Imagine you have three possible lives to live in the summer of 1969:

• You can be a carefree college student trekking to Woodstock.
• You can be an attorney on the staff of the House Ways and Means Committee drafting a new section of the Internal Revenue Code (Section 83) to correct the then generous tax treatment of restricted stock granted to executives in connection with their employment.
• You can be Lawrence Alves, the Controller of Sylvania Semi-Conductor, soon to be poached by a new company (General Digital Corp.), who as part of his onboarding package, purchased 40,000 shares of stock at its then FMV ($0.10 cents/share), but subject to certain forfeiture provisions.

Since you are currently reading this, we will assume you chose Option Two. You never thought Woodstock would amount to much and, as we shall discuss, you do not want to suffer the adverse tax fate of Mr. Alves.

Back to Section 83. While seasoned executive compensation professionals view the statute and IRS regulations as a companionable (albeit at times difficult) resource in the practice, newcomers are often left with their heads swimming, navigating complicated definitions relating to property, transferability, substantial risk of forfeiture, lapse restrictions, non-lapse restrictions and fair market value. And then there is the 83(b) election, with its unyielding 30-day IRS filing period, that fills young associates with dread least there be a late filing mistake that ruins their careers.

So how to help the newcomers understand the big picture?

First, it is worth a turn to the legislative history of Section 83, which originated out of the House Ways and Means Committee. Their initial Committee report states:

• “Present law does not contain any specific rules governing the tax treatment of deferred compensation arrangements known as restricted stock plans.”
•  “A restricted stock plan … is an arrangement under which an employer transfers stock to one or more of his employees (often without the payment of any consideration), where the stock is subject to certain restrictions which affect its value.”
• “The restrictions which are imposed on the stock are of various types. One type of restriction often imposed requires the employee to return the stock to the employer if he does not complete a specified additional period of employment and prohibits the employe from selling the stock in the interim.”
• “Another common type of restriction provides that the employee may not sell the stock for a specified period of time, such as a 5-year period, or until he retires.”

What was wrong with the existing tax treatment of these arrangements? In the view of the Committee (and no doubt the IRS) the “present treatment of restricted stock plans is significantly more generous than the treatment specifically provided in the law for similar types of deferred compensation arrangements.”

And how was it “significantly more generous”? According to the Committee (emphasis added):

• “The existing Treasury regulations generally provide that no tax is imposed when the employee receives the restricted stock.”
• “Tax is deferred until the time the restrictions lapse; at that time only the value of the stock when it was transferred to the employee …. Is treated as compensation, provided the stock has increased in value.”
• “If the stock has decreased in value in the interim, then the lower value at the time the restrictions lapse is considered the amount of compensation.”
• “Thus, under the existing regulations there is a deferral of tax with respect to this type of compensation, and any increase in the value in the stock between the time it is granted and the time when the restriction lapse is not treated as compensation.”

The Committee proposed the following “fix”:

• “A person who receives a beneficial interest in property by reason of the performance of services is to be taxed with respect to the property at the time of receipt, either if his interest in the property is transferable or if it is not subject to a substantial risk of forfeiture” whichever occurs earlier, and in such a case taxable income is “the amount by which fair market value of the property exceeds the amount (if any) paid for the property.”
• “A substantial risk of forfeiture will be considered to exist where the person’s rights to full enjoyment of the property are conditioned upon his future performance of substantial services. In other cases, the question of whether there is a substantial risk of forfeiture depends on the facts and circumstances.”

The Senate Finance Committee adopted the major provisions of the House bill but added what it viewed as “several minor modifications” including the following:

• The House bill would have required immediate taxation if the restricted stock was transferable, even if the transfer resulted in forfeiture by the transferee- the Senate Committee’s change “provides that an interest in property is to be considered to be transferable only if a transferee would not be subject to the forfeitability condition.”
• To add flexibility, the Senate Committee added what would become Section 83(b) “allowing recipients of restricted property the option of treating it as compensation in the year it is received, even though it is nontransferable and subject to a substantial risk of forfeiture” and “if this election is made, the restricted property rules are not to apply, and the later appreciation in the value of property is not to be treated as compensation.”

Section 83 became law in 1969 and implementing regulations were promulgated in 1978 (retroactive to 1969).

Which brings us to the case of Mr. Alves. In 1970 as part of his new employment arrangement with GDC he purchased 40,000 shares of restricted stock in GDC at its then fair market value of $4000 ($0.10 per share). The purchased stock was in three tranches- 1/3 was unrestricted, 1/3 was subject to 4-year vesting and 1/3 was subject to 5 -year vesting- if Alves resigned (or was terminated for cause) before those dates GDC could call the shares at his original cost ($0.10) regardless of their then FMV. In 1974 the 4-year tranche vested and GDC issued a Form W-2 to Alves-the shares were then valued by GDC at $5.90 per share and the Form W-2 reflected $27,535 in income. Alves was then terminated in March 1975 and as part of the separation the restrictions on the 5- year shares were lifted; GDC issued a Form W-2 to Alves on a portion of the 5-year shares reflecting $8,078 in income, valuing the shares at $3.33 per share

One can only suspect that the issuance by GDC of the Form W-2s, so GDC could take the corresponding tax deduction on income it reported to Mr. Alves, came as a surprise to Mr. Alves, who did not include those amounts as income in his own tax returns, and likely triggered the IRS review of Mr. Alves’ tax returns. The IRS issued a notice of deficiency to Mr. Alves, which he contested, and the case made its way to the entire Tax Court.

There were three important factual stipulations in the case, as agreed to by the IRS and Mr. Alves. First, that 4-year shares and 5-year shares were “subject to a substantial risk of forfeiture” through to the end of their respective vesting periods. Second, that the shares had a FMV of 10 cents per share- which the Tax Court was highly skeptical of but for purposes of the case stated that “since the stipulation made goes to the heart of the controversy and was obviously freely entered into, we will accept such fact as represented by the parties to be true ….” Third, that Mr. Alves did not make an election under Section 83(b)

Before the Tax Court, Mr. Alves argued that (i) Section 83 was not applicable since his stock was “purchased as an investment” and not received in connection with the performance of services and (ii) Section 83 was intended to apply to bargain purchases of stock, which was not his case since he purchased the stock at FMV. The IRS argued that the stock purchase was clearly “in connection with the provision of services” by Mr. Alves and that since Mr. Alves failed to make a Section 83(b) election, the FMV of the stock at the time there was no longer any substantial risk of forfeiture (1974 and 1975, not 1970) was taxable income.

Mr. Alves lost both arguments before the Tax Court, but five judges on the Tax Court dissented. On the first point (was the stock purchased “in connection with the performance of services”) the majority opinion reviewed the facts of Mr. Alves “onboarding” by GDC and the timing of his stock purchase and made a convincing argument that the stock purchase was in connection with his performance of services for GDC.

It is the Tax Court’s treatment of the second argument (and the dissenting opinions) that is interesting. Both the majority and dissenting opinions recognized that Section 83(b) is an elective provision to allow a taxpayer to include as income, at the time restricted property is received, the “excess” of the FMV of the property over the amount paid. Mr. Alves argued that Section 83(b) could not possibly apply, because he paid FMV and there was no “excess” with respect to make an election under Section 83(b). As one dissenting judge put it: “I do not think that Congress intended to require a taxpayer to elect to include something in gross income when that taxpayer had nothing to include in gross income.”

But the majority opinion took a very strict position that an election under Section 83(b) was “the sole means by which post-transfer appreciation may be removed from being treated as compensation.” In support of its position the majority opinion referenced language in IRS regulations implementing Section 83- published years after Mr. Alves purchased his stock but retroactive to 1969- expressly recognizing that a protective Section 83(b) election could be made when FMV was paid and there was no “excess value.” As stated by the IRS in the regulations: “The fact that the transferee has paid full value for the property transferred, realizing no bargain element in the transaction, does not preclude the use of the election as provided for in this section [Section 83(b)].”

And here is where the Alves case takes a nasty turn. As the majority opinion notes, during his IRS audit Mr. Alves requested a Technical Advice Memorandum (TAM) from the IRS that Section 83 was not applicable to his 4-Year and 5-Year shares because he paid FMV. Mr. Alves alleged that his own request for the TAM lead the IRS to amend its proposed Section 83 regulations to include the express language referenced above that acknowledges that a protective Section 83(b) election could be made.

The Tax Court did express some sympathy for Mr. Alves, noting that it “is unfortunate that the petitioner in this case did not elect the provision of section 83(b)” and that “the transfer of the stock to him was so soon after the enactment of section 83 that he may well have been unaware of the provisions of section 83(b) at the time of transfer.” The 9^th Circuit affirmed the Tax Court decision in 1984.

As for Mr. Alves- what happened to his stock in GDC after he was terminated in 1975 and after he presumably paid the additional income tax assessed by the IRS on his GDC shares? GDC rebranded itself as Western Digital and declared bankruptcy in 1976, when its business selling chips for calculators went under. Sadly, it is quite possible that Mr. Alves lost his equity due to this 1976 bankruptcy. Western Digital then emerged from bankruptcy and over the years transitioned to data storage and now, given the boom in AI and data centers, has a market capitalization of between $170-180 billion. And so it goes……