The following article is reprinted from The M&A Tax Report, Vol. 12, No. 3, October 2003, Panel Publishers, New York, NY.


By Robert W. Wood

There has been a lot of talk in the last few years about restricted property and the rules of Section 83. Of course, Section 83 generally applies when property is transferred to an employee (or an independent contractor) in connection with the performance of services. Under Section 83, the service provider is taxable on the fair market value of any property received to the extent it exceeds any amount paid for the property. This amount is often referred to as the "bargain element". Section 83(a) provides that the amount of the bargain element is taxable to the service provider.

However, where property is subject to restrictions (as it often is) the bargain element is not taken into the service provider's income until the transferred property is no longer subject to a "substantial risk of forfeiture". See § 83(a); Treas. Reg. §§ 1.83-1(a), 1.83-3(a). Unfortunately, it's then taxed as ordinary income. A great deal of metaphorical blood has been spilled over the question of whether a restriction is substantial (thus preventing current taxation), whether restrictions are lapse restrictions or non-lapse restrictions, etcetera.

Section 83(b) gives the service provider an opportunity to take a different path in life. If you choose to make an election under Section 83(b), you essentially agree to be taxed in the current year (at ordinary income rates), despite the existence of substantial restrictions. By making this "deal with the devil," you are allowed to book any future appreciation in the value of the property at capital gain rates.

So What's the Hubbub Bub?

What happens to the employer? When does it get to take its deduction? Section 83(h) addresses the tax consequences to an employer in this context. As to the amount of the deduction, Section 83(h) allows an employer a deduction under Section 162 equal to the amount included in income by the service provider. As to timing, Section 83(h) mandates the deduction be taken by the employer in the same year "such amount is included in the gross income of the person who performed such services." Section 83(h). The question quickly becomes, well, what does "included" mean?

In James G. Robinson, et ux. v. Commissioner, 335 F.3d 1365 (Fed. Cir. 2003), No. 01-102T, Tax Analysts Doc. No. 2002-15273, 2002 TNT 126-10, the Federal Circuit answered this question. The issue presented in Robinson was whether the amount of an employer's deduction is the value of the transferred property that is includible in the employee's gross income as a matter of law or the amount that is actually included in the employee's gross income. This case shattered the age-old maxim that there must be parity between the deduction claimed by the employer on a Section 83 payment and the income included by the employee.

James and Barbara Robinson owned Morgan Creek, a group of S corporations. From 1989 to 1997, Gary Barber was the Chief Operating Officer for Morgan Creek. In a 1995 employment agreement, Barber received restricted stock in Morgan Creek representing a 10% ownership share. Unbeknownst to the Robinsons, Barber filed an 83(b) election, reporting a value that has become more and more common today — zero. In other words, Barber reported zero bargain element on the issuance of the Morgan Creek shares.

Under applicable law, Barber was required to file a copy of his Section 83(b) election with Morgan Creek notifying it of his election. Treasury Regulation §§ 1.83-2(c) and (d). There was some dispute (perhaps justifiably) as to whether the company was given proper notice of the election. Barber received a copy of the 83(b) election from his lawyers, and the IRS argued that because he was an officer (and therefore an agent of the company) Morgan Creek was properly advised of the election.

Minor Correction?

Not surprisingly, the Robinsons has a different story to tell. They argued that the company learned of the Section 83(b) election years later when there was a separation settlement with Barber, and the company repurchased some of his stock. At that time, the company issued Barber an amended Form W-2 for 1995, increasing his wage income by more than $20 million (talk about an unpleasant surprise). The IRS then issued an audit report for Barber's 1995 return, alleging a corresponding increase in his income. In 1999, the company filed a refund claim in respect of its 1995 taxes, seeking deductions for the additional compensation, which would lead to a refund. In 2001, the Robinsons filed a complaint in the Court of Federal Claims, seeking a recovery of tax and interest based on the argument that they were entitled to a deduction for the amount required to be included on Barber's return for the value of the stock, not the amount Barber actually included. See Robinson v. United States, 52 Fed. Cl. 725 (2002).

The Court of Federal Claims noted that the Robinsons were only entitled to a deduction under Section 162 for an amount equal to the amount Barber included under Section 83. Under Section 83(h), these amounts must match, said the Court of Federal Claims. 52 Fed. Cl. at 727-28. Noting that its decision was consistent with the applicable Treasury Regulations, the court concluded that the employer was allowed a deduction only to the extent that an amount is actually included in the employee's gross income in that year. See Treas. Reg. § 1.183-6(a); 52 Fed. Cl. 727-28, citing Venture Funding 110 T.C. 36 (1998). The fact that an employee should have or could have included a particular amount in income for a particular tax year does not in any way support the allowance of a deduction for the employer, says the court. Ultimately, the Court of Federal Claims found the Robinson's claim unripe, and dismissed the complaint.

The Dawning of a New Day

The Federal Circuit says not so fast. On appeal, the Federal Circuit reversed the Court of Federal Claims holding that the amount of an employer's deduction is the value of the transferred property that is includible in the employee's gross income as a matter of law rather than the amount that is actually included. Not only that, says the Federal Circuit, we're going to strike down Treasury Regulation 1.183-6(a) while we're at it. Acknowledging the great deference provided to Treasury Regulations under the Supreme Court's decision in Cheveron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837, 842-843 (1984), the Federal Circuit nevertheless struck down Treasury Regulation 1.183-6(a) as inconsistent with Section 83(h). All this, and it wasn't even a special occasion.

Reciprocity and Section 83: What's Good for the Goose?, Vol. 12, No. 3, The M&A Tax Report (October 2003), p. 1.