Under Section 83 of the Internal Revenue Code (the "Code"), an employee who receives a transfer of compensatory restricted stock generally recognizes taxable income in the year in which the stock is first transferable or not subject to a substantial risk of forfeiture. Fully vested employer stock owned by a founder or key employee may become encumbered by new transfer restrictions and a substantial risk of forfeiture in connection with a capital-raising transaction of the employer in which new investors insist on "locking up" the founder's or key employee's shares for a period of time. In this general fact pattern, it has been fairly clear that such a later-imposed substantial risk of forfeiture is not a transaction to which Section 83 applies because no property has been "transferred."1 However, if the employee exchanges vested stock for unvested new stock in a merger, recapitalization, Section 351 exchange or taxable corporate transaction, it has been unclear whether or how Section 83 applies to the new shares received. Recently issued Revenue Ruling 2007-49 answers some remaining questions concerning the tax consequences of these types of transactions.

Revenue Ruling 2007-49 provides guidance by analyzing the tax consequences of three common fact patterns. The ruling's holdings are summarized below.

1. New restrictions are imposed on Employee's outstanding vested stock

In this fact pattern, Employee holds vested stock in Employer. As part of its investment in Employer, a new investor requires that Employee agree to subject his or her stock to restrictions that will cause that stock to be non-vested. Under these restrictions, if Employee doesn't continue to work for Employer through the second anniversary of the new investment, Employee will have to sell his or her Employer stock back to Employer at the lesser of the stock's fair market value (FMV) on the date of this new investment or the stock's FMV when the forfeiture occurs. As the IRS has previously privately ruled, Revenue Ruling 2007-49 holds that because the vested Employer stock is already owned by Employee, there is no "transfer," which is the predicate for Section 83's application, and, therefore, the imposition of these new forfeiture restrictions on the vested stock has no effect for purposes of Section 83. Accordingly, when the newly non-vested stock vests, Employee does not recognize compensation income under Section 83, and his or her tax basis in that stock continues to be the same as before the imposition of the new forfeiture restrictions.

2. Employee exchanges vested stock for non-vested stock in tax-free reorganization

In this fact pattern, Employer merges with Merger Sub, a subsidiary of Acquirer, in a tax-free reorganization, and Employer's shareholders receive solely Acquirer stock in exchange for their Employer stock. Employee exchanges his or her vested Employer stock for non-vested Acquirer stock in this transaction. If Employee doesn't continue to work for Employer through the third anniversary of the merger, Employee will have to sell his or her Acquirer stock back to Acquirer at the lesser of the stock's FMV on the merger date or the stock's FMV when the forfeiture occurs.

Because the Acquirer stock is subject to restrictions causing that stock to be "substantially non-vested" within the meaning of Section 83, the IRS considers the Acquirer stock received by Employee to be transferred in connection with the performance of services, so Section 83 applies to Employee's Acquirer stock.

The tax consequences here are affected by whether Employee files an 83(b) election concerning the Acquirer stock. Section 83(b) of the Code allows an employee to elect to be taxed on the FMV of unvested stock (less any amount paid by the employee for the stock) at the time the employee receives the stock, rather than when the stock vests, by filing an 83(b) election with the IRS within 30 days after the stock is transferredto the employee.

If Employee files an 83(b) election concerning the Acquirer stock, the value of Employee's Employer stock is treated as the amount paid for the Acquirer stock he or she receives, and Employee does not recognize any income upon receipt of the Acquirer stock because the Employer stock and the Acquirer stock have the same FMV on the merger date. Employee does not recognize any income when the Acquirer stock vests because of the prior 83(b) election. Employee's tax basis in the Employer stock exchanged carries over to the Acquirer stock, thereby preserving any built-in gain of the Employer stock, which will be recognized as capital gain upon Employee's later sale of the Acquirer stock.

If Employee had not made an 83(b) election, when the Acquirer stock vests, Employee would include the excess of the FMV of the Acquirer stock on the vesting date over the amount paid for that stock (the FMV of the Employer stock on the merger date) as compensation income when that Acquirer stock vests.

3. Employee exchanges vested stock for non-vested stock in a taxable stock acquisition

In this fact pattern, Employer merges with Merger Sub, a subsidiary of Acquirer, in a taxable transaction, and Employee exchanges his vested Employer stock for unvested Acquirer stock. If Employee doesn't continue to work for Employer through the third anniversary of the merger, Employee will have to sell his or her Acquirer stock back to Acquirer at the lesser of the stock's FMV on the merger date or the stock's FMV when the forfeiture occurs.

Employee recognizes capital gain on disposition of Employee's Employer stock equal to the excess of the FMV of the Acquirer stock received over his or her basis in the Employer stock. This gain is recognized under Section 1001 of the Code (whether or not Employee makes an 83(b) election). Employee's tax basis in the Acquirer stock received is his or her basis in the Employer stock plus the amount of this gain, i.e., the FMV of the Acquirer stock received.

Because the Acquirer stock is subject to restrictions causing that stock to be "substantially non-vested" within the meaning of Section 83, the IRS considers the Acquirer stock received by Employee to be transferred in connection with the performance of services, so Section 83 applies to Employee's Acquirer stock.

The amount paid by Employee for the Acquirer stock equals the FMV of the Employer stock disposed of in exchange for that Acquirer stock. When Employee makes an 83(b) election on the Acquirer stock, Employee does not recognize any additional income because the excess of the FMV of the Acquirer stock over this amount paid is zero. Employee does not recognize any income when the Acquirer stock vests because of the prior 83(b) election. Employee's tax basis in the Acquirer stock is unaffected by vesting, i.e., Employee's basis continues to be equal to the FMV of the Acquirer stock when Employee previously received that stock. When Employee sells the Acquirer stock, Employee recognizes capital gain equal to the excess of the sale price received over Employee's basis in the Acquirer stock.

If Employee had not made an 83(b) election, then he or she will have the same "phantom income" recognition under Section 83 when the Acquirer stock vests as described in the case of fact pattern (2) above.

As demonstrated by fact patterns (2) and (3) above, employees should make 83(b) elections on their exchange of already-owned vested shares for new, unvested shares (with the same FMV) in tax-free reorganizations or taxable corporate transactions to avoid undesirable "phantom" Section 83 income when those new shares vest.