Revoking the Irrevocable: Correcting a Section 83(b) Election

Winter 2007

Many employers use restricted stock as a significant form of executive compensation, and its use can be a powerful tool for executive retention. For example, an executive could be given restricted shares where the restriction requires the executive to be employed by the company at a certain point to have an unrestricted right to the shares. If the executive left prior to this date, the executive would forfeit ownership interest in these shares. The use of restricted stock, however, can result in income tax complexities, such as the timing and character of the income from the restricted stock transactions. As a general rule, Internal Revenue Code (IRC) Section 83 states that if property is transferred in connection with the performance of services, the employee who performs those services has gross income in an amount equal to the excess of the fair market value of the property received over the amount paid for the property by the employee. If the property transferred is subject to a substantial risk of forfeiture, income recognition is generally delayed until the property is no longer subject to substantial risk of forfeiture. The classic example of substantial risk of forfeiture is one that places the condition of ownership on the future performance of substantial services.

IRC Section 83(b), however, allows the employee who receives restricted shares to make an irrevocable election to include the fair market value of the restricted property over the amount paid for the property at the time of transfer in his or her income in the year of the transfer. This election must be made no later than 30 days after the date of the transfer of the restricted property. By invoking Section 83(b), an employee can avoid a future jump in ordinary income, assuming the restricted property increases in value from the date of transfer, and instead, upon sale of the property, record the increase as long-term capital gain.

The Section 83(b) election is supposed to be irrevocable, but the election may be revoked with consent of the IRS. A recently released Revenue Procedure—Revenue Procedure 2006-31, 2006-27 IRB 32—provides guidance on revoking a Section 83(b) election.

This particular regulation and its Revenue Procedure provides that such consent will only be granted if the person filing the election is under a "mistake of fact" as to the underlying transaction, and that the request must be made within 60 days of the date on which the mistake of the fact first became known to the person who had made the election. Neither a mistake as to the value of the property nor the failure of any one to perform an act that was contemplated at the time of transfer constitutes a mistake of fact for purposes of seeking revocation.

This may be viewed as a fine distinction, but the mistake of fact exception is narrow in scope. A mistake of fact is an unconscious ignorance of a fact that is material to the transaction. A mistake of law occurs where a person is ignorant of, or comes to an erroneous conclusion as to, the legal effect of the facts. The failure of the employee to understand the substantial risk of forfeiture associated with the transferred property is not a mistake of fact. Also, the failure of an employee to understand the tax consequences of making an 83(b) election is not a mistake of fact.

Revenue Procedure 2006-31 provides several examples as to the operation of these rules. The first example illustrates an employee who files a timely request for a ruling from the IRS to consent to the revocation of a valid Section 83(b) election. The basis for the request is a misunderstanding of the forfeiture provisions and the tax consequences of the election. The example in the procedure clearly states that the employee’s misunderstanding of the forfeiture provision is not a mistake of fact, but rather a failure to understand the substantial risk of forfeiture set forth in the restricted stock agreement. The misunderstanding of the tax results is a mistake of law. As set out in this example, the consent to revoke the election would not be granted.

According to the second example, however, if a request for revocation is filed within the original 30-day period in which a Section 83(b) election could be made, then consent to revoke the election would be granted, regardless of the reason.

The third illustration highlights a company that has two classes of stock. The employee was to receive a certain class, the company incorrectly transferred the other class of stock. The employee files a request for revocation within the allowable 60-day timeframe. Since this request is based on a mistake of fact as to the underlying transaction because the employee did not receive the property he or she expected, the revocation of the election would be granted. If the request was not made within 60 days of the discovery of the mistake, the request would not be granted.

The requirements of IRC Section 83 are complex, restrictive, and have the 30-day time frame for making the Section 83(b) election, if appropriate. This complexity can result in mistakes being made. If a mistake of fact is discovered after a Section 83(b) election, and a timely request is filed, a revocation may be in order. Timely action after the discovery of a mistake is critical when determining if the revocation of a Section 83(b) election is in order. Revenue Procedure 2006-31 is the path for correcting a mistake.

Larry S. Blair, CPA, JD, is a partner with the law firm of Metz Lewis LLC in Pittsburgh, and is a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at lblair@metzlewis.com.

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