New IRS Ruling on Tax Consequences of “Re-Vesting” Previously Vested Stock

From time to time, an individual service provider holding vested shares will be required to consent to the imposition of new vesting on the shares tied to his or her continued service or achievement of performance milestones.  On July 6, 2007, the Internal Revenue Service published Revenue Ruling 2007-49, which provides important new guidance addressing when the individual should consider making a special election to avoid recognizing additional income in connection with such “re-vesting” of shares and when it is not necessary to make this election.

The ruling confirms prior unpublished guidance issued by the IRS that if the imposition of new vesting restrictions occurs in connection with a financing or other event not involving an exchange of the stock for new stock (e.g., shares of a different entity), then there are no income tax consequences and no need to consider making a special election.  However, if vested stock is exchanged for new stock (stock of the acquiror) that is subject to vesting restrictions (e.g., in connection with a tax-free or taxable acquisition of the issuer), the receipt of the unvested stock is considered a transfer of property subject to the tax rules governing property received in connection with performance of services under Internal Revenue Code Section 83.  As explained below, however, as long as the recipient of the stock makes a timely election under Section 83(b) (a “Section 83(b) Election”), the receipt of the unvested stock normally will not result in any taxable compensation income to the recipient. 

Background

Under Section 83(a), if property is transferred in connection with the performance of services, the excess of the fair market value of the property over the amount paid for the property is included in the service provider’s gross income as of the first taxable year that the service provider’s rights in the property are “substantially vested,” i.e., when they are either transferable to a third party or are not subject to a substantial risk of forfeiture.  However, Section 83(b) permits the service provider to elect to include in such individual’s gross income the excess (if any) of the fair market value of the property over the amount paid for the property in the year the property is transferred, rather than the year it becomes vested.  If such a Section 83(b) election is made, no compensation income is recognized as the property vests and any subsequent appreciation in the value of the property is generally taxable as capital gain upon a future taxable disposition of the property. 

Key employees or other service providers are sometimes asked, in connection with and as a condition to a private company financing or a merger, to agree to additional restrictions on their previously vested shares as a means of retaining the individual’s services.  The IRS in the past has indicated that it did not believe Section 83 applies to the imposition of vesting restrictions in the case of a financing, since the service provider already owns the stock being subjected to the restrictions and therefore no Section 83 property transfer has occurred in connection with the financing.  Because such prior guidance was not issued in a form that could be relied upon as precedent, many tax advisors have nonetheless recommended that service providers make “protective” Section 83(b) Elections in such a situation.  In the case of an exchange of vested stock of a target company for unvested stock of the acquiror in connection with tax-free or taxable acquisitions, by contrast, a Section 83 transfer clearly does occur.  There has been some uncertainty, however, as to what the “amount paid” for the new shares should be deemed to be for purposes of determining any Section 83 compensation income arising from such receipt, since the service provider “pays” for the new shares with the shares surrendered in the exchange.

Summary of Ruling

The recent IRS ruling clarifies these issues by explaining the tax consequences under Section 83 in three common situations.  In the first situation involving the imposition of new vesting and transferability restrictions tied to continued employment on vested stock in connection with a financing transaction, the IRS determined that, because the shares were already owned by the individual for purposes of Section 83 prior to the imposition of new restrictions, no "transfer" had occurred.  In light of this ruling, the practice of filing “protective” Section 83(b) Elections is not necessary.

In the second situation, an individual received shares of an acquiring corporation's stock in a merger qualifying as a tax-free reorganization, resulting in a transferred basis on such shares of acquiror stock and deferral of gain recognition.  The individual exchanged vested stock of the target corporation for acquiror stock subject to ongoing service (vesting) requirements, causing the newly-issued shares to be substantially nonvested.  The third situation involved the same facts as in the second situation except that the merger was fully taxable, resulting in the individual recognizing capital gain on the exchange of the vested stock for the unvested stock equal to the excess of the fair market value of the stock received over the individual’s tax basis in the stock surrendered.  In both situations, the IRS determined that because the individual disposed of the vested target stock in exchange for unvested acquiror stock, such shares were transferred in connection with the performance of services and therefore were subject to Section 83.  In each of these two scenarios, a Section 83(b) Election is appropriate and (assuming the election is timely filed in connection with the exchange -- i.e., within 30 days after the closing of the merger) would result in any subsequent appreciation in the value of the stock to be taxed at the capital gains tax rate rather than the higher ordinary income rate applied to compensation.  The ruling further clarifies that the employee would not also recognize any compensation income as a result of filing the Section 83(b) Election at the time the election is filed because the "amount paid" for the exchanged shares for purposes of the election is the same as the value of the stock received in the exchange.

We note that while this recent IRS ruling does not apply to stock options, it could apply to unvested stock purchased on exercise of an option.  We also note that restricted stock generally is not subject to Code Section 409A (governing deferred compensation), though the addition of special deferral features to a restricted stock award could cause the award to be subject to Section 409A rather than Section 83.

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