Employers often use restricted stock as a means of incenting employees. Employees are either granted options to acquire stock of their employers or given actual shares, subject in each case to restrictions requiring the forfeiture of any shares acquired if the employee terminates employment during a specified vesting period. Under the general rule of Section 83 of the Internal Revenue Code, the employee does not include the value of the stock in income until the year that the stock is no longer subject to a risk of forfeiture. By that time, the stock may have risen in value substantially, resulting in the recognition of a greater amount of income by the employee. Even worse from the employee's point of view, the income resulting from the vesting of the stock would be considered compensation for services and would be taxed at ordinary income rates.

From the employer's standpoint, the deferral of the employee's tax consequences is generally good news. The increased income recognized by the employee upon vesting of the stock is matched by an increased compensation deduction and thus a greater tax benefit. However, the employer is required to pay the employer's share of FICA tax on the increased amount of income and to withhold federal, state and local income tax. The mechanics of withholding against the employee's phantom (cashless) income can be troublesome unless the employer has agreed in advance with the employee how the tax will be collected. Furthermore, startup businesses that have net operating losses in their first years of operation often have no immediate need for an additional tax benefit.

As a consequence, not only employees but also many employers prefer the alternative of having the employee make a Section 83(b) election upon the receipt of restricted stock. If a Section 83(b) election is made, the employee includes the value of the restricted stock in income in the year of receipt, at which time it is expected to have a much lower value than on its vesting date. Although the employee might have to pay a small amount of tax up front, no further tax would be due until the stock is sold or disposed of in a taxable transaction after it has vested. At that time, any appreciation in value of the stock from the date of its original receipt would be considered a capital gain and be taxed at the more favorable capital gain rates. While the business loses the opportunity for a larger compensation deduction, the employer avoids any withholding tax headaches and achieves a modest FICA tax savings.

Treasury Regulations state that employees desiring to make an election under Section 83(b) must file a statement containing certain information with the IRS within 30 days of the date that the restricted shares are transferred to them. No IRS form is available for this purpose, and employees desiring to make the election have often had to seek legal advice in order to make sure their elections are valid. In practice, the burden of making sure the Section 83(b) election is properly made often falls on the employer, who has to determine its liability for the collection and payment of the withholding and employment taxes that are currently or ultimately imposed on the employee's stock-based compensation.

The IRS National Office recently issued a memorandum (SCA 200203018, Oct. 15, 2001) to seven of its service centers (including Philadelphia) advising that Section 83(b) elections signed and filed by an employer under powers of attorney granted by its employees were valid. The employer described in the memorandum had each employee sign a Form 2848 Power of Attorney expressly authorizing representatives of the employer to file elections under Section 83(b) on his or her behalf. The authority granted under the power of attorney was specifically limited to the filing of the Section 83(b) election. The employer then filed Section 83(b) election statements with each of the affected IRS service centers together with corresponding Forms 2848. Under these circumstances, the IRS National Office found that the employer's filings met the requirement that election statements be signed by the taxpayer making the Section 83(b) election and that they were, therefore, valid with respect to the employees.

Although a service center advice memorandum cannot be legally cited as precedent in dealing with the IRS, the reasoning of SCA 200203018 appears to be correct. According to the IRS's own Form 2848 instructions, taxpayers may authorize their designees under powers of attorney to perform "any and all acts you [the taxpayer] can perform." Although tax "returns" are excepted from this general grant of authority, a Section 83(b) election statement would not seem to be a "return".

The power of attorney method used in the service center advice memorandum may benefit both employers and employees by simplifying the process of making Section 83(b) elections, preventing election statements from slipping through the cracks and avoiding potentially costly errors. Because of the significant tax risks involved in using stock-based compensation, however, clients should consult their Ballard Spahr tax advisors to make sure Section 83(b) elections comply with both the letter and spirit of the latest available guidance from the IRS.

Copyright © 2002 by Ballard Spahr Andrews & Ingersoll, LLP.

This newsletter is a periodic publication of Ballard Spahr Andrews & Ingersoll, LLP and is intended to alert the recipients to new developments in the law. It should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own lawyer concerning your situation and specific legal questions you have.