Compensation and Residual Gross Income
Chapter 5: § 61(a)(1) Compensation
C. Section 83
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break even in running the cafeteria. Must the employees include the difference between the FMV of the meals and the price paid for them? Assume that § 119 is not satisfied on the facts. See § 132(e)(2). What if the facility is an Executive Dining Room open only to Executives?
10. Conglomerate, Inc., reimburses Jacob for his parking costs in a garage close to the office building at a cost of $150 each month. Only executives’ parking costs are reimbursed.
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Suppose that you rack up frequent flier miles on business trips reimbursed by your employer and that you subsequently use those frequent flier miles to take a personal trip. That personal trip was, in substance, paid for by your employer because the miles used to take the trip were compiled on travel paid for by your employer. Nevertheless, the IRS has announced that it will not seek to tax the use of such frequent flier miles unless the employee is able to convert them to cash,16 as occurred in Charley v. Commissioner.17
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forfeiture risk lapses. Therefore, if any dividend is payable on the stock during the period before vesting, Mary would have no legal right to the dividend. Nevertheless, many corporations pay an equal amount “in lieu of” the dividends to folks like Mary, who must include these amounts as (ordinary) compensation income.
Under § 83(b), however, Mary can make an election (within 30 days of receipt) to include the FMV of the restricted property in the year of receipt (thus creating a basis equal to that Gross Income inclusion). The FMV is determined without regard to the forfeiture risk inherent in the stock. What factors should Mary consider in deciding whether to make a § 83(b) election?
As you learned in Chapter 1, the deferral of an income inclusion benefits Mary because of (all together now) the time value of money. All things being equal, Mary would like to defer an income inclusion as long as possible. But sometimes all things are not equal. For example, what if Mary believes that the top tax rate may increase beyond 39.6% before the stock vests in Year 5? She would have to weigh two factors—possibly higher tax rates in the future and the time value of deferral—against each other in determining whether deferral would be beneficial. That is to say, even though she would lose the time value of money by giving up deferral and including the
$500,000 now, that real economic loss may be more than made up for by having that inclusion taxed at 39.6% if she believes that future tax rates will be significantly higher.
Moreover, even if tax rates remain absolutely unchanged between Year 1 and Year 5, Mary may still wish to include the $500,000 FMV in Year 1 because the property received (stock) is a capital asset. While the top tax rate applicable to ordinary income (such as compensation) is 39.6%, recall from Chapter 1 that the top tax rate applicable to “net capital gain” (which requires at least some long-term capital gain, as explored more fully in Chapter 15) is generally 15% for those with Taxable Income of less than $400,000 ($450,000 for married couples filing jointly) or less and 20% for those with Taxable Income exceeding those thresholds. Suppose that Mary expects that stock to be worth $600,000 in Year 5 when the forfeiture risk lapses. If she defers inclusion until Year 5, she will include $600,000 of high-taxed ordinary income at that time. If, in contrast, she makes a § 83(b) election in Year 1 and includes the $500,000 FMV of the stock in that year, she will take a $500,000 cost basis. When the forfeiture risk lapses in Year 5 and she sells for its then-value of $600,000, she would realize $100,000 of low-taxed capital gain ($600,000 A/R less
$500,000 A/B). Which would be better? Once again, she would have to weigh the pain of losing the time-value-of-money benefit against the reduction in tax rate that could potentially apply to the $100,000 expected future appreciation.
Suppose that Mary expects the stock (FMV of $500,000 on receipt in Year 1) to lose value to, say, $200,000, before the forfeiture restriction lapses in Year 5. In that case, she clearly would not want to make the § 83(b) election to include $500,000 of high-taxed income now, creating a
$500,000 basis, only to realize a $300,000 capital loss later ($200,000 A/R less $500,000 A/B).
Not only would Mary lose the time value of money but, under the § 1211(b) capital loss limitation rule to which you were introduced in Chapter 1, the capital loss may be difficult to deduct in Year 5 if Mary does not realize substantial capital gain in that year (though she could carry forward any undeducted capital loss under § 1212(b)). If, instead, she included nothing in Year 1, she would include only the stock’s $200,000 Year-5 FMV when the forfeiture risk lapses (and would realize no loss). In this way, she enjoys both the time value of money and avoids the capital loss deduction restrictions in § 1211(b).
How good is Mary’s crystal ball …?
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Read the last sentence in § 83(b)(1). A downside of making the § 83(b) election (which, recall, creates basis equal to the amount included) is that, should the forfeiture occur, Mary would be denied deduction of her otherwise allowable $500,000 loss deduction (equal to her basis) under §§
165(b) and (c)(2). Thus, if Mary does not make a § 83(b) election and quits in Year 3, she would avoid any income inclusion. If Mary does make a § 83(b) election and quits in Year 3, she would include the $500,000 FMV in Year 1 on receipt (creating a $500,000 basis in the stock); when she quits in Year 3 and must forfeit her stock to her employer, she could not deduct her $500,000 basis.
Why should Mary be denied a loss deduction equal to the basis of this lost investment? The legislative history is silent with respect to this question. As a normative matter, it’s incorrect to deny her the loss deduction for investment property.
The employer’s § 162 deduction for compensation paid is taken in the same year and in the same amount as the employee’s compensation inclusion.18 Thus, both the timing and amount of the employer’s deduction will depend on whether the employee makes a § 83(b) election.
While stock happens to be the most common property that triggers application of § 83, notice that § 83 is not limited to stock. For example, recall CEO Sue from earlier in this chapter, who purchased Blackacre for $10,000 from her employer when the property was worth $100,000. If the retention of Blackacre is conditioned on CEO Sue not quitting or being fired for cause before the end of Year 5, she would not (contrary to our earlier analysis) include the $90,000 received for free in her Gross Income in Year 1, unless she chooses to do so by making a § 83(b) election.
Finally, what if Mary receives not stock but an option to buy stock? For example, Conglomerate gives CEO Sue an option to buy Conglomerate stock for $100 per share at a time when the stock is trading at $100 per share. That property right, even if not subject to a substantial risk of forfeiture, would have a $0 value at the time of receipt, as it provides her no benefit that any other buyer of the stock enjoys. So let’s change the facts and say that the option gives CEO Sue the option to buy Conglomerate stock for $90 per share at a time when the stock is trading at $100 per share. That property right surely has value to CEO Sue, but must she include something at the time she receives this “in the money” option if it is not subject to a substantial risk of forfeiture?
Luckily for CEO Sue, Treas. Reg. § 1.83-7(b)(1) provides that an option like Sue’s must be included on receipt as compensation only if it has a “readily ascertainable” FMV at that time, which will generally be the case only if the option is “actively traded on an established market.”19 While some stock options are traded over established markets, the kind received by CEO Sue rarely are. Thus, CEO Sue would include nothing in Gross Income as compensation on the receipt of this in-the-money option. If she exercises that option, however, for $90 per share when the FMV of the stock received is $100 per share, she would include the $10 received for free as ordinary compensation income under §§ 61(a)(1) and 83(a). Her basis for each share would then equal the
$90 that she paid (a nondeductible capital expenditure that creates basis) plus the $10 that she included as compensation income under §§ 61(a)(1) and 83(a) for a $100 total basis. If the stock continues to increase in value, and CEO Sue is able to sell it for, say $120, her $20 realized gain ($120 A/R less $100 A/B) would be capital gain. Thus, the longer she waits to exercise that option, the more high-taxed compensation income that she will realize if that stock continues to increase in value between the time of the option receipt and its exercise. Sometimes the option grant may
18 See § 83(h).
19 Options that are not actively traded on an established market are considered to have a “readily ascertainable” FMV only if certain conditions described in Treas. Reg. § 1.83-7(b)(2) are met, and they rarely are.
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stipulate that the exercise date can be no sooner than a particular date in the future in order to encourage the executive to do everything in his or her power to increase the corporation’s future share price.20 Of course, if CEO Sue expects the stock’s FMV to fall below her $90 per share option price, she would likely choose not to exercise her option, and she would thus realize no tax consequences.
Problems
What are the tax consequences for Employee Erin in each of the following?
1. In Year 1, Erin receives shares of corporate stock from her employer-corporation with a FMV of $200 for no consideration (i.e., she pays nothing for the stock shares). No restrictions attach to Erin’s receipt and continued ownership of those shares. The stock has a FMV of $300 at the end of Year 3, but she does not sell until Year 5, when she sells for $500.
2. Same as 1., except that the stock certificates are stamped with a legend that states that, should Erin quit or be fired for cause before the end of Year 3, she must forfeit the stock back to her employer-corporation. Erin does not make the § 83(b) election. The stock has a FMV of $300 at the end of Year 3, but she does not sell until Year 5, when she sells for $500.
3. Same as 2., except that Erin decides to make the § 83(b) election. The stock has a FMV of
$300 at the end of Year 3, but she does not sell until Year 5, when she sells for $500. What if, instead, the shares lose value and she is able to sell for only $100 in Year 5?
4. Same as 3., except that Erin is fired for cause in Year 2 before the stock vests, and she must forfeit the stock at that time.
5. Based on the results in 2 through 4, above, what questions would you ask Erin in helping her to decide whether or not to make a § 83(b) election?
20 Special rules apply to so-called incentive stock options (ISOs) in § 421 that differ from the rules prescribed here.
ISOs are uncommon.