Surprising Tax Issues For Shareholder-Execs Receiving Unvested Stock For Vested Stock in Reorg

I. Introduction

     When an old shareholder of a target corporation (hereinafter T) (generally a T key executive) holding vested T stock (i.e., T stock not subject to a substantial risk of forfeiture (SRF) or T stock subject to an SRF as to which a timely section 83(b) election was filed) exchanges such vested T stock in a section 368 reorganization for unvested purchaser corporation (hereinafter P) stock (i.e., P stock subject to an SRF), do the tax consequences differ from those normally encountered in a P-T reorganization?

     This situation typically arises -- most often where T is engaged in a high-tech or e-commerce business -- where (1) an old T shareholder is also a T key executive, (2) P, expecting the executive to remain an important service provider to P's newly acquired T business after the reorganization, demands a golden handcuff (i.e., an SRF on all or a portion of the P stock issued to T's executive in exchange for his T stock), and (3) the price P is paying for T (in newly issued P shares) plus the employment terms P offers to T's executive are sufficiently attractive so that the executive, however reluctantly, is willing to accept in the reorganization unvested P shares in exchange for his vested T stock, in the same ratio as T's other shareholders are receiving vested P shares.¹

Example 1

Individual A forms T on 1/1 year 1, contributing $10,000 cash to T in exchange for 100 vested T shares (i.e., $100 per share), and becomes T's key executive. One year later (on 1/1 year 2), after T has appreciated in value, venture capitalist VC contributes $500,000 to T for 100 T shares (i.e., $5,000 per share). After these transactions, A and VC each owns 100 T shares (50 percent of T's stock), none of which are subject to any SRF.

Four years later, on 12/31 year 5, P acquires T in a merger (or other reorganization) qualifying under section 368(a) in exchange for 100,000 P shares with an FV of $5 million (i.e., $25,000 FV of P stock for each of T's 200 shares). One-half of the 100,000 P shares (FV $2.5 million) is issued to T's 50 percent shareholder VC subject to no SRF. The other one-half (FV $2.5 million) is issued to T's other 50 percent shareholder, executive A, subject to three-year cliff vesting, i.e., if A leaves P's employ before 12/31 year 8, the third anniversary of the P-T merger, P has the option to repurchase A's 50,000 P shares at a forfeiture price, e.g., the lesser of the P shares' 12/31 year 5 (merger date) FV ($2.5 million) or the P shares' FV at the time of A's termination of employment.

A reluctantly agrees to subject his 50,000 new P shares to this SRF because (1) A, finding both the acquisition price and the employment terms offered by P very attractive, fully expects to satisfy the three-year vesting requirement and (2) P refuses to acquire T without the SRF golden handcuff on A's new P shares.

     If the normal reorganization rules apply to A's receipt of P stock in exchange for T stock, A recognizes no gain on the exchange and A takes a substituted basis ($10,000) and a tacked holding period (five years) in the new P stock.²

     However, there is substantial risk (as discussed below) that section 83 alters A's tax treatment. ³ Section 83's actual impact on A depends, first, on whether an expansive or a narrow interpretation of section 83 prevails and, second , whether A makes a timely section 83(b) election with respect to his receipt of P stock. Indeed, as we demonstrate hereafter, A can eliminate virtually all of the problems discussed below by making a timely section 83(b) election within 30 days after the P-T merger.

     We first discuss the expansive section 83 interpretation with no section 83(b) election (part II below), then the expansive section 83 interpretation with a timely section 83(b) election (part III below), and finally a narrow section 83 interpretation (part IV below). As we discuss these alternatives, we review such issues as (a) whether A recognizes section 83 OI (and whether P has a deduction) at vesting, (b) how A's section 83 OI is calculated, (c) how A's basis for the P shares is calculated, (d) how A's holding period for the P stock is calculated, and (e) whether section 483 creates imputed interest income to A. ⁴

II. Expansive 83 Interpretation: No 83(b) Election

     Under the expansive section 83 interpretation, the 50,000 P shares subject to the SRF are viewed as "transferred to" A "in connection with the performance of services" so that section 83 applies.⁵ In this case A's complicated and nasty tax treatment, attracted because A foolishly fails to make a timely section 83(b) election (within 30 days after the P-T merger),⁶ is as follows:

     (a) A's section 83(a) OI. As a service provider receiving unvested property (i.e., 50,000 P shares subject to an SRF) "in connection with the performance of services," A is treated as receiving the 50,000 P shares three years after the merger when the SRF expires (not on the earlier merger date), so that A has OI (and P has a deduction) when A has remained in P's employ until 12/31 year 8, the P-T merger's third anniversary. ⁷

     (b) Amount of A's section 83(a) OI. Under the expansive section 83 nterpretation, the amount of A's OI (and P's deduction) when the P shares vest is the FV of the P shares on the 12/31 year 8 vesting date less the "amount . . . paid" by A for the 50,000 P shares at the time of the P-T merger, meaning "the value of any money or property paid for the transfer"  (emphasis added).⁸ Because A paid for his 50,000 P shares by surrendering 100 T shares (FV $2.5 million at the time of the P-T merger on 12/31 year 5), A's OI is (1) the FV of A's P shares at vesting less (2) the FV of A's T shares surrendered at the time of the merger.

Example 2

Same as Example 1, except that in addition A, who made no section 83(b) election with respect to his P shares, remains in P's employ until 12/31 year 8, i.e., the merger's third anniversary, at which time A's 50,000 P shares received in the T-P merger are worth $7.5 million (i.e., $5 million more than the $2.5 million the P shares were worth on the merger date).

Under the expansive section 83 interpretation, A recognizes (on 12/31 year 8) $5 million of OI ($7.5 million FV of the 50,000 P shares at vesting on 12/31 year 8 less $2.5 million FV of the T shares surrendered in the merger on 12/31 year 5 in exchange for the 50,000 P shares).

     (c) A's basis in the P shares. Under the expansive section 83 interpretation, A's basis for his 50,000 P shares in Example 2 (under section 358 and reg. section 1.83-4(b)) is most likely $5,010,000 (i.e., A's $10,000 carryover basis from his old T shares plus A's $5 million section 83(a) OI on vesting) (the "unitary part-carryover basis approach "). However, two possible problems are encountered in reaching this conclusion:

     First, reg. section 1.83-4(b) states that A's basis for the 50,000 P shares "reflect[s] any amount [A] paid for such property and any amount includible in [A's] gross income" (emphasis added), and reg. section 1.83-3(g) states that "the term 'amount paid' refers to the value of any money or property paid for the transfer of property to which section 83 applies" (emphasis added). Read literally, this section 83 basis regulation would grant A basis of $7.5 million for the 50,000 P shares (i.e., the $2.5 million FV of the T stock A surrendered in the merger plus A's $5 million section 83(a) OI on vesting). Any such full FV basis approach of course provides a wrong answer since (by virtue of the reorganization rules) A has not yet recognized the $2,490,000 appreciation inherent in his T stock at the time of the merger.

     Thus, where A receives his P shares in exchange for T shares in a reorganization, we believe section 358's carryover basis rule (under which A's $10,000 T stock basis carries over to his new P shares) clearly trumps reg. section 1.83-4(b)'s literal language (under which the "amount [A] paid" measured by "the value of any . . . property [A] paid" for the P stock is the first element of A's P stock basis), since this section 83 regulation was not written with a tax-free reorganization in mind.

     Second, it is possible (under the "bifurcated part-carryover basis approach ") to argue that A's 50,000 new P shares should be bifurcated, with a portion of A's 50,000 new P shares viewed as received in the reorganization in exchange for A's old T shares and the remainder of his new P shares viewed as received for services. Under this approach A would be treated as (1) receiving a number of new P shares with a $2.5 million FV (calculated based on the P shares' FV on the 12/31 year 8 vesting date) in the reorganization in exchange for his old T shares, which new P shares take a $10,000 carryover section 358 basis derived from A's old T shares, and (2) receiving the balance of his new P shares, with a $5 million FV (calculated based on the P shares' FV on the 12/31 year 8 vesting date) as section 83(a) compensation, which new P shares take a $5 million FV basis under reg. section 1.83-4(b) based on the "amount includible in [A's] gross income" under section 83(a).

     If this bifurcated part-carryover basis approach were to prevail, it would be impossible to calculate the portion of A's 50,000 new P shares allocated to each of the two baskets until the 12/31 year 8 vesting date FV of the P shares is known. For example, if the 50,000 P shares turn out to be worth only $2.5 million at vesting on 12/31 year 8, all 50,000 P shares would be viewed as received in the reorganization in exchange for A's old T shares and hence as taking a $10,000 carryover basis derived from his old T shares. However, if (as in Example 2) the 50,000 P shares are worth $7.5 million on 12/31 year 8, A would be viewed as receiving only one-third of the 50,000 new P shares (or 16,667 shares) in the reorganization in exchange for his old T shares and thus these 16,667 P shares would take a $10,000 section 358 carryover basis derived from A's old T shares, while the remaining 33,333 new P shares would take a $5 million FV basis under reg. section 1.83-4(b) based on the "amount includible in [A's] gross income" under section 83(a).

     This bifurcated part-carryover basis approach is arguably supported by Rev. Rul. 80-244,⁹ where A exercised an NQO, for 2,000 new P shares with a FV of $12,000, by surrendering 1,000 old P shares with a FV of $6,000 as payment of the $6,000 option exercise price for the 2,000 new P shares. The IRS bifurcated the transaction, treating (1) A's swap of 1,000 old P shares for 1,000 of the new P shares as a section 1036 tax-free exchange with carryover basis from the 1,000 old P shares to the 1,000 new P shares and (2) A's receipt of the additional 1,000 new P shares as compensation, producing OI equal to the FV of such 1,000 new P shares and a basis for such 1,000 new P shares equal to FV at receipt.

     However, we do not believe Rev. Rul. 80-244 supports bifurcation, and hence a bifurcated part-carryover basis approach, for the unvested P shares in the T-into-P merger. In Rev. Rul. 80-244 the parties knew at the time of the exchange the number of new P shares treated as received in exchange for the 1,000 old P shares.

     In contrast, in the T-into-P merger, if the bifurcated part-carryover basis approach were to prevail, the portion of A's 50,000 new P shares treated as received in exchange for the old T shares could not be calculated until three years later at the 12/31 year 8 vesting date, since new P shares with a $2.5 million FV at the vesting date would be treated as received for the old T shares and all of the remaining P shares would be treated as compensation.

     Moreover, in Rev. Rul. 80-244, A's exchange of 1,000 old P shares for 1,000 new P shares was simply a section 1036 exchange, with A's receipt of the additional 1,000 new P shares constituting section 83 compensation. That is, the transaction was, in part, a value-for-value exchange and, in part, receipt of consideration in excess of the value surrendered. In the T-into-P merger there is no section 1036 exchange (or other tax-free exchange) for a discrete portion of the new P stock. That is, the transaction is a unitary value-for-value exchange.

     Finally, we believe the bifurcated part-carryover basis approach unlikely to prevail in the T-into-P merger for two reasons. First, because, under the bifurcated part-carryover basis approach, no matter how much A's 50,000 P shares appreciate from merger to vesting, the P shares treated as received by A in exchange for his old T shares (FV $2.5 million on the 12/31 year 5 merger date) always have only a $2.5 million FV three years later at vesting, i.e., none of the post-merger pre-vesting appreciation is treated as received by A in exchange for his old T shares, although A would clearly not be willing to exchange his $2.5 million FV of T shares at the time of the merger for an unascertainable number of P shares that will be worth no more than $2.5 million three years later. Thus, because this bifurcated part-carryover basis approach takes an uneconomic, and hence unrealistic, view of A's P-T merger exchange, we believe this approach less likely to prevail than a $5,010,000 unitary part-carryover basis for all of A's new P shares.

     Second, the consistent practice under section 83 has been a unitary basis for all section 83 shares issued in a compensatory SRF transaction. For example, assume (1) A purchases 50,000 P shares on the 12/31 year 5 merger date for $2.5 million cash (rather than receiving 50,000 P shares in the merger in exchange for old T shares), (2) such purchased P shares are subject to three-year vesting with no section 83(b) election, and (3) the 50,000 P shares are worth $7.5 million three years later at vesting. Would reg. section 1.83-4(b) award A a bifurcated basis for the P shares, i.e., (a) a $2.5 million cash purchase basis for P shares with a $2.5 million vesting date FV and (b) a $5 million FV basis for P shares with a $5 million vesting date FV? No, under reg. section 1.83-4(b) A takes a unitary $7.5 million basis for the entire 50,000 P shares and there is no bifurcation of A's shares into cash purchase shares with a cost basis and compensation shares with an amount-includible-in-income basis. ¹⁰

      Similarly, in Example 2 where A receives the 50,000 P shares not in a cash purchase but in a reorganization exchange, the shares should not be bifurcated into those treated as received in a reorganization in exchange for T shares and those treated as received as compensation, but rather A should take a unitary basis for the entire 50,000 P shares which includes both the $10,000 carryover basis from his old T shares and his $5 million amount-includible-in-income basis.

     In the balance of this article, we assume that the unitary part-carryover basis approach prevails.
     (d) A's holding period for the P shares.  The literal approach. Under the expansive section 83 interpretation and a literal reading of section 83(f), A's holding period for his entire 50,000 P shares would begin only at vesting on 12/31 year 8 (the "literal approach"). Section 83(f) states that a taxpayer receiving property to which section 83(a)applies includes in holding period "only the period beginning at the first time his rights in such property . . . are not subject to an [SRF]" (emphasis added). Reg. section 1.83-4(a) elaborates that "under section 83(f), the holding period of transferred property to which section 83(a) applies shall begin just after such property is substantially vested" (emphasis added).

     Under such a highly suspect literal reading, where A sells the P shares within 12 months after vesting, all of A's CG on sale would be ST and none LT.

Example 3

Same as Examples 1 and 2, except that in addition the P shares continue to rise in value after vesting and A sells his 50,000 P shares for $10 million on 11/30 year 9, 11 months after vesting.

A's basis for the 50,000 P shares is (1) his $10,000 cost for the T shares on 1/1 year 1 plus (2) his $5 million of section 83(a) OI recognized on vesting of the P shares on 12/31 year 8. Thus A's CG on sale of the 50,000 P shares is $4,990,000 ($10 million proceeds less $5,010,000 basis).

     A STCG result for A's $4,990,000 gain under the literal approach to section 83(f) would be wrong because (a) there was already $2,490,000 of inherent appreciation in A's T stock at the time of the P-T merger, (b) A had a LT (five-year) holding period for the T stock when the merger took place, (c) A would have recognized $2,490,000 of LTCG if A had sold the T stock immediately before the merger, and (d) section 1223(1) states that "in determining the period for which the taxpayer has held [P stock] received in an exchange, there shall be included the period for which he held the [T stock] if . . . the [P stock] has . . . the same basis in whole or in part in his hands as the [T stock] exchanged. . . ." Thus common sense dictates that the P-T merger and A of his extant LTCG characterization.

     There are at least two alternative, taxpayer-favorable resolutions of this section 83(f)-section 1223(1) conflict that reach far more sensible LTCG conclusions than does the STCG literal approach to section 83(f) discussed above.

     The additive approach. The first taxpayer-favorable interpretation (the "additive approach") is that section 83(f) does not eradicate A's prior carryover holding period for his T shares, but merely suspends the accretion of additional holding period for the P shares until vesting. Section 83(f) and reg. section 1.83-4(a) should not expunge A's pre-merger five-year holding period for his old T stock (which began 1/1 year 1 and ended 12/31 year 5), since A's old T stock was never subject to an SRF. The additive approach reconciles the inconsistency between section 83(f) and section 1223(1) by first applying section 1223(1)'s reorganization tacking rule to add A's existing five-year holding period for his old T shares to A's holding period for his new P shares and second applying section 83(f) to determine the length of the additional holding period (beginning at 12/31 year 8's vesting) that A derives by virtue of continuing to hold P stock post-merger.

      As described in (c) above, reg. section 1.83-4(b) and - 3(g) read literally would credit A with basis for his new P shares equal to the merger date FV of the old T shares surrendered. However, in the context of a reorganization, where A's basis for the old T shares ($10,000) is less than their merger date FV ($2.5 million), section 358's reorganization carryover basis rule undoubtedly trumps, so that the basis of A's new P shares derives not from the T shares' FV at the time of the merger but from the T shares' pre-existing basis in A's hands.

       Similarly where holding period (rather than basis) is the issue, reg. section 1.83-4(a) should not be read literally to the exclusion of section 1223(1). Neither the basis rules of reg. section 1.83-4(b) nor the holding period rules of section 83(f) and reg. section 1.83-4(a) were written with a tax-free reorganization in mind. Thus, when section 83 SRF stock is issued in a reorganization, it makes perfect sense to read reorganization carryover basis and reorganization carryover holding period into both the section 83 basis rules and the section 83 holding period rules.

     In examples 1 through 3, if A had sold T's stock for $2.5 million in a taxable transaction on 12/31 year 5 (immediately before T's merger into P), A would have recognized $2,490,000 LTCG on the sale. It would be strange indeed if, as a result of a tax-free exchange of T stock for P stock, that LTCG were converted into STCG. Section 83 converts into OI a portion of A's gain -- i.e., post-merger pre-vesting appreciation in A's P stock ($5 million in the example); section 83 is not meant also to convert A's pre-merger appreciation into STCG.

     Under the additive approach, where A sells his 50,000 P shares with a $5,010,000 basis for $10 million 11 months after vesting, A's entire $4,990,000 gain is LTCG, because A's holding period for the P shares is five years and 11 months (i.e., A's five-year holding period for the T shares -- from 1/1 year 1 when A purchased the vested T shares for $10,000 until the P-T merger on 12/31 year 5-- plus A's 11-month post-vesting holding period for the new P shares from 12/31 year 8 until A's sale of the P shares on 11/30 year 9). ¹¹

     The bifurcated approach. While we believe the additive approach described above to be the better answer, there is a second approach (the "bifurcated holding period approach") -- not as taxpayer- favorable as the additive approach discussed above -- to resolving the conflict between section 83(f) and section 1223(1), under which a portion of A's CG on sale of the P shares is LT and a portion ST.

     Numerous IRS precedents support a bifurcated holding period for stock. For example, in Rev. Rul. 62-140¹² the taxpayer converts a long-held $100 T debenture into one T common share and is required by the debenture's terms to pay $50 additional cash as a condition to receiving such T common share (FV $200) on conversion. The IRS ruled that the new T share takes a split holding period, with 75 percent of the share's ultimate sale proceeds (i.e., $150 convertible debenture FV divided by $200 T common share FV) attributable to the old debenture taking a tacked holding period and 25 percent of the share's ultimate sale proceeds (i.e., $50 new cash payment divided by $200 T share FV) attributable to the new cash consideration taking a new holding period starting at conversion. ¹³

     As another example, in Rev. Rul. 85-164¹⁴ the taxpayer makes a section 351 contribution of various assets with various holding periods in exchange for Newco stock. The IRS ruled that such Newco stock takes a split holding period based on the relative FVs (and the holding periods) of the contributed assets.

     In the present context there are two possible variations of the bifurcated approach to  calculating the holding period for A's 50,000 P shares. Under the "proportionate bifurcated approach," only a portion of A's 50,000 new P shares are viewed as received in exchange for his old T shares, i.e., a number of T shares with a $2.5 million FV (calculated based on the P shares' FV on the 12/31 year 8 vesting date). A's remaining new P shares, with a $5 million FV (calculated based on the P shares' FV on the 12/31 year 8 vesting date), are viewed as section 83(a) compensation.

     If this proportionate bifurcated approach prevails, one-third of A's 50,000 new P shares (or 16,667 shares) would be treated as received by A in exchange for his old T shares and only these 16,667 P shares would take a section 1223(1) eight-year tacked holding period dating from 1/1 year 1 through the 12/31 year 8 vesting date with no section 83(f) application, while A's remaining 33,333 new P shares would take a new section 83(f) holding period beginning at vesting on 12/31 year 8.

     While this proportionate bifurcated approach may be a possible solution, we believe it unlikely to prevail for two reasons. First, because, under the proportionate bifurcated approach, no matter how much the 50,000 P shares appreciate from merger to vesting, the P shares treated as received by A in exchange for his old T shares (FV $2.5 million on the 12/31 year 5 merger date) always have only a $2.5 million FV at vesting, i.e., none of the post-merger pre-vesting appreciation is treated as received by A in exchange for his old T shares, although A would clearly not be willing to exchange his $2.5 million FV of old T shares at the time of the merger for an unascertainable number of P shares that will be worth no more than $2.5 million three years later. Thus, because the proportionate bifurcated approach takes an uneconomic, and hence unrealistic, view of A's P-T merger exchange, we believe this approach less likely to prevail than the additive approach which grants all 50,000 of A's P shares a unitary holding period (five years tacked from A's old T shares plus A's post-vesting additional holding period).

      Second, the language of both section 83(f) and section 1223(1) seems more consistent with a unitary (rather than bifurcated) holding period for shares issued in a section 83 compensatory transaction or a reorganization, and the consistent practice under section 83 has been a unitary holding period for section 83 stock.

      For example, assume (1) A purchases 50,000 P shares on the 12/31 year 5 merger date for $2.5 million cash (rather than receiving 50,000 P shares in the merger in exchange for old T shares), (2) such purchased P shares are subject to three year vesting with no section 83(b) election, and (3) the 50,000 P shares are worth $7.5 million three years later at vesting. Would A take a bifurcated holding period for the P shares, i.e., (a) a holding period starting 12/31 year 5 for P shares with a $2.5 million vesting date FV (on the ground that such shares were received for property -- $2.5 million cash -- on 12/31 year 5) and (b) a holding period starting 12/31 year 8 for the remaining P shares with a $5 million vesting date FV (on the ground that such shares were received as compensation)? No, under section 83(f) A takes a unitary holding period starting 12/31 year 8 for the entire 50,000 P shares and there is no bifurcation of A's shares into cash purchase shares with a purchase date holding period and compensation shares with a vesting date holding period.

     Similarly, in Example 2, where A received the 50,000 P shares not in a cash purchase but in a reorganization exchange, the shares should not be bifurcated into those treated as received in a reorganization in exchange for T shares and those treated as received as compensation, but rather A should take an additive unitary holding period for the entire 50,000 P shares that counts both the pre-merger five-year holding period under section 1223(1) and any post-vesting holding period.

      Under a second variation of the bifurcated approach -- the "frozen bifurcated approach" -- the $4,990,000 of untaxed appreciation in A's T stock at sale on 11/30 year 9 is broken into two elements:

• First appreciation element: $2,490,000 appreciation inherent in A's old T shares at the time of the P-T merger when A exchanged his T stock (for which he had paid $10,000 on 1/1 year 1) tax-free for P stock (FV $2.5 million on 12/31 year 5 when the P-T merger took place) plus
• Second appreciation element: $2.5 million additional appreciation in A's 50,000 new P shares from vesting on 12/31 year 8 (when such shares were worth $7.5 million) until sale on 11/30 year 9 (for $10 million).

      If both the additive approach to section 83(f) and the proportionate bifurcated approach discussed above were rejected, it is possible to construct an argument that section 83(f)'s new holding period rule applies to the $2.5 million post-vesting appreciation (yielding STCG for the second appreciation element), but we think it wholly irrational not to apply section 1223(1) to award A's $2,490,000 of pre-merger gain (the first appreciation element) a tacked LT holding period.

     Under a frozen bifurcated approach, A's holding period for the P shares could be awarded (1) a tacked holding period under section 1223(1) with respect to the $2,490,000 of inherent long-term appreciation in A's T stock at the time of the merger and (2) a new holding period starting with expiration of the SRF under section 83(f) with respect to any additional gain. Thus, in Example 3, where A sells the P stock 11 months after vesting for $10 million, the $2,490,000 pre-merger appreciation would be LTCG and the $2.5 million post-vesting appreciation would be STCG. ¹⁵

     In summary, we believe a literal reading of section 83(f) to be clearly the wrong answer, the additive approach to resolving the section 83(f)-section 1223(1) conflict the best answer, and either of the two bifurcated approaches to be a serviceable answer if the additive approach were to be rejected.

     (e) A's possible section 483 imputed interest. Under the expansive section 83 interpretation with no section 83(b) election, there is one further complicating factor that we have so far ignored but that may affect all of the conclusions advanced in (a) through (d) above:

      Statutory and regulatory underpinnings for applying section 483. Section 483 states that where a person (here A) engages in "a sale or exchange of any property" (here A's T stock) and "some or all of the payments are due more than 1 year after the date of such sale or exchange," a portion of the deferred payments is treated as imputed interest (calculated at the AFR) unless the contract provides for adequate stated interest.¹⁶ Under section 483 regulations (and case law) this rule applies to deferred payments in the form of P stock issued to T's shareholders in a reorganization. ¹⁷

      Where A receives unvested P stock in the P-T merger with no section 83(b) election in exchange for his vested T stock, regulations under section 83(a) treat him as not receiving the P shares until SRF expiration.¹⁸ This section 83 principle has been applied to determine the consequences outside section 83. See, e.g., reg. section 1.1361-1(e)(3), under which nonvested stock is taken into account, in determining whether an S corporation has more than one class of stock, only if a timely section 83(b) election has been filed.

      Superimposing this section 83 principle on our analysis of the P-T merger, A is treated as giving up his old T shares in the merger on 12/31 year 5 but not as receiving his 50,000 new P shares until SRF expiration on 12/31 year 8, a deferred exchange of property apparently invoking section 483's imputed interest rules (hereinafter referred to as the "expansive section 83 interpretation with section 483 overlay ").

     Likely result if section 483 applies. Under this expansive section 83 interpretation with section 483 overlay, a portion of the 12/31 year 8 deferred payment to A (50,000 P shares FV $7.5 million) is apparently treated as a payment of imputed interest by P to A, calculated (under the "unitary section 483 approach") as (1) the FV of 50,000 P shares on the vesting date ($7.5 million in Example 2) less (2) the present value of such deferred consideration discounted at the AFR for three years from the 12/31 year 8 delivery date to the 12/31 year 5 P-T merger date.¹⁹ Assuming a 6 percent AFR, A is treated as receiving approximately $1.2 million of imputed interest income ($7.5 million of deferred consideration received 12/31 year 8 less $6.3 million 12/31 year 5 discounted present value thereof).

     Under this expansive section 83 interpretation with section 483 overlay, A's tax treatment at the time of vesting on 12/31 year 8 is as follows:

• 16 percent of the 50,000 P shares (FV $1.2 million) is treated as delivered to A on the vesting date as section 483 imputed interest income. Such P shares received as imputed interest take an FV basis ($1.2 million) and a new holding period beginning 12/31 year 8.
• 84 percent of the 50,000 P shares (FV $6.3 million) is treated as delivered to A on the vesting date in connection with A's performance of services. A's OI is such $6.3 million less the "amount . . . paid" by A for these P shares on the merger date (defined by the section 1.83-3(g) regulations as the "value of any money or property paid" by A), which is the $2.5 million FV of the old T shares surrendered by A in the merger. Hence, A recognizes $3.8 million of section 83(a) OI at vesting ($6.3 million FV at vesting for 84 percent of the 50,000 P shares less $2.5 million FV of the old T shares surrendered in the merger on 12/31 year 5 in exchange for the new P shares). ²⁰
• Under section 358 and reg. section 1.83-4(b), A's basis for the 84 percent of the new P shares not treated as section 483 imputed interest is $3.81 million (A's $10,000 carryover basis from his old T shares plus A's $3.8 million section 83 OI).
• Under sections 1223(1) and 83(f), A's holding period for the 84 percent of the new P shares not treated as section 483 imputed interest (as discussed in (d) above) should, we believe, include A's five-year holding period for the old T stock plus A's post-vesting holding period (the additive approach).

     Evaluation whether section 483 applies. Does section 483 apply to A's reorganization exchange of vested T stock for unvested P stock with no section 83(b) election or does section 83 implicitly or explicitly occupy the field so that section 483 has no application?

     At least three arguments can be made for the proposition that section 483 is not applicable to A's reorganization exchange of vested T stock for unvested P stock:

     First, it can be argued that A's receipt of the 50,000 P shares is not deferred because A in fact received the entire 50,000 P shares on 12/31 year 5 at consummation of the P-T merger. Section 483 by its terms would apply to a reorganization exchange of T shares for P shares only where the T shareholder (here A) receives all or part of the P shares "more than 1 year after the . . . sale or exchange" of his T shares, e.g., a reorganization earnout payable several years after the merger in P stock with commensurate delay in A's dividend and voting rights, whereas here A received all 50,000 P shares immediately on consummation of the P-T merger with no delay in A's dividend or voting rights.

     However, reg. section 1.83-1(a)(1) makes clear that, for all purposes of the code, when A receives P stock subject to an SRF with no section 83(b) election, "the transferor [here P] is regarded as the owner of such property [the 50,000 P shares], and any income from such property [e.g., dividends on the 50,000 P shares] received by the employee [here A] . . . constitutes additional compensation." Thus, once section 83 is taken into account, A appears (for tax purposes) to have received the 50,000 P shares three years after the P-T merger when the 12/31 year 8 vesting event occurred, apparently making A's exchange of vested T shares for unvested P shares a deferred exchange of property for section 483 purposes.

     Indeed, because P (not A) is treated by section 83(a) as owner of the 50,000 P shares until vesting, any dividends paid by P to A on the unvested P shares are (1) deductible by P as compensation expense and (2) OI to A as compensation income. Thus, for tax purposes, A is not viewed as having any right to receive "dividends" on the P shares during the SRF period.

     A second argument can be made that section 483 is not applicable to A's deferred receipt of P shares in the P-T merger on the ground that A's ultimate receipt of the 50,000 deferred P shares is not part of "a sale or exchange of property" (i.e., A is not receiving the P shares in exchange for A's old T shares), but rather A is receiving the P shares as section 83(a) compensation. If A receives the 50,000 P shares as compensation rather than in payment for his old T shares, section 483 would not apply. However, under the expansive section 83 interpretation A is viewed as receiving the 50,000 P shares in two capacities: first, the P shares constitute the sole consideration which A receives in exchange for his old T shares (FV $2.5 million on the 12/31 year 5 merger date) and, second, the post-merger pre- vesting appreciation in the P shares is viewed as section 83(a) compensation. Thus, the P shares are at least in part received by A "in a[n] . . . exchange of property."

     Indeed, as discussed in (c) above (the unitary part-carryover basis approach), we believe that A's $10,000 basis in his old T shares carries over to his new P shares under section 358 and, as discussed in (d) (the additive approach), we believe that A's five- year holding period for his old T shares becomes his initial holding period for his new P shares under section 1223(1). Both of these results follow only because A's 50,000 new P shares are received at least in part in exchange for his old T shares in a reorganization.

     A third argument can be made that section 483 does not apply to A's deferred receipt of the 50,000 P shares in the P-T merger because section 83 was meant to occupy the field and to supplant section 483 where both might apply: Where a service provider pays cash for P stock subject to an SRF (e.g., if A were to pay $2.5 million cash for 50,000 unvested P shares) without a section 83(b) election, section 83(a) occupies the field so that 100 percent of the spread in the P stock at vesting is section 83 OI and there is no section 483 imputed interest. However, this result -- in the case of a cash purchase of unvested P stock -- correctly flows from the explicit scope of section 483. That is, section 483 applies only where A surrenders "property" (and for this purpose "property . . . does not include money [or] services" -- reg. section 1.483-1(a)(1) (fifth sentence)) in "a sale or exchange" and not where A pays cash to purchase property, even where delivery of the purchased property is delayed.

     Moreover, the section 83 regulations explicitly recognize that section 483 imputed interest principles may apply to a transaction also covered by section 83. Reg. section 1.83-3(g), dealing with the amount paid by a service provider for property (e.g., the amount paid by A for P shares), states that the amount paid "does not include any stated or unstated interest payments" and refers to reg. section 1.483-1(c) "for rules regarding the calculation of the amount of unstated interest payments."

     Thus, while the section 483 overlay on the expansive section 83 interpretation is surprising, and it is possible a court might decline to apply section 483 in these circumstances, the literal language of section 483 seems to apply and no overriding policy appears to preclude the section 483 overlay.

     Alternative calculation of section 483 OI. A final issue exists with respect to the section 483 overlay: It is possible to argue that, even if section 483 applies to this transaction, the amount of section 483 imputed interest is not calculated under the unitary section 483 approach based on the full vesting date FV of A's 50,000 deferred P shares ($7.5 million in Example 2). Rather, under the "bifurcated section 483 approach ," only a portion of A's 50,000 new P shares deemed received at vesting on 12/31 year 8 would be viewed as received in exchange for A's old T shares -- specifically a number of T shares with a $2.5 million FV (calculated based on the P shares' FV on the 12/31 year 8 vesting date) -- and A's remaining new P shares, with a $5 million FV (calculated based on the P shares' FV on the 12/31 year 8 vesting date), would be viewed as section 83(a) compensation. If this bifurcated approach were to prevail, only one-third of A's 50,000 new P shares (or 16,667 shares) would be viewed as received by A in exchange for his old T shares and only these 16,667 P shares would attract section 483 imputed interest.

     Under this bifurcated approach, 16 percent of the $2.5 million FV of the 16,667 P shares viewed as received by A in exchange for property (or 2,667 P shares with a $400,000 FV) would constitute imputed interest income to A, with such P shares taking a $400,000 FV basis and a new holding period beginning at vesting, while the remaining 14,000 P shares treated as received by A in exchange for property with a $2.1 million FV, would be viewed as received tax-free by A under section 354 with $10,000 section 358 carryover basis and tacked section 1223(1) holding period dating from 1/1 year 1 through the 12/31 year 8 vesting date with no section 83(f) reduction of holding period. Under this approach A's OI in Example 2 would total $5.4 million, i.e., $5 million section 83 compensation OI plus $400,000 section 483 imputed interest.

     While this bifurcated section 483 approach may be a possible method for calculating the amount of section 483 interest, we believe it unlikely to prevail for two reasons. First, because, under this bifurcated section 483 approach, no matter how much the 50,000 P shares appreciate from merger to vesting, the P shares viewed as received by A in exchange for his old T shares (FV $2.5 million on the 12/31 year 5 merger date) always have only a $2.1 million FV on the vesting date, i.e., $400,000 less than the FV of his T shares on the merger date, with the remaining P shares always treated as compensation, although A would clearly not be willing to exchange his $2.5 million FV of T shares on the merger date for an unascertainable number of P shares that will be worth no more than $2.1 million three years later. Thus, this bifurcated section 483 approach takes an uneconomic, and hence unrealistic, view of A's P-T merger exchange.

     Second, the language of section 83 and the regulations, as well as the consistent practice thereunder, support a unitary rather than a bifurcated approach to determining the property treated as received by A in connection with the performance of services.²¹ For example, assume (1) A purchases 50,000 P shares on the 12/31 year 5 merger date for $2.5 million cash (rather than receiving 50,000 P shares in the merger in exchange for old T shares), (2) such purchased P shares are subject to three-year vesting with no section 83(b) election, and (3) the 50,000 P shares are worth $7.5 million three years later at vesting. A is treated for section 83 purposes as receiving the entire 50,000 P shares (purchased for $2.5 million cash) in connection with the performance of services, so that the entire $5 million appreciation in value from the 12/31 year 5 merger date to the 12/31 year 8 vesting date constitutes section 83(a) OI.

     Similarly, in Example 2 where A receives the 50,000 P shares not in a cash purchase but in a reorganization exchange, the shares should not be bifurcated for section 483 purposes into those treated as received in a reorganization in exchange for T shares and those treated as received as compensation, but rather the entire 50,000 P shares should be viewed as received by A in connection with the performance of services under the expansive section 83 interpretation.

     For these reasons, we believe the bifurcated section 483 approach less likely to prevail than the unitary section 483 approach.

III. Expansive 83 Interpretation: 83(b) Election

     How are the tax results discussed in II above (under the expansive section 83 interpretation) altered where A makes a timely section 83(b) election within 30 days after the P-T merger with respect to the 50,000 P shares A receives in exchange for his T shares? Such a timely section 83(b) election materially improves A's tax results and eliminates all but one of the troublesome tax issues discussed in II above.

     (a) No section 83(a) OI at vesting. Section 83(b) states that A's timely section 83(b) election causes section 83(a) "not [to] apply with respect to [P's transfer] of [the P shares to A]." Thus, when the SRF expires (if A is still employed by P on the third anniversary of the P-T merger), A recognizes no section 83(a) OI.

     (b) Zero section 83(b) OI at merger. A's section 83(b) election requires A to include in OI when he receives the P stock (the occurrence of the 12/31 year 5 P-T merger in Example 1) the FV of the P stock "at the time of transfer (determined without regard to
[the SRF] . . . ) over . . . the amount . . . paid for such [P stock]." Under this rule, A's 12/31 year 5 section 83(b) OI (and P's deduction) is zero, because the amount A "paid for such [P stock]" is the FV of A's old T stock (surrendered by A in exchange for the new P stock), which is equal to the FV of the P stock received by A in the merger. ²²

     (c) Holding period. At first blush, it appears that A's timely section 83(b) election entitles him to a section 1223(1) tacked holding period for his new P shares, which includes the five-year holding period for his old T shares (plus the post-merger holding period for his new P shares). Because section 83(a) does not apply, A is treated as receiving "property" (P shares) in the P-T merger and hence A's exchange of T shares for P shares seems to fit perfectly into section 1223(1).

     However, reg. section 1.83-4(a) (second sentence) states that "if the person who has performed the services in connection with which property is transferred [here A] has made an election under section 83(b), the holding period of such property shall begin just after the date such property is transferred" (emphasis added). If this regulation were applied literally, A's holding period for the P stock would begin "just after" the P-T merger.

     Nevertheless, inflicting an ST holding period on A for the first 12 months after the merger is surely the wrong answer. It is far more rational to read this section 83 regulation -- which was not written with a reorganization exchange in mind -- as meaning in the context of a reorganization that A's five-year holding period for old T stock is added to A's holding period for the new P stock that begins just after the P stock is issued. As described in II(c) above (relating to basis for P shares where no section 83(b) election is made) and in II(d)above (additive approach to holding period for P shares where no section 83(b) election is made), there are several places in the section 83 regulations where the drafters did not focus on receipt of unvested stock in a reorganization and hence a literal reading of the regulation would reach a clearly wrong answer. In each case the correct answer is reached by reading the section 83 regulations and the reorganization provisions (carryover basis and carryover holding period) together.

     Alternatively, this section 83 regulation could be read as referring (by virtue of section 1223(1)'s tacking rule) to a fusion of the old T stock surrendered and the new P stock received in the merger for which section 1223(1) grants a tacked holding period, so that A's holding period for the P stock begins "just after the date" the old T stock was originally transferred to A on 1/1 year 1.

     Either reading grants A a holding period for the P stock that begins on 1/1 year 1.

IV. Argument That 83 Not Applicable at All

     It can be argued that section 83 has nothing to do with the T-into-P merger discussed in this article (the "narrow section 83 interpretation"), so that the normal reorganization rules apply to A's receipt of unvested P stock in the same fashion as they would if A received vested P stock at the time of the merger, on the ground that the P shares were not transferred to A "in connection with the performance of services."

     In the Alves case,²³ Mr. Alves and seven other individuals became Newco executives and purchased Newco stock at a price equal to the stock's FV, subject to an SRF. The only other purchaser of Newco stock was Newco's underwriter. Mr. Alves made no section 83(b) election.

     Mr. Alves's Newco stock appreciated substantially in value from purchase until vesting. Mr. Alves argued that section 83(a) should not be interpreted as causing him to recognize OI equal to the spread at vesting (i.e., the excess of FV at vesting over the price paid to purchase the shares) because he had paid full value and hence had not acquired the shares "in connection with the performance of services." The courts concluded that the shares were covered by section 83 so that Mr. Alves recognized OI equal to the spread at vesting, even though, had he made a section 83(b) election within 30 days after purchasing the shares, he would not have recognized any OI:

Although payment of full fair market value may be an indication that stock was not transferred in connection with the performance of services, [Newco] issued stock only to its officers, directors, and employees with the exception of the shares sold to the underwriter. [Mr. Alves] purchased the stock when he signed his employment agreement and the stock restrictions [i.e., the SRF] were linked explicitly to his tenure with the company. In addition, . . . the restricted stock's purpose was to ensure that key personnel would remain with the company. Nothing in the record suggests that [Mr. Alves] could have purchased the stock had he not agreed to join the company. ²⁴

     A's case for avoiding section 83 (in the T-into-P merger) is obviously far better than Mr. Alves's case, because in the P-T merger every holder of T stock (whether or not a service provider to T) receives P shares in the same ratio as their T share ownership. Thus, although the SRF is imposed on A's shares "in connection with the performance of services" (i.e., to induce A to remain in P's employ), the transfer of those P shares to A is not in connection with the performance of services -- even VC performing no services for T or P receives new P shares in exchange for old T shares in the same ratio. See reg. section 1.83-3(f) stating that while "Property transferred to an employee . . . in recognition of the performance of . . . services is considered transferred in connection with the performance of services . . . , [t]he existence of other persons entitled to buy stock on the same terms and conditions as an employee [here VC's right to receive P shares in exchange for its T shares] . . . may . . . indicate that . . . a transfer [of P stock] to the employee [here A] is not in recognition of the performance of . . . services."

     While this narrow section 83 interpretation appears solidly based, there is some uncertainty as to whether post-Alves courts will embrace it.

     Moreover, there is a second section 83 risk, even if this narrow section 83 interpretation prevails: The IRS might seek to analyze the transaction between P and A as comprised of two steps:

• First step: a T-into-P merger in which each T shareholder (including A) receives identical vested P shares in a tax-free reorganization, i.e., subject to section 368 and section 1223(1) and not subject to section 83.
• Second step: A's constructive exchange of his 50,000 vested P shares for 50,000 new unvested P shares subject to an SRF, which constructive exchange (and hence A's receipt of the new 50,000 P shares) would constitute a transfer of property to A in connection with the performance of services, so that A's receipt of the unvested 50,000 P shares (in constructive exchange for 50,000 vested hypothetical P shares) is subject to section 83. Under this strained approach, A recognizes OI when the SRF on the P stock lapses equal to the excess of the P stock's FV at lapse over the FV of the P stock at the time of the constructive exchange.

     Clearly, a protective section 83(b) election made within 30 days after the P-T merger would be wise in case either (1) a court fails to embrace the narrow section 83 interpretation or (2) the IRS asserts and prevails on the constructive exchange argument. Such a protective election could state that no section 83(b) election is necessary because A did not receive the P stock in connection with the performance of services, but that he is nevertheless making this protective section 83(b) election in the event IRS takes a contrary position, in which case A will recognize no OI because the FV of the T stock surrendered in the P-T merger is equal to the FV of the P stock received in exchange.

FOOTNOTES

1. To the extent the executive receives additional P shares (in excess of the P shares he/she would have received in exchange for his old T shares pursuant to the reorganization exchange ratio), such additional P shares would generally be treated as received in exchange for services rather than pursuant to the reorganization and hence governed by the principles discussed in Ginsburg & Levin Treatise para. 1314 (dealing with stock and options issued to service providers) rather than the principles discussed in this article (included as para. 604.1.6 of the forthcoming Ginsburg & Levin Treatise 11/00 edition).

2. Sections 354(a)(1), 358(a)(1), 1223(1).

3. See Ginsburg & Levin Treatise para. 1314.1 for a more detailed discussion of section 83.

4. Throughout this article we assume the corporate transaction, e.g., T's merger into P, qualifies as a section 368(a) acquisitive reorganization, i.e., that P stock issued in the transaction satisfies the continuity of shareholder interest (COI) requirement, see reg. section 1.368-1(e). It is, we think, wonderfully unclear whether P SRF stock issued to a T shareholder who fails to make a section 83(b) election counts on the good side for COI purposes, counts on the bad side, or is neutral, an issue this article does not attempt to resolve, nor does this article discuss whether a timely section 83(b) election would alter this COI result. Thus, in each case we assume that P issues in the transaction sufficient non-SRF stock to satisfy COI requirements.

5. See IV below for a discussion of the narrow section 83 interpretation under which section 83 has no application to A's receipt of the 50,000 P shares, on the ground that while P has imposed the SRF on A's new P shares "in connection with the performance of services," A's right to receive the 50,000 P shares derived from A's status as an old T shareholder rather than from A's status as a P service provider (just as VC's right to receive the other 50,000 P shares derived from VC's status as an old T shareholder), so that the "transfer" of the P shares to A (and to VC) is thus not "in connection with the performance of services."

6. See III below for A's generally much simpler and more taxpayer-friendly tax treatment where the expansive section 83 interpretation prevails but A wisely makes a timely section 83(b) election.

7. Section 83(a); reg. section 1.83-1(a)(1); section 83(h) (P's deduction).

8. Section 83(a); reg. section 1.83-1(a)(1); reg. section 1.83-3(g) (first sentence)("the term 'amount paid' refers to the value of any money or property paid for the transfer of property to which section 83 applies" -- emphasis added); see also Rev. Rul. 80-244, 1980-2 C.B. 234.

9. 1980-2 C.B. 234.

10. Of course, the question of whether the basis of different shares derives from different sources where P shares are purchased for cash is more theoretical than practical because cost basis and amount-includible-in-income basis should yield the same result in the case of a cash purchase.

11. The additive approach to section 83(f) and section 1223(1) is to a degree supported by comparing the language of section 83(f) to the language of section 1233(b)(2) -- a statutory provision that clearly does terminate, rather than suspend, a taxpayer's holding period for property. Section 1233(b)(2) states that, where a taxpayer enters into a short sale transaction when he has held substantially identical property for not more than one year, "the holding period of such substantially identical property shall be considered to begin (notwithstanding section 1223 . . . ) on the date of the closing of the short sale" (emphasis added). Apparently section 1233(b)(2)'s drafters felt it necessary to override specifically section 1223's tacking rules.
     A review of other code provisions is not wholly supportive of the additive approach to section 83(f), however, since other code provisions that suspend, rather than terminate, the holding period do so in a more unambiguous fashion than does section 83(f). For example, section 246(c) states that the holding period required to qualify for a dividends received deduction "shall be appropriately reduced" for any period during which the taxpayer's risk of loss is diminished. Similarly, section 355(d) states that the running of the five-year holding period required to cleanse "disqualified stock" of its taint "shall be suspended" during any period during which the holder's risk of loss is substantially diminished.
      Moreover, the language of reg. section 1.83-4(a) ("the holding period of transferred property to which section 83(a) applies shall begin just after such property is substantially vested" -- emphasis added) seems to tilt away from the suspension approach. These words are similar to the holding-period termination rule of section 1233(b)(2), although significantly, unlike section 1233(b)(2), they do not expressly override section 1223.
     Thus, an analysis of other code provisions mandating suspension versus fresh start for holding periods provides some but not overwhelming support for an additive approach to section 83(f).

12. 1962 C.B. 181.

13. Significantly, the IRS allocates the entire $50 conversion date appreciation to the tacked (LT) holding period side. Addressing a series of cases in which the T share appreciates further post-conversion, or alternatively depreciates post-conversion, and then is sold within a few months following conversion date, Rev. Rul. 62-140 bifurcates, adopting the following formula to determine A's LTCG:

• Amount received by A on sale, times
• Conversion date FV of original investment divided by conversion date FV of T share received,
• Minus A's basis in the original investment.

     A's STCG or STCL, then equals A's total gain (or loss) on sale minus A's LTCG determined as above. Thus, under Rev. Rul. 62-140, on A's sale for $200, LTCG is $50 ($200 x $150/200 - $100) and STCG is $10. On A's sale for $240, LTCG is $80 ($240 x $150/200 - $100) and STCG is $10 ($90 - $80). Finally, on A's sale for $150, LTCG is $12.50 ($150 x $150/200 - $100) and STCL is $12.50 ($0 - $12.50).

14. 1985-2 C.B. 117.

15. What would be the result under a frozen bifurcated approach if the FV of A's P stock declines after vesting and A then sells the P stock within 12 months after vesting, e.g., at a price yielding A only $2.4 million of total gain (i.e., less overall gain on the P stock than the $2,490,000 of inherent appreciation at the time of the P-T merger)? Would A recognize $2,490,000 of LTCG and $90,000 STCL or would A simply recognize $2.4 million of net LTCG and no STCL? Addressing a somewhat distinguishable situation (i.e., no section 83 involvement), the IRS in Rev. Rul. 62-140, 1962-2 C.B. 181, opted for the former, a LTCG/STCL mix. However, we believe the latter would be the better answer, i.e., A's overall gain on the P stock sale is $2.4 million, all of which is LTCG, or stated differently, A's LTCG on a sale within 12 months after vesting should be the lesser of the appreciation in A's stock at the time of the P-T merger ($2,490,000) or the net gain actually recognized by A on the sale ($2.4 million).

16. Section 483; reg. section 1.483-1(a)(1).

17. Reg. section 1.483-4(b) example (2); see also extensive discussion of delayed receipt of P stock in a reorganization in Ginsburg & Levin Treatise para. 606.4.

18. Reg. section 1.83-1(a)(1).

19. See the discussion below as to one other possible method for calculating the amount of section 483 imputed interest.

20. Where the P shares appreciate at a rate at or above the AFR during the vesting period (as they do during the three-year vesting period in Example 2), A's total OI at vesting ($5 million in Example 2) is unaffected by the application of section 483: If section 483 does not  apply, A recognizes $5 million of section 83 compensation OI; if se