Tax Consequences of Revenue Ruling 83-19

The Internal Revenue Service provides guidance on the tax treatment of property transferred to satisfy a legal judgment. A central issue is whether such a transfer is governed by Internal Revenue Code Section 83, which addresses property transferred in connection with the performance of services. The distinction between a transfer that serves as a remedy for a breach of contract and one that constitutes compensation dictates how both the person transferring the property and the person receiving it must report the transaction for tax purposes.

A Common Scenario: Breach of Contract

To understand the tax implications, consider a dispute between a corporation and one of its executives. The executive had a contract with the company that obligated the corporation to sell a certain number of its shares to the executive at a fixed price. The corporation later refused to honor this agreement, leading the executive to file a lawsuit for breach of contract.

Following legal proceedings, the court rules in the executive’s favor. The judgment orders the corporation to perform its contractual duty by transferring the agreed-upon shares. The executive pays the original contract price, which is significantly less than their fair market value at the time of the court-ordered transfer.

Application of Section 83

Section 83 provides the rules for taxing property, such as stock, when it is transferred to a person “in connection with the performance of services.” If property is transferred under this section, its value is treated as compensation income to the recipient. This means the recipient pays ordinary income tax on the value of the property, and the entity transferring it gets a corresponding business expense deduction.

The IRS has determined that a court-ordered stock transfer is not subject to Section 83. The reasoning is that the transfer is not made to compensate the executive for services. Instead, the transfer is compelled by a court order to satisfy a judgment for the corporation’s breach of a stock sale agreement. Because the transfer is not “in connection with the performance of services,” its tax consequences are governed by general property disposition principles.

Tax Consequences for the Transferor

For the corporation that transferred the stock, the transaction is treated as a taxable disposition of property. Since the transfer was made to satisfy a legal obligation, the corporation is considered to have sold the stock for its fair market value at the moment of the transfer, even though the cash received was the lower contract price.

The corporation must recognize a gain or loss based on the difference between the stock’s fair market value and its adjusted basis in those shares. For example, if the stock had a fair market value of $100,000 at the time of transfer and the corporation’s adjusted basis was $10,000, the corporation would recognize a $90,000 gain. The character of the gain, whether capital or ordinary, depends on the nature of the asset.

Tax Consequences for the Transferee

The executive who received the stock must recognize income equal to the difference between the fair market value of the stock on the date of receipt and the amount they paid for it. This income is taxable in the year the stock is received. For instance, if the stock’s fair market value was $100,000 and the executive paid the contractual price of $25,000, they would recognize $75,000 of income.

Because the transfer was not compensation under Section 83, this income is not considered wages and is not subject to payroll taxes. It is reported as other income on the executive’s tax return. The executive’s basis in the stock becomes its fair market value on the date it was received. In the example, the basis would be $100,000, which is used to calculate capital gain or loss on a subsequent sale.