In what is possibly the least controversial decision ever made by the IRS, the agency has adopted its proposed amendment to the procedures for filing Section 83(b) elections, eliminating the requirement that taxpayers file a copy of the election with their tax return for the year that they make the election.
It’s Nice that We Can All Agree on Something
The amendment, which was proposed last year (see “IRS Proposes Amendment to 83(b) Election,” received no comments at all. Zip. Zero. No one requested a public hearing and no hearings were held. Cue the sound of crickets (ok, technically that’s the sound of frogs—I don’t have a video of cricket sounds). Hence the amendment was adopted with no changes from the original proposal.
Background
In the context of stock compensation, Section 83(b) elections are most frequently filed when employees exercise stock options prior to vesting. They are also sometimes filed upon grant of restricted stock. The election accelerates the taxable event for the award to the date of exercise (in the case of stock options) or grant (in the case of restricted stock). Employees wishing to file a Section 83(b) election must submit the election to their IRS service center within 30 days of the event triggering the election. Employees must also provide a copy of the election to their employer. Prior to this proposed amendment, a copy of the election also had to be included with employees’ tax returns for the year.
Now that the IRS is encouraging taxpayers to file tax returns electronically, the requirement to include the election with tax returns has proved to be problematic, since few efiling systems can attach a scanned document to the return. There was also a concern that taxpayers might be able to revoke an election after the 30-day election period by simply failing to include it with their tax return.
Effective Date
The amendment is effective for transactions occurring on or after January 1, 2016 but the IRS permitted taxpayers to rely on it for Section 83(b) elections filed in 2015. For more information, see the NASPP Alert “IRS Finalizes Amendment to Section 83(b) Election.”
More Frogs and Tax Developments
I took that frog sound video when I was visiting the Hilton Americas – Houston where the 24th Annual NASPP Conference will be held. It’s at a pond in the park across the street from the hotel. You know what else you can do in Houston besides hear the awesome sound of frogs at night? You can get an update on this and other recent tax developments directly from IRS and Treasury staffers during the session “The IRS and Treasury Speak.” Register by September 9 for the early-bird discount.
With the FASB and the SEC issuing significant announcements impacting stock and executive compensation, it only seems right that we should also be dealing with changes to the tax regs impacting stock compensation. Luckily the IRS has obliged with a proposed amendment to the procedures for filing Section 83(b) elections.
Background
I’m going to assume that you all know what a Section 83(b) election is and when it would be filed. If not, read the discussion of “Early Exercise” in the NQSO Portal and the discussion of “Section 83(b) Elections for Restricted Stock Awards” in the article “Taxation of Restricted Stock Awards,” available in the Restricted Stock Portal.
Previously, award and option holders wishing to file a Section 83(b) election had to mail the election to their IRS service center within thirty days of the triggering transfer (a grant of restricted stock or exercise of an unvested option) and also include a copy of their election with their tax return for that year. With the IRS now encouraging taxpayers to file their returns electronically, the requirement to include a copy with your tax return has turned out to be problematic. Many (dare I say all?) of the systems used to electronically file returns with the IRS simply don’t have the capability of including a copy of a Section 83(b) election, forcing taxpayers to file on paper—a situation in which everyone, both the IRS and the taxpayer, loses.
Recent Developments
Last year, in PLR 201438006, the IRS ruled that a Section 83(b) election is valid even if the taxpayer fails to include a copy of the election with his/her tax return for the year (see my February 3, 2015 blog entry, “Grab Bag“). This ruling was to avoid giving taxpayers an opportunity to rescind their election by simply failing to include the copy with their tax return but it also steered us on a course for the recently proposed amendment (if the election is valid without including a copy with your return, why is the copy necessary).
Proposed Amendments
The proposed amendment would simply eliminate this requirement altogether. There’s really no need for it; as the IRS notes in the preamble to the proposed regs, they already have the original and they scan that for their records upon receipt of it. The requirement to file the copy with your tax return is an anachronism, harkening back to a day before electronic forms and scanners were commonplace.
The IRS does note that taxpayers should keep a copy of the election in their records until the statute of limitations expires for the return on which the sale of the shares subject to the election is reported.
The proposed regulations would apply to all stock transferred (grants of restricted stock and exercises of unvested stock options) on or after January 1, 2016 but taxpayers can rely on them for stock transferred in 2015.
At the same time that the IRS released regulations designed to clarify which restrictions constitute a substantial risk of forfeiture under Section 83 (see my blog entry “IRS Issues Final Regs Under Section 83,” March 4), a recent tax court decision casts doubt on the definition in the context of employees that are eligible to retire.
Background
As my readers know, where an employee is eligible to retire and holds restricted stock that provides for accelerated or continued vesting upon retirement, the awards are considered to no longer be subject to a substantial risk of forfeiture, and, consequently, are subject to tax under Section 83. This also applies to RSUs, because for FICA purposes, RSUs are subject to tax when no longer subject to a substantial risk of forfeiture and the regs in this area look to Section 83 to determine what constitutes a substantial risk of forfeiture.
Although there’s usually some limited risk of forfeiture in the event that the retirement-eligible employee is terminated for cause, that risk isn’t considered to be substantial. As a practical matter, at many companies just about any termination after achieving retirement age is treated as a retirement.
Austin v. Commissioner
In Austin v. Commissioner however, the court held that an employee’s awards were still subject to a substantial risk of forfeiture even though the only circumstance in which the awards could be forfeited was termination due to cause. In this case, in addition to the typical definition of commission of a crime, “cause” included failure on the part of the employee to perform his job or to comply with company policies, standards, etc.
Implications
Up until now, most practitioners have assumed that providing for forfeiture solely in the event of termination due to cause is not sufficient to establish a substantial risk of forfeiture, regardless of how broad the definition of “cause” is. Austin seems to suggest, however, that, in some circumstances, defining “cause” more broadly (e.g., as more than just the commission of a crime) could implicate a substantial risk of forfeiture, thereby delaying taxation (for both income and FICA purposes in the case of restricted stock, for FICA purposes in the case of RSUs) until the award vests.
On the other hand, there are several aspects to this case that I think make the application of the court’s decision to other situations somewhat unclear. First, and most important, the termination provisions of the award in question were remarkably convoluted. So much so that resignation on the part of the employee would have constituted “cause” under the award agreement. There were not any special provisions relating to retirement; all voluntary terminations by the employee were treated the same under the agreement. In addition, the employee was subject to an employment agreement and the forfeiture provisions of the award were intended to ensure that the employee fulfilled the terms of this agreement.
Finally, the decision notes that, for a substantial risk of forfeiture to exist, it must be likely that the forfeiture provision would be enforced. I think that, for retirees, this often isn’t the case–the only time a forfeiture provision would be enforced would be in the event of some sort of crime or other egregious behavior. Termination for cause is likely to be met with resistance from the otherwise retirement-eligible employee; many companies feel that, with the exception of circumstances involving clearly egregious acts, it is preferable to simply pay out retirement benefits than to incur the cost of a lawsuit.
Never-the-less, it is worth noting that 26% of respondents to the NASPP’s recent quick survey on retirement provisions believe that awards held by retirees are subject to a substantial risk of forfeiture.
Last week, the IRS issued the final version of the new Section 1.83-3 regs that were proposed back in 2012.
Background: The Proposed Regs
Section 83 provides that property transferred in exchange for services is taxable when it is transferable or no longer subject to a substantial risk of forfeiture (whichever occurs first). As explained in the preamble to the proposed regs, the purpose of this revision was to clarify that, for a substantial risk of forfeiture to exist, there has to be 1) some reasonable possibility of forfeiture (e.g., a performance goal which is certain to be met would not give rise to a substantial risk of forfeiture) and 2) there has to be some likelihood that the forfeiture provision would be enforced.
Most of us always thought this was the case, so we were surprised to see the proposed regs. Some speculated that companies would now have to estimate the likelihood of forfeiture due to failure to meet the vesting requirements to determine if taxation is delayed under Section 83. During his session at the 2012 NASPP Conference, Stephen Tackney, of the Office of Chief Counsel, at the IRS explained that this wasn’t the IRS’s intention and that they were really only concerned about situations where the likelihood of forfeiture was so infinitesimally small as to be almost nonexistent. Apparently the IRS lost a couple of enforcement actions in court due to a misunderstanding about this concept, so they decided to make the rules a little clearer.
The proposed regs also clarified that lock-up restrictions and trading black-out periods don’t delay taxation under Section 83 and codified a prior Rev. Rul. clarifying when taxation is deferred as a result of the operation of Section 16(b) (for practical purposes, virtually never).
What’s New in the Final Regs
Well, not much, really. In response to the concerns that the regulations were perhaps raising the threshold for a substantial risk of forfeiture, the IRS explains in the preamble that the new regulations are not intended to depart from the historic position that the IRS has taken with respect to Section 83. The IRS also edited the language of the regs, I think with the intention of making this clearer.
The IRS added a sentence to the regs to further clarify that it must be likely that the forfeiture restrictions would be enforced for there to be a substantial risk of forfeiture. Here again, I don’t think this represents a change in position for the IRS.
Finally, the IRS added an example to clarify that, where a Section 16 insider engages in a non-exempt purchase in the six months before an otherwise taxable acquisition under a stock option or award, the non-exempt purchase doesn’t delay taxation of the option or award (even though it does delay when the insider can sell the shares acquired under the option/award). We had noticed there were some differences in opinion among practitioners as to whether this was the case and had asked for clarification. Although the situation probably doesn’t come up that often, when it does come up, we thought it important to know what the correct tax treatment is. And now we know (and I think it’s the answer most of us had been assuming all along).
Read more about the final regs, including our redline comparing the proposed and final regs, in the NASPP Alert “IRS Issues Final Regs Under Section 83.”
In today’s blog I’m going to deviate a bit from our normal format and invite you to take a little quiz. Don’t worry, nobody’s keeping score except for you, so this is just for fun. Why a quiz, you ask? Have you ever wondered where to find something in the massive IRS Tax Code? Many of us have memorized the names and basics about various tax code sections that apply to stock compensation (e.g. Sections 421, 422, 423, 424, 83, 162 and so on). Or, you’ve heard of some pending regulations, but aren’t really sure whether there’s a pending regulation that covers your area of interest? I personally found it fairly straightforward to memorize the basics about all the major tax code sections, but what I find more challenging is keeping on top of all the subsequent revenue rulings and other guidance that emerges from the IRS. If you’re having the same challenge, you’ll want to be sure to visit our new Tax Code portal. It’s simple and concise – there’s a list and description of the various tax code sections, as well as related rulings and other interpretive guidance that apply to stock compensation. Call it a tax code crib sheet, if you may. Wait! Before you check it out, pause for a moment, in that spirit, to take the Tax Code Challenge!
Tax Code Challenge:
1. Where would you find information about the procedures to revoke an 83(b) election?
a. In Code Section 83(b)(2)
b. The IRS had not provided guidance on any specific procedures
c. Section 83 of the Code is clear that an 83(b) election may never be revoked for any reason
d. In Revenue Proc. 2006-31, which became effective June 13, 2006
2. Which revenue ruling provides guidance on the treatment of dividends and dividend equivalents on restricted stock and restricted stock units for 162(m) purposes?
a. There is no revenue ruling that covers dividends/dividend equivalents
b. Revenue Rul. 2012-19
c. Revenue Rul. 98-34
d. There is no revenue ruling, but there are proposed regulations pending on this topic
3. Which of the following reflect pending regulations?
a. Rules relating to the additional medicare tax
b. Rules related to valuing employee stock options that have been gifted for estate planning purposes
c. Rules regarding new information disclosures for Section 6039 related information returns
d. There are no pending revenue rulings that would affect stock compensation
The answers are listed below. If you knew all of the answers – great! You’re a tax guru. For the rest of us that may have been stumped by one or more questions, a visit to the Tax Code portal may help gain clarity in this area.
The IRS has been busy on projects related to stock compensation lately (see “Dividends and Section 162(m),” July 10, 2012, and “Section 83 Update,” June 12, 2012). Their latest project is a sample Section 83(b) filing, something Stephen Tackney and Thomas Scholz, both of the IRS, had alluded to being in the works at last year’s NASPP Conference.
Rev. Proc 2012-29 provides a sample Section 83(b) election, along with examples clarifying the tax treatment that applies when the election is filed. See the NASPP alert “IRS Issues Sample 83(b) Election Form” for more information.
A Quick Review
Section 83(b) elections can be filed by employees when they receive stock that is subject to forfeiture and transferability restrictions. The most common arrangement in which employees would receive stock like this is a restricted stock award. A less common arrangement is an early-exercise stock option, under which employees are allowed and choose to exercise prior to vesting. Normally stock acquired under these arrangements is taxed at vest; filing a Section 83(b) election accelerates the taxable event to the grant/exercise date.
The election has to be made relatively quickly–within 30 days of when the stock is transferred to the employee–and must contain specific details about the transaction for which it is made. There’s not a lot of room for error here–miss the 30-day deadline and you are out of luck.
Incomplete Filings?
I was surprised at last year’s Conference to hear that the IRS was working on a sample 83(b) election. I had assumed most companies assisted employees wishing to make the election, ensuring that their elections are complete. But, given the Rev. Proc, now I’m not so sure.
I don’t know this for a fact, but I have to believe that the IRS issued the sample election because they receive a high number of incomplete filings and this is an effort to mitigate the problem. This is an area where you may want to take action to protect your employees. I think it’s a best practice for companies to provide a form that employees can use to make the election and to review their elections before they file them, just to make sure they’ve completed the form correctly. An incomplete or incorrect filing could be a mess if the error isn’t caught before the 30-day deadline. In a worst case scenario, the entire election could be considered invalid.
Note, however, that I never recommend that companies make the election on behalf of employees. Leave the responsibility for actually submitting the election in employees’ hands so that you don’t bear any responsibility if (or should I say “when”) elections aren’t mailed on time.
I’ll never forget a stock plan administrator telling me about starting a new job and opening a drawer in the prior stock plan administrator’s desk only to find a folder filled with Section 83(b) elections that the company had promised to file on behalf of employees over the past year and that had never been mailed. It was a private company and the elections were for early-exercise options that had been exercised at grant. If they had been filed on time as the company had promised, the employees would not have recognized any compensation income on their options. It still makes me a little sick to my stomach to think about it. Don’t do that! Make the employees mail their own elections.
More at the NASPP Conference
Attend the panel, “The IRS Speaks,” at the 20th Annual NASPP Conference to hear more about this Rev. Proc. as well as other rule-making activity that the IRS has completed this year–and hear what’s on tap for next year.
In the category of “really, doesn’t the IRS have anything better to do,” the IRS has proposed revisions to existing regulations under Section 83 of the Internal Revenue Code. The proposed changes are designed to clarify when a substantial risk of forfeiture exists with respect to shares that are subject to restrictions on transferability.
Was Anyone Confused About This?
Specifically, the regulations clarify that a substantial risk of forfeiture is established only with a service condition or a condition related to the purposes of the transfer. I have no idea what this means or why the IRS thinks it needs to be clarified. The extent of this change was to add the word “only” to the sentence:
A substantial risk of forfeiture exists [only] where rights in property that are transferred are conditioned, directly or indirectly, upon the future performance (or refraining from performance) of substantial services by any person, or upon the occurrence of a condition related to a purpose of the transfer if the possibility of forfeiture is substantial.
Gosh, that is so much clearer now.
More Changes That Don’t Really Change Anything
The proposed changes are also designed to clarify that the likelihood of forfeiture must be considered when assessing whether a substantial risk of forfeiture exists. The preamble to the proposed regulations cites an example involving shares that are non-transferable and subject to forfeiture if specified performance conditions are not achieved. In the example, it is highly probable that the conditions will be achieved. As a result, the award is not considered to be subject to a substantial risk of forfeiture.
Finally, the proposed changes clarify that transfer restrictions in and of themselves don’t create a risk of forfeiture even if violation of the restriction carries the potential for disgorgement or forfeiture of the stock. The only exception is for stock that must be held to avoid triggering short-swing profits recovery under Section 16(b) (and this is only an exception because it is baked into the tax code). This clarification codifies a prior IRS Rev. Rul. (see the NASPP alert “Section 83 Treatment of Sale Restrictions Imposed for Securities Law Purposes“).
The last two clarifications seem to be intended to mitigate the results of a First Circuit Court decision. The case involved an employee who was required to sell stock he acquired upon exercise of an option back to the company at cost if he sold the stock within one year of his exercise. The court ruled that this requirement delayed taxation under Section 83, even though the likelihood that the employee would try to sell the stock during this one-year period was very small. See the Akin Gump memo included with our alert for a great summary of the case and its relevance to the IRS proposal.
And while these changes seem a little more substantive, given the fact that we’ve had a Rev. Rul. on this matter since 2005, I’m not sure this changes how any practitioners interpret Section 83.
Taxation of Clawbacks?
I wonder if the IRS is targeting clawback provisions here. With all the recent hubbub over clawbacks (for example, see last week’s guest blog entry by Mike Melbinger) and the fact that regulations for mandated clawbacks under Dodd-Frank are expected from the SEC this year, I think the IRS might be trying to get out ahead of any ideas anyone might have that clawback provisions somehow delay taxation under Section 83.
More at the NASPP Conference
I’m sure rule change will be discussed during the session “The IRS and Treasury Speak” at the 20th Annual NASPP Conference. It will be interesting to hear what the IRS and Treasury staffers have to say about it.
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so we keep an ongoing “to do” list for you here in our blog.
Don’t miss your local NASPP chapter meetings in Chicago, San Francisco, and Wisconsin. I will be at the San Francisco chapter meeting–I hope to see you there.