IRS Issues Needed Guidance on Exchanges of Restricted Stock in Reorganizations
M&A Alert 2007-10
Key Points and Opportunities– Mergers & Acquisitions
It is very common for keyemployee shareholders to retain an interest in the target business following anacquisition, whether the acquisition is structured as taxable or tax-free. In many cases, the employee shareholder’sstock is either converted into or exchanged for stock that vests over timebased upon the shareholders continued employment with the target or theacquirer. This stock is commonlyreferred to as “restricted” or “substantially nonvested” stock. A recent IRS ruling provides much needed guidanceas to the treatment of the exchange of or conversion to restricted stock inboth taxable and tax-free transactions. However, the ruling is conspicuously silent as to the larger issues thatmay affect the overall impact of restricted stock exchanges in reorganizationsintended to represent tax-free exchanges.
Background
For many years theappropriate treatment of the receipt of restricted stock in a reorganizationhas remained unclear. Has a compensatorytransfer occurred when a restriction is placed the previously unrestrictedshares? What about when restrictedshares are received in exchange for unrestricted shares in a taxable ortax-free reorganization?
The question of whetherproperty is transferred in connection with the performance of services isdetermined based on all facts and circumstances, and a transfer can occur inconnection with services where the recipient pays full value for theproperty. See Alves v. Commissioner, 734F.2d 478 (9th Cir. 1984), aff’g 79 T.C. 864 (1982). In the event a transfer of restrictedproperty is compensatory, the property is not taxable to the recipient untilthe restriction on the property lapses. The recipient of restricted property does have the option to elect underIRC § 83(b) (an “IRC § 83(b) election”) to have the value of the property taxedto him on the date of the transfer, at its value on that date, rather than onthe date the property is vested. Such anelection allows taxation of future appreciation from the date received underpreferable capital gains rates.
In addition to thecompensatory issues, the treatment of restricted shares in determining thecontinuity of interest (COI) requirement in a tax-free reorganization isunclear. In fact, the IRS and Treasuryannounced in the preamble to final regulations issued in September 2005, thatthey were continuing to consider the appropriate treatment of restricted sharesin determining COI. T.D. 9225, 2005-2C.B. 716. Why the uncertainty? What if the stock never fully vests? Should the stock count towards determiningwhether a sufficient continuing equity interest was received to qualify underIRC § 368(a)?
Recent Guidance
On July 6, 2007 the IRSissued Rev. Rul. 2007-49, providing guidance on treatment of the placement ofrestrictions upon previously unrestricted shares, and the treatment of thereceipt of restricted shares in exchange for unrestricted shares in bothtaxable and tax-free reorganizations.
Under the ruling, arestriction placed upon unrestricted stock does not subject the stock to IRC §83, as no transfer has occurred. Theruling also holds that receipt of restricted stock in exchange for unrestrictedstock in a reorganization is a transfer subject to IRC § 83. The ruling also holds that the receipt of therestricted stock is taxable or tax-deferred depending on the reorganization’soverall status as taxable or tax-deferred pursuant to IRC § 368(a).
With the exchange subject toIRC § 83, the failure to make an IRC § 83(b) election could be disastrous. Assuming the value given up is equal to thevalue received, a valid IRC § 83(b) election will forestall recognition ofordinary income on the future appreciation of the stock received, while afailure to elect will subject appreciation from the date of the exchange to thevesting date to ordinary income rates.
Additional Guidance Needed
At first glance the rulingappears to help resolve the COI issue. If the stock is received tax-free in a qualifying IRC § 368(a)transaction, it would seem fair to assume that the stock is qualifyingconsideration for purposes of determining whether COI is satisfied. However, the ruling does not state thisaffirmatively, and the facts in the ruling do not provide enough information tocome to a conclusion that the restricted stock is counted in determining COIfor the reorganization.
Summary
Rev. Rul. 2007-49 providesvaluable guidance in determining whether the receipt of restricted stock in areorganization is received in connection with the performance of services;however, additional guidance is needed to determine the appropriate treatmentof restricted stock in determining COI.
