§1.83-1: Taxing Property Transferred for Services

Treasury Regulation §1.83-1, along with Internal Revenue Code (IRC) Section 83, establishes the tax principles for property transferred for services. This framework governs how and when employees or independent contractors are taxed on awards like company stock. The regulation dictates the timing of income recognition and applies to any transfer of property granted in connection with the performance of services.

The General Rule for Taxable Events

Under §1.83-1, a taxable event does not occur upon the receipt of property. Taxation is deferred until the recipient’s rights become “substantially vested,” which is determined by two components: the substantial risk of forfeiture and transferability. A property transfer occurs when a person acquires a beneficial ownership interest, giving them the right to the property’s potential increase in value and exposing them to the risk of its decline. These rules apply when property is provided “in connection with the performance of services,” which includes most employer-to-employee equity grants.

The most common condition preventing property from being substantially vested is a “substantial risk of forfeiture” (SRF). An SRF conditions property ownership on the future performance of substantial services. For example, stock that an employee will only own after completing three more years of employment is subject to an SRF. If the employee leaves before the three-year mark, they forfeit the stock, which is a common time-based vesting schedule.

An SRF can also be tied to performance metrics, such as meeting corporate revenue targets or individual performance goals. The risk that the property’s value might decline does not constitute an SRF. The rights to the property itself must be conditional and subject to being lost.

The second component of the substantially vested test is transferability. Property is transferable if the recipient can move it to a third party free of the substantial risk of forfeiture. If the recipient can sell or gift the property to someone who is not bound by the same forfeiture conditions, the property is considered transferable.

The taxable event occurs on the first date the property is either no longer subject to an SRF or becomes transferable. On this date, the property is considered substantially vested. This triggers immediate income recognition for the service provider, and the value of the compensation becomes fixed for tax purposes.

Calculating and Reporting Taxable Income

When property becomes substantially vested, the employee must recognize ordinary compensation income. The amount is the fair market value (FMV) of the property at the time of vesting, less any amount the employee paid for it.

As ordinary income, this amount is subject to the employee’s marginal income tax rate and payroll taxes, such as Social Security and Medicare (FICA). The income is reported on the employee’s Form W-2, similar to regular wages.

The employee’s new tax basis in the property is the amount paid plus the ordinary income recognized upon vesting. For example, if an employee paid $1,000 for stock worth $10,000 at vesting, they would recognize $9,000 of ordinary income, and their new basis would be $10,000. This basis is used to calculate capital gains or losses on a future sale.

The employer receives a business expense deduction equal to the amount of ordinary income the employee recognizes. The employer claims this deduction in their taxable year in which the employee’s taxable year of income inclusion ends.

The employer must also handle tax withholding on this compensation. When the property vests, the employer withholds federal and state income taxes and the employee’s share of payroll taxes on the recognized income amount, just as with cash wages.

Rules for Forfeiture of Property

The tax consequences of forfeiting property depend on whether it was substantially vested when lost. If an employee forfeits property before it becomes substantially vested, it is a non-event for tax purposes. Since no income was recognized, there is no loss to claim, and the employer has no tax impact.

If property is forfeited after it has substantially vested and income has been recognized, the employee can claim a loss. This can occur if a condition, such as a non-compete agreement, is violated, forcing the return of vested shares. The loss is an ordinary loss, not a capital loss, and is limited to the employee’s basis in the property (the amount paid plus the income recognized). For example, if an employee paid $1,000 for stock and recognized $9,000 in income at vesting, their basis is $10,000; if they later forfeit that stock, their deductible ordinary loss is $10,000.

The employee cannot claim a loss for the property’s full fair market value at the time of forfeiture if it was higher than their basis. The deduction is tied to the amount previously included in income and paid, preventing a loss claim on appreciation that was not retained.

The Section 83(b) Election

A Section 83(b) election alters the timing of taxation for property received for services. Instead of deferring the taxable event until the property substantially vests, the election allows an individual to recognize ordinary income when the property is granted. This choice accelerates the tax liability to the year of transfer and carries both benefits and risks.

With a Section 83(b) election, taxable income is the property’s fair market value on the grant date, minus any amount paid. The main reason for this election is potential tax savings. If the property’s value is low at grant and expected to appreciate, the election recognizes a small amount of ordinary income upfront. All later appreciation is treated as a capital gain, which may be taxed at lower long-term rates if held for more than one year after the grant.

This strategy is risky. If the taxpayer makes the election and later forfeits the property before it vests, they cannot recover the taxes paid. No deduction or loss is allowed for the income recognized due to the election. The taxpayer is left having paid tax on property they never owned.

The procedural requirements for a Section 83(b) election are strict. The election must be filed with the Internal Revenue Service (IRS) no later than 30 days after the property is transferred, and this deadline is absolute with no extensions. The election statement must contain specific information, including:

• The taxpayer’s details
• A description of the property
• The transfer date
• The nature of any restrictions
• The property’s fair market value at grant
• The amount paid for the property

The taxpayer must send the completed election statement to the IRS service center where they file their annual tax return and provide a copy to their employer. Using certified mail with a return receipt is recommended to prove timely filing.