Revenue Ruling 83-69: Taxing Contractor Compensation

A common compensation arrangement involves a corporation paying an independent contractor for services not with cash, but with shares of its own stock. This form of payment is a frequent strategy, particularly for companies looking to conserve cash while still attracting necessary talent. The arrangement is designed to align the contractor’s interests with the company’s success.

The central feature of such an agreement is a contingency placed upon the stock transfer. The contractor does not receive full, unrestricted ownership of the shares immediately. Instead, the right to keep the stock is conditioned upon the contractor completing the agreed-upon services. This creates a direct link between the performance of duties and the ultimate ownership of the compensation.

If the independent contractor fails to fulfill their service obligations as stipulated in the contract, they must forfeit the shares back to the corporation. This forfeiture clause establishes that the contractor’s rights to the stock are not guaranteed at the time of the initial agreement but are earned over the period of service. This type of conditional payment structure has specific tax implications.

Key Tax Concepts Under Section 83

Section 83 of the Internal Revenue Code governs the taxation of property, such as stock, when it is transferred to a service provider in connection with the performance of services. The rules determine when the value of that property is included in the service provider’s gross income.

The term “property” under Section 83 is broad and includes real and personal property, most commonly company stock. It does not, however, include an unfunded and unsecured promise to pay money or property in the future. When a contractor receives stock, they are receiving property, and the tax treatment hinges on whether their rights to that property are vested.

Vesting is determined by two main factors: transferability and a substantial risk of forfeiture. A substantial risk of forfeiture exists when the service provider’s rights to the full enjoyment of the property are conditioned on the future performance of substantial services. In the scenario described, the requirement for the contractor to complete services to keep the stock creates this risk, as they would otherwise have to return it.

Property is considered transferable if the service provider can sell, assign, or pledge their interest in it to another person, and that person is not subject to the same forfeiture conditions. If the stock is subject to a substantial risk of forfeiture and is not transferable, it is considered non-vested. The tax consequences under Section 83 are deferred until the moment that either the risk of forfeiture is removed or the property becomes transferable.

Tax Treatment Upon Vesting

The default tax treatment for a contractor under Section 83 occurs at the moment the property vests. Vesting happens in the taxable year when the substantial risk of forfeiture is removed. In the scenario described above, this is the point at which the contractor has fulfilled all service requirements and their right to the stock becomes unconditional.

At the time of vesting, the contractor must recognize income. The amount of income is its fair market value on the date of vesting, minus any amount the contractor paid for the property. This amount is treated as ordinary income, not capital gain, because it is payment for services rendered. This is an important distinction, as ordinary income is taxed at higher rates than long-term capital gains.

From the perspective of the corporation that paid the contractor, there are corresponding obligations. The company is entitled to a business expense deduction equal to the amount of income the contractor is required to recognize. The timing of this deduction must match the timing of the contractor’s income recognition, meaning the company takes the deduction in the same taxable year that the property vests.

If the fair market value of the vested stock is $600 or more for the calendar year, the corporation must report the payment. The company issues a Form 1099-NEC, “Nonemployee Compensation,” to the contractor for the year of vesting. This form reports the stock’s fair market value as ordinary income, which the contractor reports on Schedule C where it is also subject to self-employment taxes.

The Section 83(b) Election Alternative

An independent contractor facing the tax treatment outlined under Section 83 has an alternative path: making a Section 83(b) election. This is an irrevocable choice to change the timing of the tax event. Instead of recognizing income upon vesting, the contractor elects to include the income in the year the property is initially granted, despite the existing risk of forfeiture.

Making this election requires the contractor to pay ordinary income tax on the fair market value of the property at the grant date. The primary motivation for this choice is the potential for future appreciation to be taxed at more favorable long-term capital gains rates. If the stock’s value is low at the grant date but is expected to increase significantly by the vesting date, the election can result in substantial tax savings.

To make a valid election, the contractor must file a written statement with the IRS service center where they file their taxes. This is not a standard IRS form but a letter drafted by the taxpayer containing all required elements. The statement must include the following information:

• The taxpayer’s full name and address
• A description of the property received
• The date on which the property was transferred
• The property’s fair market value at the time of transfer
• A full description of any restrictions on the property
• The amount, if any, that was paid for the property

The procedure for filing is strict. The election must be filed within 30 days of the property’s grant date, and this deadline is absolute with no extensions. The contractor must send the election to the IRS, provide a copy to the company that granted the stock, and retain a copy for their own records. It is highly recommended to use certified mail with a return receipt to prove timely filing.