Employer Deduction Rules Under Treas. Reg. §1.83-6

Internal Revenue Code Section 83 provides the framework for taxing property, such as stock, when it is transferred to a service provider for their work. A related rule, Treasury Regulation §1.83-6, specifies the rules for the employer’s deduction for that compensation. The regulation’s purpose is to align the employer’s deduction with the employee’s income inclusion. This means the timing and amount of the business’s tax deduction for transferring property corresponds with the income recognized by the person who performed the services.

The General Rule for Employer Deductions

The regulation’s “matching rule” synchronizes the employer’s deduction with the employee’s income recognition. An employer is allowed a deduction equal to the amount the service provider includes in their gross income. This deduction must be taken in the employer’s taxable year that includes the end of the service provider’s taxable year in which they recognize the income.

The timing of the deduction is influenced by a “substantial risk of forfeiture,” or a vesting schedule. If an employee receives stock that is not fully theirs until a condition is met, the property is not “substantially vested.” The employee’s income recognition is deferred until the stock vests, and so is the employer’s deduction. For example, if a company grants restricted stock that vests in 2025, the employee includes the stock’s value in their 2025 income, and the company takes the deduction on its tax return for the year that includes the end of 2025.

The timing can be altered if the employee makes a Section 83(b) election, which allows them to include the property’s value in their income at the time of grant rather than waiting for it to vest. This choice accelerates the tax event for the employee. Because the deduction is matched to the employee’s income inclusion, an 83(b) election also accelerates the deduction for the employer. The employer can then deduct the same amount the employee included in income in the taxable year the election was made.

An exception to the timing rule exists for property that is substantially vested at the time of transfer. In these cases, the employer can take the deduction according to its regular method of accounting, rather than waiting for the end of the employee’s taxable year. This often applies to the exercise of non-qualified stock options where the shares received are fully vested. This allows the deduction in the same year the employee recognizes the income.

Withholding as a Prerequisite for Deduction

An employer must properly withhold taxes to secure its deduction for property compensation. The regulation conditions the ability to deduct the compensation on the fulfillment of these statutory withholding obligations. Failure to deduct and withhold the appropriate income and employment taxes can lead to the complete disallowance of the employer’s deduction.

This requirement creates challenges when compensation is property, like stock, rather than cash. The employer is obligated to remit taxes based on the fair market value of the vested stock, but there is no cash payment from which to subtract the withholding. Therefore, companies must establish a mechanism to collect the necessary tax funds from the employee to remit to tax authorities.

Employers use specific arrangements to handle this. A common method is a “sell-to-cover” transaction, where the company facilitates the immediate sale of a portion of the employee’s newly vested shares. The proceeds are then used to cover the tax withholding obligation. Another approach involves the employer collecting the required tax amount directly from the employee in cash.

The regulation provides a safe harbor related to this requirement. If an employer satisfies the reporting requirements of Section 6041 by properly reporting the income on an employee’s Form W-2, the service provider is deemed to have included the compensation in their gross income. This procedural safeguard helps secure the deduction.

Special Rules and Scenarios

Transfers by a Shareholder

When a shareholder transfers their personal stock to a corporate employee as compensation, the transaction is re-characterized for tax purposes. It is treated as if the shareholder first made a capital contribution of the stock to the corporation, which then transfers it to the employee. As a result, the corporation, not the shareholder, is entitled to a compensation deduction equal to the amount the employee includes in income. Any payment the employee makes for the stock is considered paid to the corporation and then distributed to the shareholder.

Forfeiture of Previously Deducted Property

A “recapture” rule applies if an employee forfeits property for which the employer has already taken a deduction, such as after a Section 83(b) election. If that employee terminates employment before the stock has vested, they forfeit the property. In the year of the forfeiture, the employer must include in its gross income the amount it previously deducted. For instance, if a company deducted $50,000 when stock was granted and the employee later forfeits it, the company must add that $50,000 back to its income on its tax return in the year of forfeiture.

Property Transfers as Capital Expenditures

A current deduction is denied if the services rendered are considered a capital expenditure. In these cases, the value of the transferred property must be capitalized into the basis of the asset created by the services. For example, if a company pays an architect with company stock to design a new building, the value of that stock is not a deductible expense. Instead, its value is added to the cost basis of the new building and recovered over time through depreciation.