Blake Christian
Blake Christian

IRS releases Sec. 83(b) election guidance and language

Rev. Proc. 2012-29 reminds taxpayers of planning opportunities with Sec. 83 and the importance of a timely election.

July 26, 2012
by Blake E. Christian, CPA

Sec. 83(a), which first appeared in the Code in 1969, requires service provider(s) (including W-2 employees or independent contractors) to include the value of property (other than cash and some stock options) received in return for services, less the amount paid for the property, in taxable income in the first year the rights to the property are transferable or not subject to substantial risk of forfeiture. Under Sec. 83(b), a service provider can elect to include the value of property less any amount paid for it in income in the year the property is received even if it is not transferable or is subject to substantial risk of forfeiture.

Many companies and recipient service providers overlook these provisions, even though the future tax consequences of a transfer of property can be significant to the service provider and the service recipient. With proper planning, Sec. 83 can offer valuable tax and economic benefits to both parties.

The broad application of Sec. 83, the ability to control the timing of income and deductions, and the amount and character of the income associated with the property transfer, make Sec. 83 one of the most powerful and flexible tax planning tools for closely held businesses. The strategy of using property instead of cash can benefit businesses in almost any industry and offers flexibility for cash-strapped companies.

Sec. 83 applies to a wide variety of transfers and fact patterns, including:

  • Compensatory transfers of equity interests in corporations, LLCs, or partnerships;
  • Compensatory transfers of real estate interests; and
  • Compensatory transfers of vehicles, inventory, or other property.

The strategy for minimizing overall taxes is driven primarily by the future expected and actual appreciation (or devaluation) of the property transferred. In general, if the property is of a type that is expected to increase materially in value in the future (e.g., equity interest in businesses or real estate), a Sec. 83(b) election should be considered. However, if the underlying property is of a type likely to decrease in value—e.g., vehicles and other personal property—deferring income recognition by not making a Sec. 83(b) election until any restrictions on the property lapse generally produces a more favorable result for the recipient.

For service providers subject to Sec. 83, the general strategy is threefold:

  • Minimize ordinary income;
  • Maximize capital gain income; and/or
  • Defer income without significantly compromising items 1 and 2.

Generally, under Sec. 83(a), when a service provider receives property as compensation for past or future services, the service provider must include in taxable income the difference, if any, between (1) the fair market value of the property and (2) the amount paid for the property. As noted above, the year the service provider includes this amount in income depends on whether the property is subject to transfer restrictions or forfeiture conditions and whether the service provider makes an election under Sec. 83(b) to accelerate the inclusion of the amount in income.

A Sec. 83(b) election effectively allows the service provider to elect within 30 days of a property transfer to treat the property as vested even if there are still restrictions on the receipt of the property. Even if the parties believe there is no income on the initial transfer, and that the value of the property will decline in the future, a Sec. 83(b) election disclosing the transfer and reporting no value or taxable income can save the recipient from devastating tax results in the future. These results include treating any increase in the value of the property subsequent to its transfer as ordinary income rather than capital gain.

Similarly, the business that receives the services claims a tax deduction for the compensation the service provider reports as income. The business will normally report the deduction in the year in which the service provider reports the income; thus, a Sec. 83(b) election by the service provider may accelerate the business’s compensation deduction. However, businesses using fiscal years may have to delay the compensation deduction under Sec. 83(h).

Sample language for making Sec. 83(b) election in Rev. Proc. 2012-29

Note: It is critically important for a service provider to file the Sec. 83(b) election with the IRS Service Center where the service provider files his or her federal income tax return no later than 30 days after the initial property transfer.

On June 26, 2012, the IRS released Rev. Proc. 2012-29, which, in Section 6, provides sample language for a Sec. 83(b) election. In addition to providing specific language for a Sec. 83(b) election, the revenue procedure provides useful fact patterns that illustrate the potential tax benefits and pitfalls to both the business receiving the services and the service provider. The election can apply to a wide variety of assets transferred for services provided.

The prototype Sec. 83(b) election format provided in the revenue procedure is a useful reference for ensuring that the election is properly filed and the relevant details are disclosed.

Employees and other service providers considering making a Sec. 83(b) election should engage in discussions with the business to which the services were provided to discuss the possibility of having the company absorb a portion of the income tax triggered by the election. The company may realize that this accelerated tax deduction is an unanticipated economic windfall and agree to apply a portion of the company’s tax savings to the recipient’s liability.

Additional background on Sec. 83 strategies can be found at Christian, “Section 83: Property in Exchange for Services,” Corporate Taxation Insider (Sept. 27, 2007).

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Blake E.Christian, CPA, MBT, is a tax partner in the Long Beach, Calif., office of Holthouse Carlin and Van Trigt LLP (www.hcvt.com).