Earlier this year, the IRS issued proposed regulations under section 83(b) of the Internal Revenue Code that would eliminate the current requirement that a copy of a section 83(b) election be attached to the federal income tax return for the taxable year of the relevant transaction. The proposal (which, if finalized, would be in effect as early as the 2015 tax year) is intended to simplify tax reporting, especially for taxpayers who file tax returns electronically.
A bit of background on section 83 is in order. The general rule under section 83(a) governs compensatory transfers of property (e.g., employer stock) to a service provider (an employee or consultant). The rule generally requires that the service provider recognize ordinary income in the year in which the transferred property is no longer subject to a substantial risk of forfeiture (SRF) (or is transferable free of an SRF) equal to the difference between (a) the property’s fair market value on the date it became free of any SRF and (b) the purchase price, if any, for the property. This approach recognizes that taxpayers do not have full ownership of property subject to an SRF (e.g., a vesting schedule) until the forfeiture conditions no longer apply, and defers taxation until that point. The employer’s tax deduction for the ordinary income amount included by the service provider is similarly deferred.
As an alternative to the general rule set forth in section 83(a), section 83(b) permits a service provider who receives property subject to an SRF (and thus subject to the general rule) to make an election to be taxed as of the time of transfer as if the property were not subject to an SRF, in which case the service provider would recognize ordinary income equal to the difference between (a) the property’s current fair market value (disregarding any SRF) and (b) the purchase price, if any, paid for the property. The service recipient’s deduction is similarly determined. This election must be made no later than 30 days following the transfer of the property in question and cannot readily be reversed by revocation or rescission. In general terms, the reason a service provider might decide to make a section 83(b) election is because while the transferred property may not have a great deal of value at the outset, it is expected to increase significantly in value over the vesting period (e.g., stock of a successful start up). That said, an 83(b) election is not without risk—if the stock depreciates in value or the property is forfeited under the SRF, the electing service recipient can be a significant loser.
The current rules governing 83(b) elections require the service provider to take three procedural steps:
- The election document must be filed within the 30-day period described above with the IRS Service Center with which the service provider files his/her individual tax return. This filing puts the election into effect—without filing the election document, no 83(b) election has been made, even if the election document has been fully executed.
- The service provider must attach a copy of the election document to his or her tax return filed with the IRS for the taxable year of the transfer.
- The service provider must submit a copy of the election to the service recipient.
The proposed regulations do not affect steps (1) and (3) above, but propose to eliminate step (2), in large part because of the technological difficulties in attaching an 83(b) election to a federal tax return when filing electronically The proposal may also represent a recognition that there is good support for the view that the failure to accomplish steps (2) or (3) should not invalidate an 83(b) election (i.e., the timely filing of the 83(b) election with the IRS is the key step).
The IRS makes a notable observation in the preamble to the proposed regulations about the service provider’s obligation to maintain documents, stating that taxpayers have a duty to maintain sufficient documents to establish the tax basis in property, and that this duty extends until the expiration of the period of limitations following the date of the disposition of the property (i.e., the taxable disposition of the property subject to the 83(b) election, which could occur years after the date of the 83(b) election itself). Current recordkeeping practice may not correspond to the IRS’ view.
If adopted, the new rule would be effective with respect to property transferred on or after January 1, 2016, but taxpayers can rely on the new rule for property transferred on or after January 1, 2015. To be clear, an 83(b) election made in January 2015 with respect to property transferred in December 2014 would not appear to be covered by the new rule (the election should be attached to the 2014 tax return), even if the return is on extension for the 2014 year.