Internal Revenue Code Section 83: Opportunities and Pitfalls

Generally speaking, Internal Revenue Code Section 83 requires that receipt of “property” in exchange for the performance of services creates income upon receipt of that property, measured by excess of the fair market value of the property over whatever amount is paid for the property.

An exception exists, however, when the property received is subject to a “substantial risk of forfeiture” — in that event, recognition does not occur until that risk may lapse.

In some cases, there is no easily ascertainable fair market value amount when the property is received. In that case, no problem; no income recognition. And in other cases, the fair market value is ascertainable, and further, the recipient may have an expectation that the value of the property has a good chance of increasing over time.

Let’s say, then, that an employee receives stock in a corporation, which may be subject to a substantial risk of forfeiture. He may choose to make an election under IRC Section 83 to actually go ahead and recognize compensation income on day one (fair market value less any amount he pays for the stock). If this election is made, any subsequent appreciation in the property’s value is not treated as compensation income and is not recognized until the property is disposed of. Further, the post-election appreciation would be treated as capital gain (as opposed to ordinary income) in this case, thus taxable at potentially a more favorable rate.

Be sure to follow the formalities required with respect to the election, which must be made no later than 30 days after the date of the transfer of the property.