceled on the occurrence of certain extraordinary events. It should not matter whether such an understanding is reduced to writing for clarity and certainty for purposes of contract law. Rather, the issue should be whether the anticipated cancellation is remote. Had the TAM discussed this issue and found the formula price buy-back provision to be a lapse restriction because the circumstances under which it would be canceled were not remote, the law would be clearer than it is today.

FROM JUDITH E. ALDEN, J.D., WASHINGTON, DC

Robert Zarzar, CPA
Partner
Washington National Tax Service
PricewaterhouseCoopers
Washington, DC