Revoking a Section 83(b) Election
Many employers use equity interests in their company as an incentive for an employee to build the company (including LLCs) or as a reward for contributing to the success of the company. This is true of companies of all sizes, but is more prevalent in start-up companies where cash is tight, the value of the company is low, and the potential for growth is exponential. Typically, there are service or performance criteria (restrictions) attached to the grant of equity interests in the company, which would allow the employee (or independent contractor) to make an Internal Revenue Code section 83(b) (section 83(b)) election with respect to the property received. Occasionally, an employee that has made an election under section 83(b) will later for some reason decide that they want to revoke their election, such as something has occurred with the employer that results in the potential growth of the company being substantially reduced. Since a section 83(b) election is meant to be irrevocable, revocation is possible only in limited circumstances. After some background and definition information, this Alert addresses when and under what circumstances a section 83(b) election may be revoked.
Section 83(a) provides generally that if, in connection with the performance of services, property is transferred to an employee, the excess of the fair market value of the property (determined without regard to any restriction other than a restriction which by its terms will never lapse), as of the first time the employee's rights in the property are transferable or are not subject to a substantial risk of forfeiture,, over the amount (if any) paid for the property is included in the employee's gross income for the taxable year which includes such time.
Under Treasury Regulation (Treas. Reg.) section 1.83-3(f), property is transferred in connection with the performance of services if it is transferred to an employee or independent contractor in recognition of the performance of services, or refraining from performance of services. The transfer of property is subject to section 83 regardless of whether the transfer relates to past, present, or future services.
Section 83(b) Election
Section 83(b) permits the employee to elect to include in income the excess, if any, of the fair market value of the property at the time of transfer over the amount, if any, paid for the property.
Section 83 does not apply to the transfer of an option without a readily ascertainable fair market value at the time the option is granted, which is generally the case for all options other than those of public companies traded on an options exchange. As a result, a section 83(b) election may only be made with respect to the transfer of an option that has a readily ascertainable fair market value (as defined in Treas. Reg. section 1.83-7(b)), at the time the option is granted and that is substantially nonvested (as defined in Treas. Reg. section 1.83-3(b)). If substantially nonvested property is received upon exercise of an option without a readily ascertainable fair market value at grant, an employee is permitted to make a section 83(b) election with respect to the transfer of such (restricted) property upon the exercise of the option.
An election made under section 83(b) must be made in accordance with the regulations and must be filed with the Internal Revenue Service no later than 30 days after the date that the property is transferred to the employee. If the 30th day following the transfer of the property falls on a Saturday, Sunday, or legal holiday, then the election will be considered timely filed if it is postmarked by the next business day.
An election under section 83(b) is made by filing a copy of a written statement (see IRS Revenue Procedure 2012-29 for a sample election) with the Internal Revenue Service office with which the employee files his income tax return. Section 83(b) also requires that the employ submit a copy of the section 83(b) election to his employer. Further, the employee is required to submit a copy of the election with his income tax return for the taxable year in which such property was transferred.
Revoking a Section 83(b) Election
An election under section 83(b) may not be revoked except with the consent of the Commissioner of the Internal Revenue Service (Commissioner). If an employee decides to revoke the election within the initial 30-day election period (this rarely occurs), he may request a revocation by the Commissioner using the same procedures that apply for letter ruling requests. The request will generally be granted regardless of the reason for the request and is effective as of the date of the original election.
After the initial 30-day election period, the regulations provide that a revocation of the election will only be granted where the employee filing the election is under a mistake of fact as to the underlying transaction and the request must be made within 60 days of the date on which the mistake of fact first became known to the employee who made the election. The mistake of fact exception is narrow in scope. According to IRS Revenue Procedure 2006-31, a mistake of fact is an unconscious ignorance of a fact that is material to the transaction involving the transfer of property. Under Rev. Proc. 2006-31 the following are not mistakes of fact for this purpose:
- A mistake as to the value (or decline in the value) of the property for which the election was made.
- The failure of anyone to perform an act that was contemplated at the time of transfer of the property.
- The failure of the employee to understand the substantial risk of forfeiture associated with the transferred property.
- The failure of the employee to understand the tax consequences of making the section 83(b) election.
Rev. Proc. 2006-31 provides an example what constitutes a mistake of fact. The example describes a company that has two classes of stock. The employee was to receive one class and the company incorrectly transferred the other class of stock. The employee files a request for revocation within the allowable 60-day time frame. 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.
It is important for employees that receive restricted (unvested) property to be fully informed of the potential positive and negative consequences related to making a section 83(b) election because once the election is made, it can be very difficult to revoke the election.