Guest Article

(From the August 25, 2003 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits. Hyperlinks within the article have been added by BenefitsLink.)

Amount of Employer's Section 83(h) Deduction Is Independent of Amount Employee Actually Includes in Income

(Thanks to Stephen LaGarde of the EB Tax group for preparing this article.)

Rejecting language in the preamble to the regulations under section 83 and decisions rendered by the Tax Court, the Sixth Circuit, and the Federal Claims Court, the Federal Circuit has ruled that an employer is entitled to a deduction under section 83(h) for amounts that are required to be included in an employee's income, even if such amounts are not actually reported on the employee's tax return or included in the employee's income on audit. Robinson v. U.S., 2003 U.S. App. LEXIS 14182. However, most employers rely on a safe harbor provision in the regulations and therefore will be unaffected by the decision.

Background

In general, section 83 provides that when property is transferred in connection with the performance of services, the fair market value (less any amount paid for the property by the service provider) is taxed when the rights to the property become transferable or are no longer subject to a substantial risk of forfeiture. However, if the service provider makes an election under section 83(b), such amounts are taxed as ordinary income in the year of transfer, and any gain on a later sale of the property is taxed as a capital gain. Section 83(h) provides that an employer's deduction for property transferred to an employee is equal to the amount "included... in the employee's gross income."

In 1995, the IRS published final regulations under section 83(h). The preamble to those regulations provides that "the amount included means the amount reported on an original or amended return or included in gross income as a result of an IRS audit of the service provider." (T.D. 8599, 7-18-95.) However, the regulations provide a safe harbor for employers who properly report the amounts using Form W-2. Treas. Reg. Sec. 1.83-6(a)(2).

Robinson v. U.S.

Under normal circumstances employers can rely on the safe harbor in the regulations, but the facts in Robinson were unusual. In 1995, the Chief Operating Officer of an S corporation was granted stock for which he made a section 83(b) election. However, due to his unique position in the company, his election was filed with himself and the amount was neither reported on his Form W-2 nor deducted as a compensation expense by the S corporation shareholders, James and Barbara Robinson. Asserting that the fair market value of the stock equaled the $2 million he paid for it, the COO did not include the stock in his income on his 1995 tax return.

In 1999 the Robinsons became aware of the COO's section 83(b) election and filed a refund claim for income taxes paid. They argued that they were entitled to a deduction under section 83(h) for over $20 million, which reflected the true value of the stock in 1995. The IRS rejected their refund claim because the amount included in the COO's income in 1995 was zero, the conditions of the safe harbor were not satisfied, and although the COO's 1995 tax return was under examination by the IRS, final settlement had not yet been reached.

The Robinsons sued in Federal Claims Court and lost. On appeal, the Federal Circuit reversed, acknowledging its departure from the language in the preamble to the applicable regulations and the Tax Court and Sixth Circuit decisions in Venture Funding v. Commissioner, 110 T.C. 236 (1998), aff'd per curiam, 84 AFTR 2d 99-5929 (6th Cir. 1999), cert. denied, 530 U.S. 1205 (2000). The Federal Circuit decision explains that the statute and legislative history clearly indicate that "included" was intended to mean "required to be included," or "includible," not actually reported on the employee's tax return or included in the employee's income on audit. (Indeed, the IRS endorsed this meaning until the 1995 regulations were published.)

Implications

Because most employers can rely on the safe harbor under Treas. Reg. Sec. 1.83-6(a)(2), the Robinson decision is of limited practical significance. Nevertheless, if a taxpayer does not meet the requirements of the safe harbor offered in the regulations, it should be able to rely on the Robinson decision for substantial authority. Taxpayers filing refund claims or taking a return position based on the Robinson decision should disclose the position to avoid an accuracy-related penalty. While the case provides substantial authority for deducting such amounts, the position could be interpreted by the IRS as a disregard of rules and regulations, requiring disclosure under IRC Sec. 6662(b)(1).

If you have questions or need additional information, please contact your Deloitte advisor.

The information in this Washington Bulletin is general information only and not intended to provide advice or guidance for specific situations. Contact your Deloitte advisor for information regarding your specific circumstances. If you have questions or need additional information about this article and you do not have a Deloitte advisor, please contact Martha Priddy Patterson (202.879.5634) or Robert B. Davis (202.879.3094). Human Capital Advisory Services, Deloitte LLP, 555 12th Street NW, Suite 500, Washington, DC 20004-1207. Copyright 2003, Deloitte.