The following article is adapted and reprinted from the M&A Tax Report, Vol. 11, No. 3, October 2002, Panel Publishers, New York, NY.


By Robert W. Wood and Jonathan R. Flora

Stock options have been much in the news lately. Most of this news has been pejorative. It seems stock options have been targeted as the cause (or at least a byproduct) of various financial crises during the past year. This all comes on the heels of a good bit of adverse financial press, particularly with respect to the alternative minimum tax ("AMT") consequences of incentive stock options ("ISOs").

In the face of a bursting internet bubble, and much of the rest of the economy deflating as well, ISOs have been especially libeled. The earnings games of various companies have at least in part been attributed to stock options, and stock option accounting in particular. As we've noted recently, there have been various proposals to amend the treatment of stock options for earnings purposes. See Wood, "Stock Option Ruminations," Vol. 11, No. 2, The M&A Tax Report (Sept. 2002), p. 1. Recently, suggestions have been floated that companies would help employees by issuing cash in exchange for underwater options. See, e.g., "Seibel Plans to Offer Employees Either Cash or Stock for Options," Wall Street Journal (Aug. 30, 2002) (Seibel offered its employees $1.85 in cash for each option with an exercise price equal to or greater than $40 per share).

Stock for Services and §83

Section 83, of course, is a relatively short (but vastly important) Code section that applies to transfers of property in exchange for services. The basic rule is that when stock (or other property) is transferred to an employee in exchange for services, the employee must include the value of the stock in his income when the stock is substantially vested. I.R.C. §83(a); Reg. §1.83-1(a). Stock substantially vests when it is either transferable or is no longer subject to a substantial risk of forfeiture. §83(a)(1).

The amount of taxable income is the fair market value of the stock (at the time it substantially vests), less any amount the employee pays for the stock. §83(a). The fair market value of the stock is determined without regard to restrictions, except for restrictions that will never lapse (so-called "nonlapse" restrictions).

The Effect of 83(b) Elections

Most tax professionals know what an 83(b) election is, even if they have never made one. When an employee makes an election under Section 83(b), he sets aside the income deferral rules that apply while stock is non-vested. Section 83(b) allows an employee to elect to currently include in income the fair market value of the stock, less any amount paid for it, at the time stock is issued even though not substantially vested. (Of course, the election is not available if stock is already substantially vested and hence immediately includible without regard to an election.) In short, the employee elects to incur tax on the value of the stock currently, rather than waiting until it vests.

When an 83(b) election is made, an employee includes the fair market value of the stock after taking into account any nonlapse restrictions, but without regard to any lapse restrictions (those restrictions that will lapse). He does not recognize any income at all when the stock substantially vests. Reg. §1.83-2(a). Instead, any appreciation (or depreciation) after the date of the election is taxable as a capital gain (or loss) when the employee sells the stock. The holding period also is effected, beginning on the day after the day the property is transferred to the employee. Reg. §1.83-4(a).


What happens if an employee who makes an election leaves his job before the stock substantially vests? In that case, the employee forfeits his stock and is allowed a limited loss deduction. The amount of the deduction on forfeiture is limited to the amount paid for the stock, less the amount realized on the forfeiture (if any). Reg. §1.83-2(a). Notably, though, no deduction is allowed for the amount the employee previously included in income by making the 83(b) election.

See §83(b)(1). The employer is also effected by a forfeiture. The employer must include in income on the date of the forfeiture the lesser of the fair market value of the stock or the amount of the deduction that it took when the employee made the election. Reg. §1.83-6(c).

What's an Employee to Do?

Do employees receiving restricted stock want to make these elections? Obviously, both the timing of the tax to the employee and the character of income as ordinary or capital can be effected.

With most restricted property, Section 83 provides that income in includible at the time the restrictions lapse. If an employee makes an 83(b) election, in contrast, he will recognize immediate income at the time of the election, but he will not recognize income when the stock substantially vests. As to character, all appreciation from the time of an 83(b) election is capital gain. If no election were made, in contrast, ordinary income arises when the stock vests which causes his tax basis in the stock to increase. Only the difference between the value at that time and the amount realized on an eventual sale date would be capital gain.

So why would an employee want to accelerate income? In essence, the employee is betting that the stock will appreciate, and so he is limiting the amount of compensation income he will recognize as a result of the stock grant. Optimistic employees may have lots of reasons for making an 83(b) election, although the current economic doldrums make 83(b) elections a little less attractive than they once were. Of course, an 83(b) election is not risk free: an election followed by a drop in value of stock can result in ordinary income (when the election is made) followed by a capital loss — not a very attractive tax position!

Not surprisingly, a good deal of Section 83 lore relates to how one determines value. As we've noted in these pages before, an important decision nearly 20 years ago emphasized that Section 83(b) elections can be made reporting zero value. See Alves v. Commissioner, 734 F.2d 478 (9th Cir. 1984.

ISOs and 83(b) Elections

ISOs are taxed more favorably than nonqualified options. For a comparison, see Wood, "Tax and Accounting Treatment of ISOs," Vol. 9, No. 10, The M&A Tax Report (May 2001), p. 1; and Wood, "Tax and Accounting Primer for Nonqualified Stock Options," Vol. 9, No. 10, The M&A Tax Report (May 2001), p. 1. ISOs are generally beyond the reach of Section 83. Section 83(e)(1) states that the section does not apply to the exercise of an option to which section 421 applies. Section 421(a)(1) provides that an employee does not recognize regular income when an ISO is exercised (assuming various requirements are met). An employee will recognize capital gain (or loss) if he later sells the shares in a qualifying sale based on the difference between the sale price and the exercise price.

However, if an employee sells the stock within two years from the date of grant or one year after the shares are transferred to the employee, it is a "disqualifying" sale. §421(b). A disqualifying sale operates as if it were under section 83 — the employee must include in ordinary income the difference between the exercise price and fair market value at the time of the option exercise. Prop. Reg. §1.422A-1(b)(1). This amount is added to his basis, and the remainder is taxed as capital gain (all in the year of the sale).

It is a marked understatement to say that ISOs aren't treated as favorably under the AMT regime as they are for regular tax purposes. The exclusion from income under Section 421 is ignored in computing alternative minimum taxable income ("AMTI"). Rather, an employee must include in his AMTI the difference between the exercise price of an ISO and the fair market value of the stock acquired at the time of exercise. §56(b)(3). Obviously, for options with a low exercise price and high value, the AMT consequences can be substantial. For ISOs that result in the acquisition of restricted stock, the fair market value of the stock (less the amount paid) is includible in AMTI only after the stock substantially vests.

Suppose you have a client with ISOs who is considering an early exercise of an ISO (that is, before the acquired stock has substantially vested). Is it possible for him to make a Section 83(b) election in hopes of triggering the one-year holding period that applies to disqualifying sales? The answer appears to be no. The IRS has informally stated that making an 83(b) election with respect to an ISO is invalid for regular income tax purposes. Thus, the holding period for a disqualifying sale is triggered when the stock vests, and not when the ISO is exercised, regardless of whether he makes a Section 83(b).

But interestingly, the IRS has indicated (again informally) that a Section 83(b) election may be available with respect to ISOs for AMT purposes. This position is reflected in the instructions for completing Form 6251 (AMT), at p. 3. There, the IRS states:

"Even if your rights in the stock are not transferrable and are subject to a substantial risk of forfeiture, you may elect to include in AMT income the excess of the stock's fair market value (determined without regard to any lapse restriction) over the exercise price upon the transfer to you of the stock acquired through the exercise of the option."

Do or Die?

What does all this mean? The absence of real honest-to-goodness IRS guidance is troubling. Still, where there is not too much appreciation built into the restricted stock acquired when an ISO is exercised, it can make sense to elect (under Section 83(b)) to currently include this gain in AMTI even though the stock has not yet substantially vested. Although the election will accelerate recognition of AMTI, it appears that when the stock does substantially vest, the election will prevent any further AMTI recognition. This is good news if the stock has appreciated significantly during that period.

Obviously, Section 83(b) plays a significant role in stock options. While this one-page election may not resolve all of the blame currently being leveled at stock options, it can certainly help in planning for individuals who receive stock or options as part of their compensation.

ISOs And Section 83(b) Elections, by Robert W. Wood and Jonathan R. Flora, Vol. 11, No. 3, The M&A Tax Report (October 2002), p. 1.