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Stock-based compensation reporting issues.

Can an employer take a deduction for stock-based compensation not reported on Form W-2 or 1099? Stock-based compensation falls under Sec. 83, which deals with transfers of property in connection with the performance of services. "Property," for this purpose, is defined in Kegs. Sec. 1.83-3(e) to include stock, real property and personal property other than money or an unfunded and unsecured promise to pay money or property in the future. Regs. Sec. 1.83-3(f) defines property transferred in connection with the performance of services as "property transferred to an employee or an independent contractor (or beneficiary thereof) in recognition of the performance of, or the refraining from performance of, services...." The transfer of property is subject to Sec. 83 whether such transfer is in respect of past, present or future services.

Taking the Deduction

Sec. 83(h) and Regs. Sec. 1.836(a)(1) entitle an employer to a deduction for the amount included as compensation in an employee's gross income, but only to the extent such amount meets the requirements of Sec. 162 or 212 (i.e., ordinary, necessary and reasonable) . The employer is allowed a deduction for the tax year in which or with which ends the tax year in which such amount is included in the employee's gross income.

Regs. Sec. 1.83-6(a)(2), a safe-harbor provision, provides that the employee is presumed to have included in gross income any compensation received, if the employer has timely met all the requirements of Sec. 6041 or 6041A, and the regulations thereunder, with respect to such compensation. Secs. 6041 and 6041A specify the requirements for reporting on Forms W-2 and 1099. If a company does not comply with the filing regulations, it may not claim a deduction until the employee has actually included the compensation in income.


Venture Funding: In Venture Funding Ltd., 110TC 236 (1998), aff'd, 198 F3d 248 (6th Cir. 1999), the employer remunerated its employees with stock and claimed a deduction in the transfer year for the stock's value. It issued Forms W-2 or 1099 to the employees, but none of them included the value in income for the transfer year.

Venture argued that Sec. 83(h) allowed it to claim a deduction, because the employees were required to recognize the income in the year compensated; the fact that they did not should not bear on its right to the deduction. It further alleged the income was includible in the employees' income, and that the regulations requiring the employer to issue Forms W-2 "impermissibly adds restrictions to a statute which are not there."

The IRS maintained that Sec. 83(h) did not allow the employer to deduct the reported amount in the transfer year, because it failed to meet Sec. 83'S requirements. The Tax Court held that for the compensation deduction to be allowed under Sec. 83(h), the employees have to report the income. Because the income was not reported, the taxpayer was not entitled to a deduction.

The court ruled that the regulations merely establish a safe harbor for concluding that the corresponding amount was included in income, and that the regulatory implementation of the Congressional mandate set forth in Sec. 83(h) is reasonable and valid. Also, importantly, this was a 9-8 decision; all the court's judges were present and voted on this issue. The close vote shows that the court was sharply divided.

Robinson: In Robinson, Fed. Cir., 7/15/03, rev'g 52 Fed. Cl. 725 (2002), an employee received stock as compensation, but estimated its fair market value as the amount paid for it (zero). He elected under Sec. 83(b) to include the zero value in income in the year the stock was received. As the employee was the company's chief financial officer, he sent his notification of the election to himself. The company's owners were not aware of the election. Subsequently, the employee was discharged by the company; it issued corrected Forms W-2 reflecting additional income from the stock-based compensation. The employee contested the computed value of the stock compensation and did not include the amount in income; the company took a deduction under the safe-harbor provision.

The court held that the information reporting was untimely and that there was no reasonable-cause exception for late filing, so it disallowed the deduction. It stated that the employer's deduction under Sec. 83(h) is limited to the value of the transferred property actually included in the employee's gross income, either on a return or as a result of a final determination between the employee and the IRS that is binding on the employee.

On appeal, the Federal Circuit determined that the central issue was the meaning of "included" for Sec. 83(h) purposes. The debate centered on whether the employer's deduction is the value of the transferred property includible in gross income as a matter of law, or only the amount actually included in his gross income. The statute provides that the amount of the employer's deduction equals the amount included in the employee's gross income as a result of the transfer.

The IRS argued that the "amount included in the employee's gross income" means the amount actually included on the return, while the employer argued it meant the amount included in gross income as a matter of law. The IRS argued that if Congress had intended "included" to mean "included as a matter of law," to be applicable in Sec. 83, the word "includible" would have been used instead.

The Federal Circuit concluded that the employer was entitled to a deduction based on the amount legally required to be included in the employee's gross income, without regard to the amount actually included on the employee's return for purposes of calculating his tax liability. According to Sec. 61(a), "gross income" means all income from whatever source derived. Sec. 61(b) states, "[f]or items specifically included in gross income, see part II (sec. 71 and following). For items specifically excluded from gross income, see part III (sec. 101 and following)." Sec. 61 clearly addresses gross income as a legal concept, said the court, and the term "included" in Sec. 61(b) plainly refers to items included in gross income as a matter of law or legally deemed to be included in gross income. Part II of the Code, to which Sec. 61(b) refers, contains Sec. 83. The Federal Circuit specifically rejected the contrary interpretation set forth in Regs. Sec. 1.83-6(a).


The Sixth Circuit affirmed the ruling in Venture Funding, but in all other circuits, there is a reasonable basis for adopting either position. Until this issue is resolved, practitioners contemplating a position inconsistent with Kegs. Sec. 1.83-6(a) in preparing a return should consider including Form 8275-R, Regulation Disclosure Statement.

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Author:Moore, Daniel
Publication:The Tax Adviser
Date:Oct 1, 2005
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