THE LOS ANGELES COUNTY BAR ASSOCIATION TAXATION SECTION CORPORATE TAX COMMITTEE1 MAKING RESTRICTED STOCK LESS RESTRICTING A PROPOSAL by kmc16296

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									             THE LOS ANGELES COUNTY BAR ASSOCIATION
                        TAXATION SECTION
                   CORPORATE TAX COMMITTEE1


   MAKING RESTRICTED STOCK LESS RESTRICTING: A
PROPOSAL FOR CLARIFICATION OF THE TAX TREATMENT OF
                RESTRICTED STOCK




            This proposal was principally prepared by James W. Chapman,
Vice-Chair of the Los Angeles County Bar Association Corporate Tax
Committee (the ―Committee‖), and Myron D. Mendelowitz, Secretary of the
Committee. The authors wish to thank Shahzad Malik of Akin, Gump,
Strauss, Hauer & Feld, Eugene Cowan of Riordan & McKinzie, and Richard
Fung of Ernst & Young LLP for their valuable contributions to this paper. 2



         Contact Persons:                    James W. Chapman
                                             Riordan & McKinzie
                                             300 South Grand Avenue, 29th Floor
                                             Los Angeles, California 90071
                                             Phone:     (213) 229-8443
                                             Fax:       (213) 229-8550
                                             E-Mail:    jwc@riordan.com




         1
          The comments contained in this paper are the individual views of the authors who prepared this
paper and do not represent the position of the State Bar of California or of the Los Angeles Bar Association.
         2
          Although the participants on the project might have clients affected by the rules applicable to the
subject matter of this paper and have advised such clients on applicable law, no such participant has been
engaged by a client to participate on this project.
                                                                                         James W. Chapman
                                                                                    Myron D. Mendelowitz
Myron D. Mendelowitz
Ernst & Young LLP
725 South Figueroa Street
Los Angeles, California 90017
Phone:      (213) 977-7609
Fax:        (213) 240-7435
E-Mail:     myron.mendelowitz@ey.com




   2                     James W. Chapman
                       Myron D. Mendelowitz
EXECUTIVE SUMMARY


             There is a lack of definitive legislative and regulatory guidance
regarding the application of Section 83 of the Internal Revenue Code (the
―Code‖) in the context of certain merger, acquisition, and financing
transactions. Guidance is requested regarding four principal issues.

             First, guidance is requested as to the application of Section 83 to
transactions where, as a condition to a corporation's receipt of financing,
employment-based forfeiture restrictions are imposed on the previously
unrestricted shares of the corporation that are owned by its employees. There
does not appear to be a "transfer" of property in this situation as is required
for the application of Section 83. The Committee recommends regulatory
action to confirm this conclusion in the form of an amendment to Treasury
Regulation Section1.83-3(a)(1).

             Second, guidance is requested as to the application of Section 83
where, in a transaction intended to qualify as a tax-free reorganization under
Section 368(a) of the Code, employee-shareholders of the target corporation
exchange in the reorganization their unrestricted shares of target stock for
shares of stock of the acquiring corporation that are subject to post-
acquisition employment based forfeiture restrictions. Such an exchange
should not be considered to constitute a transfer of property ―in connection
with the performance of services‖ within the meaning of Section 83. The
Committee proposes legislative action to confirm this conclusion in the form
of an amendment to Section 83(e) and regulatory action in the form of
amendments to Treasury Regulation Section 1.83-3(f) and Treasury
Regulation Section 1.83-2(a). If these recommendations are not adopted, the
Committee recommends the amendment of Section 83(b) and Treasury
Regulation Section 1.83-2(c) to provide for a deemed Section 83(b) election
following the exchange.

             Third, guidance is requested as to the manner in which Section
83 and the tax-free reorganization provisions of the Code should be integrated
if both are found to apply to a transaction described above. A bifurcated
method, one of several possible integration methods, appears reasonable. The
Committee recommends that the Treasury consider possible integration
methods and amend Treasury Regulation Section 1.83-4(a)-(b) to reflect an
appropriate method.
                                     3                         James W. Chapman
                                                             Myron D. Mendelowitz
             Finally, guidance is requested as to the treatment of substantially
nonvested stock for purposes of the continuity of interest requirement of tax-
free reorganizations. One view is that the making of a timely Section 83(b)
election controls whether or not substantially nonvested stock counts toward
satisfying the continuity of interest test. Another view is that substantially
nonvested stock should count for continuity of interest purposes regardless of
whether or not such election is timely made. The Committee recommends
regulatory action in the form of an amendment to Treasury Regulation
Section 1.368-1(e) adopting the latter view. If these recommendations are not
adopted, the Committee recommends the amendment of Section 83(b) and
Treasury Regulation Section 1.83-2(c) to provide for a deemed Section 83(b)
election following certain reorganization exchanges of substantially
nonvested stock.




                                     4                         James W. Chapman
                                                             Myron D. Mendelowitz
                        TABLE OF CONTENTS


I.     INTRODUCTION.                                                8
II.    BACKGROUND.                                                  9
       A.   Section 83.                                             9
            1.    Purpose.                                          9
            2.    Operation.                                        11
                  (a) Generally.                                    11
                  (b) Timing and Type of Gain.                      12
                  (c) Basis and Holding Period.                     13
                  (d) Ownership.                                    14
                  (e) Subsequent Disposition of Property.           14
                  (f)    Broad Application.                         15
       B.   Tax-Free Reorganization Provisions.                     15
            1.    Purpose.                                          15
            2.    Operation.                                        16
                  (a) Timing and Type of Gain.                      16
                  (b) Basis and Holding Period.                     16
                  (c) Ownership.                                    17
III.   ISSUES FOR RESOLUTION.                                       18
       A.   Introduction.                                           18
            1.    Imposition of Restrictions as “Transfer.”         18
            2.    Reorganization Exchange as “In Connection
                  With the Performance of Services.”                19
            3.    Effect of Section 83 if Applicable.               19
            4.    Continuity of Interest.                           19
       B.   Imposition of Restrictions.                             19
            1.    Requirement of a Transfer of Property.            19
            2.    Application to Financing Transaction.             20
       C.   In Connection With the Performance of Services.         22
            1.    Meaning of “In Connection With the
                  Performance of Services.”                         22
                  (a) Code and Regulations.                         22
                  (b) Judicial Guidance.                            23
                         (1) Four-Factor Test.                      23
                         (2) Cases Finding Transfers in
                               Connection With the Performance
                               of Services.                         24

                                  5                       James W. Chapman
                                                        Myron D. Mendelowitz
                 (3)     Cases Finding Transfers Not in
                         Connection With the Performance
                         of Services.                         25
     2.    Application Where Shareholders/Employees
           Receive Restricted Stock for Unrestricted
           Stock in a Reorganization.                         26
                  (a) Assumed Facts.                          26
                  (b) Four-Factor Test.                       27
                  (c) Additional Considerations.              30
                  (d) Conclusion.                             32
D.   Integration of Section 83 and the Reorganization
     Provisions.                                              33
     1.    Possible Application of Section 83 Provisions
           Absent Application of Reorganization
           Provisions.                                        33
           (a) Exchange of Target Stock for Acquirer
                  Stock.                                      33
           (b) Vesting of Acquirer Stock.                     34
           (c) Disposition of Acquirer Stock.                 35
     2.    Possible Application of Reorganization
           Provisions Without Application of Section 83.      35
           (a) Exchange of Target Stock for Acquirer
                  Stock.                                      35
           (b) Vesting of Acquirer Stock.                     36
           (c) Disposition of Acquirer Stock.                 36
     3.    Integration of Section 83 and the Reorganization
           Sections.                                          36
           (a) Exchange of Target Stock for Acquirer
                  Stock.                                      37
           (b) Vesting of Acquirer Stock.                     38
           (c) Disposition of Acquirer Stock.                 38
     4.    Conclusion.                                        39
E.   Continuity of Interest                                   39
     1.    Section 83(b) Election Controls.                   39
     2.    Substantially Nonvested Stock Should Count
           Regardless of Section 83(b) Election.              40
           (a) Similarity to Unrestricted Stock.              40
           (b) Relevance to Control.                          41


                           6                        James W. Chapman
                                                  Myron D. Mendelowitz
                (c) Treatment of Non-voting Preferred Stock.      41
                (d) Final Continuity of Interest Regulations.     41
                (e) Similarity to Escrowed Stock.                 42
                (f)    Public Policy Issues.                      44
          3.    Treatment as Securities.                          44
          4.    Conclusion.                                       45
IV.   PROPOSALS.                                                  46
      A.  Imposition of Restrictions.                             46
          1.    Legislative Action – None.                        46
          2.    Regulatory Action – Amendment to Treasury
                Regulation Section 1.83-3(a)(1).                  46
      B.  In Connection With the Performance of Services.         46
           1. Legislative Action.                                 46
                (a) Amendment to Section 83(e).                   46
                (b) Amendment to Section 83(b).                   48
          2.    Regulatory Action.                                49
                (a) Amendment to Treasury Regulation
                       Section 1.83-3(f).                         49
                (b) Amendment to Treasury Regulation
                       Section 1.83-2(a).                         50
                (c) Amendment to Treasury Regulation
                       Section 1.83-2(c).                         50
      C.  Integration of Section 83 and the Reorganization
          Provisions.                                             51
          1.    Legislative Action – None.                        51
          2.    Regulatory Action – Amendment to Treasury
                Regulation Section 1.83-4(a)-(b).                 51
      D.  Continuity of Interest.                                 52
          1.    Legislative Action – Amendment to Section
                83(b).                                            52
          2.    Regulatory Action.                                53
                (a) Amendment to Treasury Regulation
                       Section 1.368-1(e).                        53
                (b) Amendment to Treasury Regulation
                       Section 1.83-2(c).                         53




                                 7                      James W. Chapman
                                                      Myron D. Mendelowitz
                                            DISCUSSION



I.       INTRODUCTION.

       An explosion of equity-based compensation has occurred in the
United States over the course of the last decade, especially with respect to
companies in the technology, internet, and e-commerce fields. For many of
these companies, the ability to offer compensation in the form of their own
stock, through such arrangements as grants of stock options or sales of
restricted stock, represents the only meaningful method of attracting and
retaining the necessary skilled labor force. Companies in the high-
technology field are also expected to experience an increase in merger and
acquisition activity due to their limited ability to raise capital through public
markets as a result of the decline of stock market enthusiasm for technology
related companies.

       Since a large part of the value of many high-technology companies is
dependent on the retention of a skilled labor force, potential acquirers are
frequently insisting, as a condition to the acquisition, that shareholders of
the target corporation who are also key target employees accept their
proportionate share of the acquisition proceeds, which is usually stock of
the acquiring corporation, subject to post-acquisition employment based
forfeiture restrictions (e.g., the acquirer stock will be forfeited if the
shareholder-employee leaves the employ of the acquiring corporation within
a certain number of years of the acquisition), which restrictions are not
imposed on the acquisition proceeds received by non-employee
shareholders of the target corporation.

      While the business community has been quick to embrace equity-
based compensation arrangements, the federal tax laws are unclear as to
their implications in the context of frequently occurring mergers,
acquisitions, and financial transactions. The tax consequences of equity-
based compensation are generally governed by Section 83 of the Internal
Revenue Code of 1986 (the ―Code‖)3 whereas the tax consequences of
merger, acquisition, and financing transactions are generally determined


         3
             All Section references are to the Internal Revenue Code of 1986, as amended, unless otherwise
indicated.
                                                   8                                 James W. Chapman
                                                                                   Myron D. Mendelowitz
under the reorganization provisions of Subchapter C of the Code.4 The
broad statutory language of Section 83 and the expansive interpretation of
that language by case law (e.g., Alves v. Commissioner5) have resulted in
significant conflict between Section 83 and other Code provisions.

       The lack of definitive legislative or regulatory guidance regarding the
application of Section 83 in the context of mergers, acquisitions, and
financing transactions is impairing the ability of companies to timely and
efficiently complete these legitimate business transactions. In order to
solicit guidance regarding these matters, this paper will (a) consider the
purposes and operation of Section 83 and certain of the reorganization and
gain recognition provisions of the Code, (b) identify and explore certain
issues in need of guidance, and (c) provide suggestions for such guidance.

II.     BACKGROUND.

        A.         Section 83.

                   1.       Purpose.

                    Section 83 was enacted as part of the Tax Reform Act of
1969 (―TRA 1969‖) to address the tax treatment of restricted stock plans.
The restricted stock plans at which Section 83 was aimed are arrangements
under which an employer transfers stock to an employee, ―often without
payment of consideration‖ by the employee, where the stock is subject to
certain restrictions that may affect its value.6 Restrictions may require the
employee to return the stock to the employer if the employee does not
complete a specified additional period of employment and prohibit the
employee from selling the stock in the interim, or may prohibit the
employee from selling the stock for a specified period of time or until the
employee retires.7 Although the stock is subject to restrictions, the



        4
          Subchapter C, containing rules for the treatment of corporate distributions and adjustments,
comprises Sections 301 through 385.
        5
            79 T.C. 864 (1982), aff’d, 734 F.2d 478 (9th Cir. 1984).
        6
           H.R. Rep. No. 413 (Part 1), 91 st Cong., 1st Sess. 86-88 (1969); S. Rep. No. 552, 91st Cong., 1st
Sess. 119-122 (1969); Staff of the Joint Comm. on Internal Revenue Tax‘n, 91 st Cong., General Explanation
of the Tax Reform Act of 1969, 109-111 (1970) (the ―Blue Book‖).
        7
            Id.
                                                     9                                James W. Chapman
                                                                                    Myron D. Mendelowitz
employee possesses the stock and has voting rights as well as dividend
rights with respect to the stock.8

                     Prior to TRA 1969, no tax was imposed when the
employee received restricted stock. Instead, the time for income recognition
and the imposition of tax was deferred until the time the restrictions lapsed.
If at the time of lapse, the stock had increased in value, the value of the
stock when it was transferred was treated as compensation, and any increase
in value between the time that the stock was granted and the time
restrictions lapsed was deferred until the employee disposed of the stock, at
which time the increase in value was treated as capital gain rather than
compensation. If at the time of lapse, the stock had decreased in value, then
the lower value at the time the restrictions lapse was considered
compensation.9

                   The Treasury, in statements before the Senate, argued
that ―[t]his combination of deferral and capital gain treatment of
appreciation during the deferral period with respect to property received as
compensation represent[ed] an unwarranted and unintended benefit.‖ 10
Congress viewed restricted stock plans as deferred compensation plans
rather than as a means of allowing certain employees to become
shareholders in the business.11

                     By enacting Section 83, Congress generally sought to
equalize the treatment of restricted stock plans with that of pension or
profit-sharing plans, which taxed employees in full when an employer made
a transfer to a nonqualified plan or trust at the time of the transfer. 12 More
specifically, Congress intended to capture appreciation during the deferral
period as compensation income rather than capital gain and to limit deferral
to situations where a restriction subjected stock to a ―substantial risk of
forfeiture‖ rather than a restriction that merely had a significant effect on its

         8
             Id.
         9
             Id.
         10
            Treasury Statements of Hon. Edwin S. Cohen, Assistant Secretary of the Treasury for Tax
Policy, before the Senate Finance Committee
         11
           H.R. Rep. No. 413 (Part 1), 91 st Cong., 1st Sess. 86-88 (1969); S. Rep. No. 552, 91 st Cong., 1st
Sess. 119-122 (1969); Blue Book at 109-111.
         12
             Id.

                                                  10                                   James W. Chapman
                                                                                     Myron D. Mendelowitz
value.13 ―To add flexibility‖ the Senate added a provision (Section 83(b))
that allows employees receiving restricted property the option to treat the
property as compensation in the year it is received, even though it is
nontransferable and subject to a substantial risk of forfeiture, and to treat
later appreciation in the value of the property as other than compensation. 14
This provision has the effect of encouraging the payment of tax at the time
of transfer.

                   2.        Operation.

                             (a)        Generally.

                            If an employee receives stock in connection with
the performance of services, then the employee‘s tax treatment is determined
under Section 83.15 Stock generally is taxable upon receipt by the employee.
However, Section 83(a) provides the general rule that the recipient of
property must include the property‘s fair market value in gross income when
the property first becomes ―transferable‖ or not subject to a ―substantial risk
of forfeiture‖ (i.e., ―substantially vested‖). At that time, the recipient must
recognize as ordinary income the excess of (1) the fair market value of such
property at the time of vesting, over (2) the amount paid for such property.

                            A ―substantial risk of forfeiture‖ exists when the
employee‘s rights to full enjoyment of the property are conditioned upon the
future performance of substantial services.16 Property is ―transferable‖
when a transferee‘s rights in the property are no longer subject to a
substantial risk of forfeiture.17 Generally, property that is both subject to a
substantial risk of forfeiture and nontransferable is considered ―substantially
nonvested,‖ and property that is either not subject to a substantial risk of
forfeiture or is transferable is considered ―substantially vested.‖ 18 At the

        13
             H.R. Rep. No. 413 (Part 2), 91st Cong., 1st Sess. 61-62 (1969).
        14
             S. Rep. No. 552. 91st Cong., 1st Sess. 119, 123 (1969).
        15
            The term ―employee‖ is used herein for convenience and is intended to include all service
providers, including independent contractors.
        16
             I.R.C. § 83(c)(1); Treas. Reg. § 1.83-3(c)(1).
        17
             I.R.C. § 83(c)(2); Treas. Reg. § 1.83-3(d).
        18
             Treas. Reg. § 1.83-3(b).

                                                     11                          James W. Chapman
                                                                               Myron D. Mendelowitz
time an employee receives restricted stock, the stock is typically both
subject to a substantial risk of forfeiture and nontransferable. Therefore, for
Federal income tax purposes, the restricted stock is substantially nonvested
and the employee will be not be taxed with respect to such stock until either
of the forfeiture or nontransferability restrictions lapse, at which time the
stock will become substantially vested.19

                           Section 83(b) provides an exception to the Section
83(a) general rule that no income is recognized at the time of receipt of
stock that is substantially nonvested. An employee receiving substantially
nonvested stock can make an irrevocable election within 30 days following
the transfer of the stock to the employee. In that situation, the employee
must currently include in gross income and be taxed at ordinary income
rates on the excess of (1) the fair market value of such property at the time
of transfer, over (2) the amount paid for the property. The employee‘s basis
in the property will be equal to the amount paid and the amount included in
gross income at the time of the transfer. All tax on any appreciation in
value between the time of the transfer of the stock and the time of the
stock‘s becoming substantially vested is deferred until the recipient disposes
of the stock. Moreover, that appreciation will generally be taxed as a capital
gain.

                          Section 83(h) generally allows a matching
deduction to the employer for the employer‘s taxable year in which the
recipient recognizes ordinary income with respect to the transferred stock.

                           (b)      Timing and Type of Gain.

                           The application of the general rule of Section
83(a) results in deferral of income until such time as the property becomes
substantially vested, at which time the amount recognized will be treated as
ordinary compensation income (the maximum marginal tax rate of which is
currently 39.6 percent). In contrast, the application of Section 83(b)
requires the inclusion of ordinary compensation income at the time of
transfer and treats all future appreciation from the time of transfer to the
time of disposition of the property as capital gain, generally taxed at a
maximum rate of 20 percent if the property is held for more than one year.

         19
            Restricted stock will generally be referred to as ―substantially nonvested‖ stock throughout this
paper as this term describes the initial classification of restricted stock for Federal income tax purposes.

                                                  12                                   James W. Chapman
                                                                                     Myron D. Mendelowitz
                           The consequences of failing to make a timely
Section 83(b) election can be severe to an employee who paid fair market
value for substantially nonvested stock that appreciates significantly
between grant and vesting. Consider the following example: An employee
receives substantially nonvested stock, the fair market value of which is $1
per share at the time of transfer, and the employee pays $1 at that time. The
employee does not make a Section 83(b) election. The stock increases in
value to $100 per share at the time of vesting several years later. The
employee will recognize as ordinary income the excess of the fair market
value of the stock at the time of vesting ($100), over the amount the
employee paid for the stock ($1), or $99.20

                          If the employee made a timely Section 83(b)
election, the employee would have no current ordinary income upon receipt
of the substantially nonvested stock because the employee paid its full fair
market value, and would have no income or gain upon vesting. Moreover,
tax with respect to the $99 of appreciation which occurred between the
receipt and the vesting of the stock would be deferred until the employee
ultimately disposes of the stock, when the appreciation would generally be
taxed as capital gain subject to a maximum rate of 20 percent if the gain
qualifies as long-term capital gain.

                             (c)      Basis and Holding Period.

                           A recipient‘s basis in property that is substantially
nonvested is the sum of (1) any amount paid for such property, and (2) any
amount with respect to such property that is includible in the gross income
of the person who performed the services.21 The ―amount paid‖ is the value
of any money or property paid for the transfer of the restricted property. 22
The recipient‘s holding period generally begins the first time the recipient‘s
rights in the property are transferable or are not subject to a substantial risk
of forfeiture.23 However, if a Section 83(b) election is made with respect to
such property, the recipient‘s holding period will begin the day after the


      20
           I.R.C. § 83(a).
      21
           Treas. Reg. § 1.83-4(b)(1); Treas. Reg. § 1.83-2(a).
      22
           Treas. Reg. § 1.83-3(g).
      23
           I.R.C. § 83(f); Treas. Reg. § 1.83-4(a).

                                                      13            James W. Chapman
                                                                  Myron D. Mendelowitz
date the property is transferred to the recipient. 24 The effect of Section 83‘s
basis and holding period provisions is to give the recipient a stepped-up fair
market value basis and to institute a fresh holding period in the substantially
nonvested property.

                             (d)         Ownership.

                           Until property becomes substantially vested, the
transferor is generally treated as the owner of such property, and any income
from such property received by the recipient or any right to use such
property by the recipient constitutes additional ordinary compensation
income.25 However, a timely Section 83(b) election generally causes the
transferee rather than the transferor to be regarded as the owner of the
restricted property for Federal income tax purposes so that dividends
received with respect to stock as to which an election has been made retain
their character as dividends.26

                             (e)         Subsequent Disposition of Property.
                          Section 83(g) provides that if property to which
the general rule of Section 83 applies is exchanged for property with
substantially similar restrictions and conditions in a transaction to which
certain tax-free reorganization provisions apply, then the exchange shall be
disregarded for Section 83 purposes and the property received is considered
substituted for the property disposed of.27 This provision was intended to
prevent the exchanging employees from becoming taxable due to the receipt
of substantially nonvested stock of an acquiring corporation for the
employee‘s substantially nonvested stock of the target corporation in what
would otherwise be a tax-free exchange.28

         24
              Treas. Reg. § 1.83-4(a).
         25
              Treas. Reg. § 1.83-1(a)(1).
         26
            Rev. Rul. 83-22, 1983-1 C.B. 17; Rev. Proc. 83-38, 1983-1 C.B. 773. For guidance regarding
the treatment of the ownership of restricted stock as to which a Section 83(b) election has been made for
purposes of the application of other tax rules, see Treas. Reg. § 1.1361-1(b)(3) (regarding the S corporation
one class of stock rules), PLR 9712029 (regarding corporate affiliation rules), and C.C.A. 199944001 (Nov.
5, 1999) (regarding reverse acquisition rules).
         27
              I.R.C. § 83(g); Treas. Reg. §1.83-1(b)(3).
         28
          S. Rep. No. 552, 91st Cong., 1st Sess. 119, 123 (1969); H.R. Rep. No. 782, 91 st Cong., 1st Sess.
303-04 (1969).

                                                     14                                James W. Chapman
                                                                                     Myron D. Mendelowitz
                            (f)     Broad Application.

                         Section 83(e) provides limitations on Section 83‘s
reach, including that Section 83 does not apply to certain stock options,
transfers to certain employees‘ trust or annuity plans, or group-term life
insurance. Another limitation on Section 83‘s reach is the statutory
requirement that it apply only to transfers of property ―in connection with
the performance of services.‖29 However, this requirement has been broadly
interpreted so that Section 83 has been held to reach a wide range of
property transfers, even when the recipient pays full fair market value for
the property.30

         B.         Tax-Free Reorganization Provisions.

                    1.      Purpose.

                    In contrast to Section 83, which focuses on the employee
status of recipients of stock and was intended to limit tax deferral, the tax-
free reorganization provisions address the shareholder status of recipients of
stock and are intended to implement tax deferral. The basic theory of the
reorganization provisions is

                            to except from the general rule [of current gain
                            recognition] certain specifically described
                            exchanges incident to such readjustments of
                            corporate structures . . . as are required by business
                            exigencies and which effect only a readjustment of
                            continuing interest in property under modified
                            corporate forms.31

Because the new enterprise created by the reorganization is substantially a
continuation of the old corporation and no gain or loss is recognized, the
reorganization provisions provide for a continuity of the tax attributes of


         29
          I.R.C. § 83(a). See Part III.C of this paper for a further discussion of the ―in connection with the
performance of services‖ requirement.
         30
          Alves v. Commissioner, 79 T.C. 864, 877-78 (1982), aff’d, 734 F.2d 478 (9th Cir. 1984); PLR
7829007 (April 14, 1978); John L. Utz, 384-2nd T.M., Restricted Property – Section 83, § II.A.
         31
              Treas. Reg. § 1.368-1(b). See Boris I. Bittker & James S. Eustice, FEDERAL INCOME TAXATION
OF CORPORATIONS AND SHAREHOLDERS ¶12.01[3],          12-12 (7th ed. 2000).

                                                   15                                   James W. Chapman
                                                                                      Myron D. Mendelowitz
parties to the reorganization that preserves gain or loss to be later
recognized upon the ultimate liquidation of the shareholder‘s interest.

                 2.           Operation.

                         (a)        Timing and Type of Gain.

                          Section 354 generally protects exchanging
shareholders from the gain or loss that would otherwise be required to be
recognized in a taxable exchange.32 It provides that no gain or loss shall be
recognized if stock or securities in a corporation that is a party to a
reorganization is exchanged solely for stock or securities in such
corporation or another corporation that is a party to the reorganization. 33
Instead, the gain realized to exchanging shareholders will be preserved for
later recognition as capital gain through carry-over basis, holding period,
and other tax attribute provisions.       Section 361 similarly protects
corporations that are a party to a reorganization from recognizing gain or
loss.34

                              (b)   Basis and Holding Period.
                        An exchanging shareholder‘s investment in the
property exchanged in the reorganization is preserved because the property
received in a reorganization without the recognition of gain or loss is
―exchanged basis property‖, which generally takes the basis of the property
exchanged.35 Complementarily, the property received by a corporation in
connection with a reorganization is ―transferred basis property‖, which is
deemed to have the same basis to the corporation as that of the exchanging
shareholder.36

                         An exchanging shareholder‘s holding period in
property received in a reorganization generally includes the holding period
of the property exchanged because the basis of the property received is

      32
           I.R.C. § 1001(c).
      33
           I.R.C. § 354(a)(1).
      34
           I.R.C. § 361(a).
      35
           I.R.C. § 358(a)(1). See I.R.C. § 7701(a)(44)(defining ―exchanged basis property‖).
      36
           I.R.C. § 362(b). See I.R.C. § 7701(a)(43)(defining ―transferred basis property‖).

                                                  16                                  James W. Chapman
                                                                                    Myron D. Mendelowitz
determined with reference to basis of the property exchanged.37 Along
similar lines, the corporation‘s holding period in property received in a
reorganization generally includes the holding period of the transferor since
the corporation‘s basis in the property received is determined with reference
to the transferor‘s basis.38

                                (c)      Ownership.
                          The continuity of interest requirement for tax-free
reorganizations looks to the ownership of stock by the transferring
shareholders. The purpose of this requirement is ―to prevent transactions
that resemble sales from qualifying for nonrecognition of gain or loss
available to corporate reorganizations.‖39       A tax-free reorganization
―presuppose[s] a continuance of interest on the part of the transferor in the
properties transferred.‖40 This interest must be ―proprietary‖, something
more definite and material than short-term purchase money notes, bonds, or
cash.41 Further, it must constitute a ―substantial part‖ of the value of the
property transferred.42     Generally, the continuing interest of target
shareholders in the acquiring corporation is substantial if the stock
consideration received by target shareholders equals 40-50 percent of the
value of target stock exchanged.43

                      Historically, the transferor corporation was
required to receive stock in the transferee corporation without a
           37
                I.R.C. § 1223(1).
           38
                I.R.C. § 1223(2).
           39
                Treas. Reg. § 1.368-1(e)(1)(i).
           40
                Cortland Specialty Co. v. Commissioner, 60 F.2d 937, 940, cert. denied, 288 U.S. 599 (1933).
           41
             Pinellas Ice & Cold Storage Co. v. Commissioner, 287 U.S. 462, 470 (1933); Helvering v.
Minnesota Tea Co., 296 U.S. 378, 385 (1935); LeTulle v. Scofield, 308 U.S. 415, 420-21 (1940); Treas.
Reg. § 1.368-1(e)(1)(i). While common stock or nonvoting preferred stock constitutes proprietary interests,
it is unclear whether contingent stock or escrowed stock should be similarly treated.
           42
          Minnesota Tea, 296 U.S. at 385; Southwest Natural Gas Co. v. Commissioner, 189 F. 2d 332,
      th
334 (5 Cir.), cert. denied, 342 U.S. 860 (1951); Treas. Reg. § 1.368-1(e)(1)(i).
           43
            Rev. Proc. 77-37, § 3.02, 1977-2 C.B. 568 (providing a safe harbor for continuity of interest for
letter ruling purposes of 50 percent); John A. Nelson Co. v. Helvering, 296 U.S. 374, 376-77 (1935)
(finding 38 percent continuity of interest sufficient); See generally Martin D. Ginsburg & Jack S. Levin, 1
MERGERS, ACQUISITIONS, AND BUYOUTS: A TRANSACTIONAL ANALYSIS OF THE GOVERNING TAX, LEGAL,
AND ACCOUNTING CONSIDERATIONS ¶ 610.2 (Nov. 2000).


                                                      17                                 James W. Chapman
                                                                                       Myron D. Mendelowitz
preconceived plan or arrangement for disposing of any of the stock 44 and
with at least five years of unrestricted rights of ownership. 45 However,
recent regulations disregard dispositions of acquiring corporation stock
received in a potential reorganization to persons not related to the acquiring
corporation.46

III.   ISSUES FOR RESOLUTION.

       A.         Introduction.

             There are four principal issues related to substantially
nonvested stock in the context of mergers, acquisitions, and financing
transactions for which guidance is requested:

                  1.        Imposition of Restrictions as “Transfer.”

                    If an employee of a corporation owns substantially
vested stock of the corporation, will the imposition of forfeiture restrictions
on the employee's stock, as a condition to the corporation's receipt of
financing from a third party, so that the stock is substantially nonvested
thereafter, constitute a ―transfer‖ of property to the employee within the
meaning of Section 83?




       44
            Rev. Proc. 86-42, 1986-2 C.B. 722.
       45
            Rev. Rul. 66-23, 1966-1 C.B. 67, obsoleted by 1998-14 I.R.B. 4, Treas. Dec. Int. Rev. 8760.
       46
            Treas. Reg. § 1.368-1(e)(1)(i) and -1(e)(6), Ex. 1.
                                                    18                                James W. Chapman
                                                                                    Myron D. Mendelowitz
                    2.       Reorganization Exchange as “In Connection With the
                             Performance of Services.”
                   If an employee of a corporation owns substantially
vested stock of the corporation, will the exchange of that stock for
substantially nonvested stock of an acquiring corporation in a transaction
that qualifies as a reorganization within the meaning of Section 368(a)
constitute a transfer of property "in connection with the performance of
services" within the meaning of Section 83?

                    3.       Effect of Section 83 if Applicable.

                    If Section 83 is found to apply to either of the above
situations, what are the effects of its application?

                    4.       Continuity of Interest.
                   Is substantially nonvested stock considered "stock" for
purposes of the continuity of interest requirement of tax-free
reorganizations?47

         B.         Imposition of Restrictions.

                    1.       Requirement of a Transfer of Property.

                   In order for Section 83 to apply, there must be a "transfer
of property", which occurs "when a person acquires a beneficial ownership
interest in such property . . ."48 While the Treasury Regulations provide
guidance with respect to situations where a recipient lacks the benefits and
burdens of ownership of property such that no transfer of property is found
         47
            For other recent articles/papers addressing the treatment of restricted stock for Federal income
tax purposes, see Danni Dunn & Donald F. Brosnan, The New Deal Landscape and Employee Equity
Compensation (article/materials for Tax Management Advisory Board Jan. 18, 2001 meeting); Robert H.
Scarborough, NYSBA Suggests Reforming the Taxation of Property Exchanged for Services, TAX NOTES
(Dec. 7, 2000); Jack S. Levin, Donald E. Rocap & Martin D. Ginsburg, Surprising Tax Issues for
Shareholder-Execs Receiving Unvested Stock for Vested Stock in Reorg, TAX NOTES (Dec. 4, 2000); Bill
Morrow, e-M&A: Recurring Merger, Acquisition and Restructuring Tax Issues for e-Commerce
Companies: Acquisitions of Technology Companies: Service-Based Vesting and Acquisitions of Pass-
Through Entities (unpublished article, Dec. 2000); Lee A. Sheppard, The Tax Treatment of Dot-Com Brats,
TAX NOTES (Nov. 20, 2000); Dennis B Drapkin, Stuart J. Offer & Roger M. Ritt, Tax-Free Reorganizations
and Restricted Stock (article/materials for ABA Taxation Section Fall Meeting, Oct. 14, 2000); Steven K.
Mathias, It’s Dot.Stock, But is it ”Stock”?, 8 M&A TAX REP. 1 (March 2000).
         48
              Treas. Reg. § 1.83-3(a)(1).

                                                  19                                  James W. Chapman
                                                                                    Myron D. Mendelowitz
to have occurred,49 there is no clear authority regarding the treatment of the
imposition of a substantial risk of forfeiture on property which is already
owned by a taxpayer.

                    2.       Application to Financing Transaction.

                    A common scenario encountered by early stage
corporations is the imposition, as a condition to the receipt of financing, of
employment-based forfeiture restrictions, which constitute a ―substantial
risk of forfeiture‖ within the meaning of Section 83, on the substantially
vested stock of the corporation‘s management team. It is currently unclear
whether the imposition of a substantial risk of forfeiture on a shareholder's
pre-existing and substantially vested stock is a scenario to which Section 83
applies.

                     Since the shareholders in this scenario were the pre-
existing owners of the stock, they did not receive any property in the
transaction. Rather, it appears that they have merely been subjected to a
liability in the form of a substantial risk of forfeiture. Therefore, Section 83
would apparently not apply. A similar analysis and conclusion was
presented and adopted on at least one occasion by the Internal Revenue
Service (the ―IRS‖) in an informational letter in response to a taxpayer's
inquiry.50 However, as there is no official guidance regarding the proper
treatment of this situation, there is some concern whether this situation
might be treated otherwise on examination.

                    It is possible that the IRS could find the requisite
Section 83 property transfer by treating the transaction as a constructive
exchange involving the shareholder‘s constructive transfer to the
corporation of the shareholder‘s previously acquired substantially vested
stock in exchange for the corporation‘s constructive transfer to the
shareholder of identical stock that is substantially nonvested. 51 The IRS has
adopted a constructive exchange treatment for transfers of property from a
         49
              Treas. Reg. § 1.83-3(a)(2) through -3(a)(7).
         50
          Letter dated June 12, 2000 from Robert B. Misner, Assistant Chief, Branch 1, Office of the
Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities) to James K. Dreyfus and
Mark A. Holdsworth of Fulbright & Jaworski L.L.P., New York.
         51
           Query whether the shareholder‘s agreeing to the imposition of restrictions to facilitate the receipt
of financing by the corporation or a merger involving the corporation has other constructive exchange
implications based upon Rev. Rul. 73-233, 1973-1 C.B. 179.

                                                     20                                 James W. Chapman
                                                                                      Myron D. Mendelowitz
shareholder of a corporation to an employee of such corporation or to an
independent contractor in consideration of services performed for the
corporation in Treasury Regulation Section 1.83-6(d). The regulation
recasts the transaction as a contribution of the shareholder‘s property to the
capital of the corporation, followed by a transfer of the property to the
employee or independent contractor.

                    If a transfer of property were found to have occurred due
to the imposition of restrictions on previously substantially vested stock, it
would be necessary to determine whether the transfer was "in connection
with the performance of services" before Section 83 would apply. 52 Whether
property is transferred "in connection with the performance of services" is
dependent on all the facts and circumstances. 53 Despite the broad scope of
the "in connection with . . . services" requirement, its application in this
situation remains uncertain.

                   If the imposition of a substantial risk of forfeiture on
previously acquired and unrestricted stock were found to be a transfer of
property in connection with the performance of services, then Section 83
would apply, and, absent a timely Section 83(b) election, the shareholders
upon whom the substantial risk of forfeiture was imposed would recognize
compensation income upon the vesting of the stock in accordance with the
general rules of Section 83(a). Alternatively, each shareholder could
presumably file a Section 83(b) election within 30 days of the imposition of
the substantial risk of forfeiture, in which case the shareholder would
presumably not recognize any income at the time of the election due to the
equivalence of value (determined without regard to any lapse restriction)
between the previously acquired unrestricted stock (which in the
constructive exchange analysis would be deemed to have been used as
payment for the substantially nonvested stock) and the same stock after the
imposition of a substantial risk of forfeiture. The shareholder would
presumably not recognize any income or loss under Section 1001 upon such
a constructive exchange by virtue of either Section 1036 or, if the
constructive exchange were characterized as a recapitalization pursuant to
Section 368(a)(1)(e), under Section 354(a).

        52
          I.R.C. § 83(a). See Part III.3 of this paper for a discussion of the ―in connection with the
performance of services‖ requirement.
        53
         E.g., Centel Communications Co., Inc. v. Commissioner, 92 T.C. 612, 628 (1989), aff’d, 920
F.2d 1335 (7th Cir. 1990); Alves v. Commissioner, 734 F.2d 478, 481 (9 th Cir. 1984); Bagley v.
Commissioner, 85 T.C. 663, 669 (1985), aff’d, 806 F.2d 169 (8th Cir. 1986).
                                                21                              James W. Chapman
                                                                            Myron D. Mendelowitz
      C.          In Connection With the Performance of Services.
                  1.         Meaning of “In Connection With the Performance of
                             Services.”

                             (a)    Code and Regulations.

                          Section 83 applies to transfers of property ―in
connection with the performance of services.‖54 The regulations provide
that property is considered to be transferred in connection with the
performance of services when ―property [is] transferred to an employee or
an independent contractor (or beneficiary thereof) in recognition of the
performance of, or the refraining from performance of, services.‖55 The
regulations further specify that such Section 83 transfers may be with
respect to past, present, or future services.56 While this guidance supports
an expansive interpretation of the scope of the ―in connection with‖
language, other regulatory language recognizes that the IRS considered that
at least some stock issuances to employees would extend beyond the reach
of Section 83:

      The existence of other persons entitled to buy stock on the
      same terms and conditions as an employee, whether pursuant to
      a public or private offering may, however, indicate that in such
      circumstances a transfer to the employee is not in recognition
      of the performance of, or the refraining from performance of,
      services.57




      54
           I.R.C. § 83(a).
      55
           Treas. Reg. § 1.83-3(f), sentence 1.
      56
           Treas. Reg. § 1.83-3(f), sentence 3.
      57
           Treas. Reg. § 1.83-3(f), sentence 2.

                                                  22             James W. Chapman
                                                               Myron D. Mendelowitz
                            (b)      Judicial Guidance.
                                     (1)       Four-Factor Test.
                                  Case law has further defined when a transfer
of property is ―in connection with the performance of services.‖ Whether
property is so transferred is a question of fact. 58 The broad ―in connection
with‖ language indicates that Section 83 is not limited to compensatory
transfers.59 Instead, the language requires merely ―some sort of relationship
. . .[or] nexus‖ between the services performed and the property
transferred.60 A four-factor test has developed for purposes of determining
the existence of this relationship. This test considers the following factors:

        (1) Whether the property right is granted at the time the
           employee or independent contractor becomes employed or
           otherwise associated with the employer;

        (2) Whether the property restrictions are linked explicitly to the
           employee‘s or independent contractor‘s tenure with the
           employing company;

        (3) Whether the consideration furnished by the employee or
           independent contractor in exchange for the transferred
           property is services; and

        (4) The employer‘s intent in transferring the property.61

When a transfer of property is governed by the terms of an employment
agreement, courts have generally found that the employee received property
in connection with the performance of services. 62 This is true even where


        58
             E.g., Centel, 92 T.C. at 628; Bagley, 85 T.C. at 669; Alves, 734 F.2d at 481.
        59
           Centel, 92 T.C. at 630; MacNaughton v. United States, 888 F.2d 418, 421 (6 th Cir. 1989); Alves,
734 F.2d at 482.
        60
          Montelepre Systemed, Inc. v. Commissioner, T.C. Memo 1991-46, aff’d, 956 F.2d 496 (5th Cir.
1992). See Aidoo v. Commissioner, T.C. Memo 1993-28.
        61
           Montelepre, T.C. Memo 1991-46; Aidoo, T.C. Memo 1993-28; Chalmette Gen. Hosp., Inc. v.
United States, 71-A A.F.T.R.2d (RIA) 3314 (1990).
        62
           Wachner v. Commissioner, T.C. Memo 1995-88. Alves, 79 T.C. at 873-74; Bagley, 85 T.C. at
669-70. See Centel, 92 T.C. at 631-32 (distinguishing Alves and Bagley on grounds that Centel did not
involve an employment agreement); Aidoo, T.C. Memo 1993-28 (refusing to find a stock transfer to be in
                                               23                                 James W. Chapman
                                                                              Myron D. Mendelowitz
the employee pays fair market value for the property. 63 Moreover, transfers
for purposes of allowing employees/independent contractors to obtain or
increase their ownership or of raising working capital have been held not to
prevent transfers from being considered in connection with the performance
of services.64

                                     (2)       Cases Finding Transfers in Connection
                                               With the Performance of Services.

                                 The seminal case involving whether
property was transferred in connection with the performance of services is
Alves v. Commissioner.65 In that case, Western Digital Corp. sold shares of
common stock, which were subject to an employment-based forfeiture
restriction, to Mr. Alves and several others upon their commencement of
employment in exchange for payment of the shares‘ full fair market value.
The terms of the issuance were contained in an employment and stock
purchase agreement, which provided that the company intended to employ
Mr. Alves, to raise working capital, and to provide Mr. Alves with an
additional equity interest. Mr. Alves failed to make a Section 83(b)
election. Neither the payment of fair market value nor the presence of
investment motives prevented a finding by the court that the transfer had
been made in connection with the performance of services. In that case,
however, except for the shares issued to an investment bank, all shares
issued were to officers, directors, and other employees, or to parties related
to them.66

                            In Bagley v. Commissioner,67 Spencer
Foods, Inc. (―Spencer‖) and Mr. Bagley entered into an employment
contract and an option agreement. Pursuant to these agreements, Mr.


connection with the performance of services without an employment contract or other agreement or any
restrictions tied to tenure).
        63
           Alves, 79 T.C. at 877-78; PLR 7829007 (April 14, 1978).
        64
           Alves, 79 T.C. at 876-77 (citing H. Rept. 91-413 (1969), 1969-C.B. 200; S. Rept. 91-552
(1969), 1969-3 C.B. 423, 500-01); Montelepre, T.C. Memo 1991-46; Wachner, T.C. Memo 1995-88;
Chalmette, 71-A A.F.T.R. 2d (RIA) 3314.
        65
             79 T.C. 864 (1982), aff’d, 734 F.2d 478 (9th Cir. 1984).
        66
          For further discussion of Alves, see Donald J. Mathison, Transfer of Restricted Stock at Fair
Market Value: Alves v. Commissioner, 11 TAX. MGMT. COMP. PLAN. J. 13 (July, 1983).
        67
             85 T.C. 663 (1985), aff’d, 806 F.2d 169 (8th Cir. 1986).
                                                    24                               James W. Chapman
                                                                                   Myron D. Mendelowitz
Bagley agreed to work as a vice president for compensation that included a
qualified stock option and the right to receive an amount in exchange for his
option if Spencer were acquired by another entity. Shortly before Spencer
was acquired by another corporation, Spencer paid Mr. Bagley an amount to
terminate his option. Mr. Bagley claimed that this amount was capital gain
whereas the IRS took the position that it was ordinary income because
Spencer had transferred the amount in connection with Mr. Bagley‘s
performance of services. The company‘s intent to compensate Mr. Bagley
and to better secure his services was discerned from three facets: the
employment agreement, the option agreement, and the fact that Mr.
Bagley‘s sole consideration for the option was his promise to render
services as an employee. Therefore, the court found that there was a
transfer in connection with the performance of services.

                                   (3)      Cases Finding Transfers Not in
                                            Connection With the Performance of
                                            Services.
                                 In contrast to Alves, Bagley, and their
progeny, a few cases have held that property transfers were not made in
connection with the performance of services. In Centel Communications
Co., Inc. v. Commissioner,68 Mr. Davis, Mr. Grey, and Fisk Electric Co.
(collectively, "DGF‖) were the three largest shareholders in a new company
named Fisk Telephone Systems (―Telephone‖). Mr. Davis served as a
director and president of Telephone while Mr. Grey served as chairman of
the board and was also compensated as a consultant. Intending to keep the
fledgling company afloat, voluntarily, and without expectation of
compensation, DGF entered into guarantee, indemnity, and subordination
agreements necessary to obtain and continue Telephone‘s bank loans.
When Telephone later became profitable, the company issued warrants to
DGF in consideration of the increased risks that DGF had assumed
regarding the guarantees and agreements. The court determined that this
issuance was not in connection with the performance of services because
DGF‘s actions were essentially an assumption of additional financial risk in
their roles as shareholders or investors.




      68
           92 T.C. 612 (1989), aff’d, 920 F.2d 1335 (7th Cir. 1990).

                                                  25                     James W. Chapman
                                                                       Myron D. Mendelowitz
                                 In Aidoo v. Commissioner,69 Mr. Aidoo and
two partners incorporated Red River Center Corporation (―Red River‖) for
the purpose of developing a nursing home. Red River sold Mr. Aidoo
shares of no-par common stock for the amount of paid-in capital required
under its articles of incorporation. Over the following three years, Mr.
Aidoo devoted his full time to the development of the nursing home,
including obtaining a certificate of need from Louisiana authorities, a
contract for construction of the nursing home, a loan commitment, and an
option on land. Mr. Aidoo also incurred various expenses in the course of
these activities. The court concluded that the transfer of stock to Mr. Aidoo
was not in connection with the performance of services due to the absence
of evidence of an employment contract or other agreement with respect to
the stock, any stock restrictions tied to Mr. Aidoo‘s tenure, the specification
of services to be rendered in consideration for the stock, and the intent of
Red River in issuing the stock.
                2.      Application Where Shareholders/Employees Receive
                        Restricted Stock for Unrestricted Stock in a
                        Reorganization.

                        (a)     Assumed Facts.

                          Assume that in Year 1, Shareholder/Employee
contributed property to Target in a tax-free exchange in return for 10 shares
of unrestricted stock in Target. Other shareholder/employees own 40 shares
of unrestricted stock. An unrelated venture capital firm and other unrelated
non-employee shareholders each own 25 unrestricted shares.
                          In Year 5, Acquirer wishes to acquire Target in a
stock for stock acquisition that qualifies as a tax-free reorganization. The
fair market values of one share of Target stock and one share of Acquirer
stock are equal. Because workforce-in-place constitutes Target‘s most
valuable asset, Acquirer insists that Target shareholder/employees accept
restricted Acquirer shares for their Target unrestricted shares to ensure that
the Target shareholder/employees will continue to work for Acquirer.

                         The terms of the restrictions, contained in each
shareholder/employee‘s employment contract and restricted stock
agreement, provide that forfeiture of the stock will result upon termination
or departure from Acquirer within 5 years and that the stock is
      69
           T.C. Memo 1993-28.
                                        26                     James W. Chapman
                                                             Myron D. Mendelowitz
nontransferable in the interim. The shareholder/employees support the
acquisition because they believe that the combination will be synergistic
and because Target has been encountering difficulty in raising capital.
Other non-employee shareholders receive unrestricted shares in the same
proportion, based on their stock ownership of Target, as do the
shareholder/employees.

                          (b)      Four-factor Test.

                         For Section 83 to apply in the instant case, the
Acquirer restricted stock must have been transferred to
shareholder/employees in connection with the performance of services.
This determination requires the application of the Section 83 four-factor
test.

                          The first factor weighs against an ―in connection
with‖ finding because Shareholder/Employee is employed with the Target
enterprise prior to the reorganization and continues to be employed in the
same position with the surviving enterprise following the merger. Alves and
Bagley maintain that the existence of the employment and restricted stock
agreements generally supports an ―in connection with‖ finding. 70 However,
the instant case can be distinguished from Alves and Bagley. Neither Mr.
Alves nor Mr. Bagley was an employee prior to the issuance of restricted
stock or options. Rather, the issuance of the restricted property occurred
upon the commencement of their employment.                     In contrast,
Shareholder/Employee was already an employee of the merging enterprise
and merely continues in the same capacity for the merged enterprise.

                           The second factor weighs in favor of an ―in
connection with‖ finding because the restrictions on Acquirer stock
received by Shareholder/Employee are linked to his employment. The
restrictions, contained in Shareholder/Employee‘s employment contract and
restricted stock agreement, provide that Shareholder/Employee will forfeit
the stock upon termination or departure from Acquirer within 5 years and


        70
          Alves, 79 T.C. at 873-74, aff’d, 734 F. 2d at 481-83; Bagley, 85 T.C. at 669-70. See Centel, 92
T.C. at 631-32 (distinguishing Alves and Bagley on grounds that Centel did not involve an employment
agreement); Aidoo, T.C. Memo 1993-28 (refusing to find a stock transfer to be in connection with the
performance of services without an employment contract or other agreement or any restrictions tied to
tenure).

                                                 27                                 James W. Chapman
                                                                                  Myron D. Mendelowitz
that Shareholder/Employee may not transfer the stock free of the restriction
in the interim.

                           The third factor weighs against an ―in connection
with‖ finding because Shareholder/Employee paid full fair market value in
the form of Target stock in exchange for Acquirer stock. 71
Shareholder/Employee also received the same pro-rata consideration as non-
employee shareholders. Therefore, the consideration provided in exchange
for the transferred property is not services. Additionally, the facts indicate
that Shareholder/Employee, like Mr. Davis, Mr. Grey, and Fisk Electric Co.
in Centel, and Mr. Aidoo in Aidoo, made the exchange for restricted stock in
his capacity as a shareholder preserving his investment, rather than in his
capacity as an employee: Shareholder/Employee‘s acceptance of the stock
restrictions helped to facilitate a positive business combination, and, like the
Centel shareholders, to raise capital.

                           While some cases, including Alves, Wachner v.
Commissioner, Montelepre Systemed, Inc. v. Commissioner, and Chalmette
Gen. Hosp., Inc. v. Commissioner, maintain that investor motives do not
preclude an ―in connection with‖ finding, those cases can be
distinguished.72 None of the taxpayers in those cases were shareholders
until the issuance of restricted stock or options. 73 In contrast, and like the
taxpayers in Centel, Shareholder/Employee was already a shareholder prior
to the restricted stock issuance.74 Shareholder/Employee exchanged Target
stock for Acquirer stock in the reorganization and Shareholder/Employee‘s
interest continues in substance following the exchange. Thus, the exchange
is arguably a quintessential shareholder/investor action rather than that of an
employee. Because the stock transfer (albeit substantially nonvested stock)
was received in Shareholder/Employee‘s status as a shareholder/investor, it
does not appear to be in connection with the performance of services.

                       The fourth factor is unclear with respect to an ―in
connection with‖ finding because Acquirer has multiple intentions in

        71
             Alves, 79 T.C. at 873-74, and 734 F.2d at 481.
        72
           Alves, 79 T.C. at 876-77 (citing H. Rept. 91-413 (1969), 1969-C.B. 200; S. Rept. 91-552
(1969), 1969-3 C.B. 423, 500-01); Montelepre, T.C. Memo 1991-46; Wachner, T.C. Memo 1995-88;
Chalmette, 71-A A.F.T.R. 2d (RIA) 3314.
        73
             Id.
        74
             Centel, 92 T.C. at 615-620 (1989); Aidoo, T.C. Memo 1993-28.
                                                   28                         James W. Chapman
                                                                            Myron D. Mendelowitz
transferring the restricted stock: to acquire Target, and to retain Target
shareholder/employees. Several cases have held that secondary intentions
for the transfer of stock to an employee other than to attract or retain the
employee, such as to raise capital and to provide the employee with an
equity stake in the business, do not prevent an ―in connection with‖
finding.75 However, none of those cases arose in a reorganization context.
Moreover, none of those cases presented situations where the employer‘s
other intentions were the primary motivation for the issuance of restricted
property. In the instant case, a full fair market value exchange of Target
stock for substantially nonvested Acquirer stock occurred pursuant to a plan
of reorganization. In addition, Acquirer‘s primary intention in transferring
stock to Shareholder/Employee is arguably to obtain the Target stock
necessary to acquire control of Target rather than to retain
Shareholder/Employee.

                           The application of the Section 83 four-factor test
indicates that the transfer of Acquirer restricted stock to
Shareholder/Employee was not made in connection with the performance of
services so that Section 83 should not apply to the transfer. However, some
authority, which provides that neither the payment of fair market value for
substantially nonvested stock so that there is no compensatory element, nor
the presence of other motives for the transfer, precludes a finding that a
transfer is in connection with the performance of services under the four-
factor test, makes this determination uncertain under current law.
Therefore, considerations other than the four-factor test, which provide
further support for a not ―in connection with‖ finding, are examined below.




        75
           Alves, 79 T.C. at 876-77 (citing H. Rept. 91-413 (1969), 1969-C.B. 200; S. Rept. 91-552
(1969), 1969-3 C.B. 423, 500-01); Montelepre, T.C. Memo 1991-46; Wachner, T.C. Memo 1995-88;
Chalmette, 71-A A.F.T.R. 2d (RIA) 3314.
                                               29                               James W. Chapman
                                                                             Myron D. Mendelowitz
                            (c)      Additional Considerations.
                          The first additional consideration supporting a not
―in connection with‖ finding is the anachronistic nature of the Section 83
four-factor test. This four-factor test was developed in the 1980‘s prior to
the so-called ―new economy‖ and the development of the practice of issuing
restricted stock in reorganizations. None of the cases before the courts
during the evolution of the four-factor test involved issuances of restricted
stock in multiple entity reorganizations. Because the four-factor test was
not designed with current business practices in mind, this test should not be
the sole arbiter of Section 83‘s application in the reorganization context.
This conclusion is especially true where Shareholder/Employee pays fair
market value for restricted stock. The unfairness of applying Section 83 in
this situation was even recognized in the Alves case.76

                           A second additional consideration supporting a not
―in connection with‖ finding is Congressional intent that Section 83 would
not apply to sales of restricted stock for fair market value. When Congress
enacted Section 83 in 1969, it was addressing a common business practice
of granting restricted stock to employees at a price that was materially less
than fair market value as deferred compensation.77 Tax on such stock,
consisting of the difference between fair market value on the grant date and
the amount paid for the stock, was deferred until the expiration of
restrictions.

                           To discourage this deferral, Congress imposed tax
at ordinary rates on any appreciation of the stock between grant and the
expiration of restrictions.78 Congress also encouraged the current payment
of tax by allowing taxpayers a choice to pay tax currently and avoid tax at

         76
              The Alves court observed:

          [A]lthough some unfairness and inequity may result from the operation of section 83,
         Congress could rationally have concluded that such result was justified by the ease and
         certainty of the section‘s operation . . . It is unfortunate that the petitioner in the case did
         not elect the provisions of section 83(b) . . . [H]e may well have been unaware of the
         provisions of section 83(b) at the time of the transfer. 79 T.C. at 878-79.
         77
           H.R. Rep. No. 413 (Part 1), 91 st Cong., 1st Sess. 86-88 (1969); S. Rep. No. 552, 91 st Cong., 1st
Sess. 119-122 (1969); Blue Book at 109-111. See Alves, 79 T.C. 880-87 (dissents of judges Fay and
Whitaker); Robert H. Scarborough, NYSBA Suggests Reforming the Taxation of Property Exchanged for
Services, Tax Notes (Dec. 7, 2000).
         78
          See discussion of the legislative history of Section 83 in Part II.A.1 of this paper and
accompanying notes.
                                              30                                 James W. Chapman
                                                                             Myron D. Mendelowitz
ordinary rates on future appreciation (the Section 83(b) election). Thus, as
long as the employee remits current tax on the difference between the fair
market value and the amount paid at the time of the grant, the evil at which
Section 83 was addressed is remedied. Accordingly, when there is no such
difference due to an employee paying fair market value for stock, Section 83
should not apply.

                          In addition to Section 83‘s purpose and the design
of the Section 83(b) election, Section 83(g) evidences Congressional intent
that Section 83 not apply in value for value exchanges of substantially
nonvested stock. Section 83(g) provides that where restricted property is
exchanged for property subject to similar restrictions in a reorganization, the
exchange will be disregarded for purposes of Section 83 and the property
received will be treated as the property exchanged. Section 83(g) operates
to provide tax-free treatment to the exchange. The legislative history of
Section 83(g) indicates that its purpose was to prevent exchanging
shareholders from becoming taxable in such exchanges.79 However, Section
83(g) does not specifically address exchanges involving substantially vested
stock. Furthermore, the legislative history does not indicate whether
Congress considered the relative values of the properties exchanged or
whether or not such values were equivalent. Nevertheless, the values of
properties exchanged at arms-length are either equal in fact or are presumed
to be equal.80

                          A third additional consideration for a not ―in
connection with‖ finding is Treasury Regulation Section 1.83-3(f). This
regulation may prevent an ―in connection with‖ finding where ―other
persons [are] entitled to buy stock on the same terms and conditions as an
employee whether pursuant to a public or private offering.‖ In the case at
hand, the venture capital firm and several other non-employee shareholders
received Acquirer stock in the acquisition on the same terms and conditions,
i.e., in the same proportion based on ownership of Target stock, as did
Shareholder/Employee. However, Alves declined to permit a negative
inference based upon this regulation because all of the shareholders were
either employees, officers, or directors, or were affiliated with them. 81

         79
          S. Rep. No. 552, 91st Cong., 1st Sess. 119, 123 (1969); H.R. Rep. No. 782, 91 st Cong, 1st Sess.
303-04 (1969).
         80
              See Philadelphia Park Amusement Co. v. United States, 126 F. Supp. 184, 189 (Ct. Cl. 1954).
         81
              79 T.C. at 875.
                                                    31                                 James W. Chapman
                                                                                     Myron D. Mendelowitz
                          In the instant case, neither the venture capital firm
nor the non-employee shareholders are related to Shareholder/Employee. It
might be asserted that the lack of restrictions on the Acquirer stock of non-
employee shareholders provides evidence that they were not offered stock
on the same terms and conditions as Shareholder/Employee. Nonetheless,
Alves involved the issuance of restricted stock to some shareholders and
unrestricted stock to others, and neither the court nor the parties advanced
this assertion.82

                          A fourth consideration for a not ―in connection
with‖ finding is public policy. Applying Section 83 where an employee
receives substantially nonvested Acquirer stock in return for substantially
vested Target stock in a reorganization treats shareholders who happen to be
employees less favorably than other shareholders who also exchanged stock
in the reorganization.         This dichotomy effectively penalizes a
shareholder/employee for being an employee.
                      (d)      Conclusion.
                          The application of the Section 83 four-factor test
indicates that the transfer of Acquirer stock to Shareholder/Employee in
exchange for Target stock was not made in connection with the performance
of services. Moreover, the anachronistic nature of the test, Congressional
intent, and Treasury Regulation Section 1.83-3(f) provide further support
for this conclusion. Therefore, Section 83 should not apply to the transfer
of Acquirer restricted stock to Shareholder/Employee.

                          The resolution of whether a transfer is in
connection with the performance of services so that Section 83 applies may
be crucial to the tax consequences of a potential reorganization. Stock that
is subject to Section 83 is generally treated as received as compensation
rather than as part of reorganization exchange. Thus, such stock may not
count toward reorganization requirements and may not receive tax-free
treatment. In light of these factors, the presence of contrary authority, and
the potentially draconian consequences of an ―in connection with‖ finding
after the time for a Section 83(b) election has run, further guidance on this
issue is merited.
      D.         Integration    of   Section   83   and   the   Reorganization
                 Provisions.

      82
           Id.
                                        32                        James W. Chapman
                                                                Myron D. Mendelowitz
             The transfer of acquiring corporation restricted stock to a target
shareholder who is also an employee in exchange for unrestricted target
stock should not be considered to be in connection with the performance of
services. Accordingly, Section 83 should not apply to such a transfer.
However, because of the uncertainty of the law in this area, the following
analysis considers the tax consequences if Section 83 were to apply.

             Assume that the scenario discussed above is modified as
follows. Shareholder/ Employee acquired the contributed property 2 years
prior to contributing the property to Target. Shareholder/Employee‘s basis
in the contributed property was $5 and the fair market value of Target stock
was $1 per share when Target was formed in Year 1. Since the company‘s
formation, the fair market value of Target stock increased to $10 per share
on the Year 5 date of acquisition by Acquirer, to $20 per share early in Year
10, and to $30 per share late in Year 10.

                 1.        Possible Application of Section 83 Provisions Absent
                           Application of Reorganization Provisions.
                    Shareholder/Employee‘s beginning basis in his 10 shares
of Target stock is the same as his basis in the property contributed, or $5. 83
Shareholder/Employee‘s holding period in the shares includes his 2-year
holding period in the contributed property.84
                           (a)     Exchange of Target Stock for Acquirer Stock.
                          If Shareholder/Employee does not make a Section
83(b) election, then, under Section 83(a), he will not currently recognize
gain with respect to the receipt in Year 5 of the Acquirer restricted stock in
the reorganization. Shareholder/Employee‘s basis in his/her shares of
Acquirer restricted stock is the sum of (1) any amount paid for the restricted
stock ($100 fair market value of Target stock on the date of the acquisition),
and (2) any amount includible in gross income under Section 83(a) ($0), or
$100.85 Shareholder/Employee‘s holding period in the Acquirer restricted




      83
           I.R.C. § 358(a)(1).
      84
           I.R.C. § 1223(1).
      85
           Treas. Reg. § 1.83-4(b)(1).

                                            33                       James W. Chapman
                                                                   Myron D. Mendelowitz
stock will start only when the stock first becomes transferable or is no
longer subject to the restrictions.86

                          If the reorganization provisions of the Code did
not apply to this exchange,87 and instead Section 1001 applied, then the $95
step-up in basis from $5 to $100 would be attributable to gain recognized on
the exchange of Target stock for Acquirer stock. Gain would be recognized
to the extent of the excess of the amount realized ($100 fair market value of
Acquirer stock received by Shareholder/Employee), over the adjusted basis
in the property sold or exchanged (Shareholder/Employee‘s $5 adjusted
basis in Target stock), or $95, in the absence of other income tax Code
sections preventing gain recognition. 88 Therefore, Shareholder/ Employee
could be currently taxed on the $95 built-in gain in his/her Target stock at
the time of its exchange for restricted Acquirer stock. If neither the
reorganization provisions nor Section 1001 applied to this exchange, then
the Shareholder/Employee‘s $95 step-up in basis would be tax-free.
                                (b)    Vesting of Acquirer Stock.
                         Upon the expiration of forfeiture restrictions early
in Year 10, Shareholder/Employee will recognize as ordinary income the
excess of the fair market value of Acquirer restricted stock at that time
($200), over the amount paid for the stock ($100), or $100. 89
Shareholder/Employee‘s basis in Acquirer stock will increase by the $100
amount of income recognized to $200.90 Shareholder/Employee‘s holding
period will be deemed to commence on the expiration of restrictions.91
                                (c)    Disposition of Acquirer Stock.
                         If Shareholder/Employee sells the stock late in
Year 10, he will recognize gain to the extent that the amount realized ($300)

         86
              I.R.C. § 83(f); Treas. Reg. § 1.83-4(a).
         87
            For example, the reorganization provisions would not apply if the transaction failed to qualify as
a reorganization, or if it was determined that stock considered received in connection with the performance
of services can not also be considered received in pursuance of a plan of reorganization.
         88
              I.R.C. § 1001(a)-(c).
         89
              I.R.C. § 83(a).
         90
              Treas. Reg. § 1.83-4(b)(1).
         91
              I.R.C. § 83(f); Treas. Reg. § 1.83-4(a).

                                                         34                             James W. Chapman
                                                                                      Myron D. Mendelowitz
exceeds his adjusted basis ($200), or $100. 92 This gain will be short-term in
character because Shareholder/Employee‘s holding period in the Acquirer
stock is less than or equal to one year.93

                           Due to the application of Section 83 holding
period provisions, Shareholder/Employee might not receive credit for his 2-
year holding period in the contributed property or for his 5-year additional
holding period in Target stock. Therefore, Shareholder/Employee‘s capital
gain on the sale of Acquirer stock could be short-term, generally taxed at
ordinary income rates of up to 39.6 percent, rather than long-term capital
gain, generally taxed at a maximum rate of 20 percent.

                 2.        Possible Application of Reorganization Provisions
                           Without Application of Section 83.
                    It is unclear whether the strict application of the Section
83 provisions prevents the operation of the reorganization provisions that
permit the deferral of gain and carryover of tax attributes in qualifying
reorganizations. These provisions generally apply when property is
transferred to a corporation in a tax-free contribution under Section 351(a)
or upon the occurrence of a tax-free reorganization under Section 368(a).
                           (a)     Exchange of Target Stock for Acquirer Stock.
                        If the reorganization provisions apply, then
Shareholder/Employee would recognize no gain or loss upon the exchange
of Target stock for restricted Acquirer stock.94 Shareholder/Employee‘s
basis and holding period would be preserved upon the contribution of
property to Target and upon the exchange of Target stock for Acquirer
stock.95
                           (b)     Vesting of Acquirer Stock.
                         If the reorganization provisions were to override
the normal operation of Section 83, then Shareholder/Employee would not
be affected by the vesting of Acquirer stock early in Year 10. Instead, any
gain due to appreciation in the stock between the exchange in Year 5 and

      92
           I.R.C. § 1001(a)-(c).
      93
           I.R.C. § 1222(1).
      94
           I.R.C. § 354(a)(1).
      95
           I.R.C. §§ 358(a)(1) & 1223(1).
                                            35                       James W. Chapman
                                                                   Myron D. Mendelowitz
the vesting early in Year 10 would be deferred until Shareholder/Employee
disposes of Acquirer stock late in Year 10.
                             (c)     Disposition of Acquirer Stock.
                         Shareholder/Employee‘s $95 built-in gain,
determined as of the time of the reorganization, would be recognized upon
Shareholder/Employee‘s disposition of Acquirer stock late in Year 10. 96
Moreover, this gain would be long-term capital gain.97

                   3.        Integration of Section 83 and the Reorganization
                             Sections.

                   There is no direct IRS guidance or case law regarding
methods for integrating the application of Section 83 and the reorganization
provisions to achieve both Section 83‘s deferral limitation purpose and the
reorganization provisions‘ deferral preservation purpose. Commentators
have proposed several possible methods, including a ―bifurcated part-
carryover basis approach‖ and a ―proportionate bifurcated holding period
approach.‖98

                   Under the bifurcated part-carryover basis approach,
Shareholder/Employee would initially take a basis in the Acquirer stock
equal to his basis in the Target stock exchanged. Upon vesting of the
Acquirer stock, Shareholder/Employee would divide his newly vested
Acquirer stock into two portions. The first portion would consist of a
number of shares of Acquirer stock equal in value to the value of Target
stock exchanged on the date of the reorganization. The second portion
would be consist of a number of shares of Acquirer stock equal in value to
the Section 83(a) gain (the appreciation in value in the Acquirer stock
between the date of issuance in the reorganization and the vesting of the
stock) recognized upon vesting. The first portion of Acquirer stock would
be treated as received by Shareholder/Employee in the reorganization, and
the second portion would be treated as received in connection with the
performance of services.       Therefore, Shareholder/Employee would

        96
             I.R.C. § 1001(a)-(c).
        97
             I.R.C. § 1222(3).
        98
            Jack S. Levin, Donald E. Rocap & Martin D. Ginsburg, Surprising Tax Issues for Shareholder-
Execs Receiving Unvested Stock for Vested Stock in Reorg, Tax Notes 1289 (Dec. 4, 2000). See Danni
Dunn & Donald F. Brosnan, The New Deal Landscape and Employee Equity Compensation
(article/materials for Tax Management Advisory Board Jan. 18, 2001 meeting).
                                                36                                  James W. Chapman
                                                                                Myron D. Mendelowitz
ultimately take a basis in the first portion equal to his basis in the Target
stock exchanged and a basis in the second portion equal to the Section 83(a)
gain.

                     Under the proportionate bifurcated holding period
approach, the first portion would take a holding period that takes into
account Shareholder/Employee‘s 2-year holding period in contributed
property and additional 5-year holding period in Target stock. The second
portion would begin a new holding period upon the expiration of
restrictions early in Year 10.

                    The application of these or similar integration methods
would prevent current gain recognition by Shareholder/Employee or would
eliminate an unintended tax-free step-up in basis at the time of the exchange
of Target stock for Acquirer stock. Further, these or similar integration
methods would ensure the long-term character of Shareholder/Employee‘s
built-in gain in Target stock.

                              (a)   Exchange of Target Stock for Acquirer Stock.
                          Shareholder/Employee would not recognize gain
at the time of the exchange of Target stock for restricted Acquirer stock. 99
Under       the      bifurcated     part-carryover      basis     approach,
Shareholder/Employee‘s beginning basis in the Acquirer stock would be its
$5 basis in the Target stock exchanged.100 Under a proportionate bifurcated
holding period approach, Shareholder/Employee‘s beginning holding period
in the Acquirer stock would be his/her 7-year holding period in the Target
stock exchanged.101

                              (b)   Vesting of Acquirer Stock.

                          Upon the expiration of restrictions early in Year
10, Shareholder/Employee would recognize as ordinary income the excess
of the fair market value of Acquirer restricted stock at that time ($200), over
the amount paid for the stock ($100), or $100. 102 Shareholder/Employee
      99
           I.R.C. § 354(a)(1).
      100
            I.R.C. § 358(a)(1).
      101
            I.R.C. § 1223(1).
      102
            I.R.C. § 83(a).

                                             37                       James W. Chapman
                                                                    Myron D. Mendelowitz
would be treated as receiving in a reorganization exchange 5 Acquirer
shares equal in value to the $100 fair market value of Acquirer shares on the
date of the reorganization (the first portion). Shareholder/Employee‘s basis
in the first portion would be his $5 basis in the Target stock exchanged and
Shareholder/Employee‘s holding period in the first portion would include
his/her 7-year holding period in Target stock and 5-year holding period in
Acquirer stock.103 Shareholder/Employee would also be treated as receiving
in connection with the performance of services 5 Acquirer shares equal in
value to the $100 Section 83(a) gain, which is equal to the appreciation in
value between the date of the reorganization and the expiration of
restrictions (the second portion). Shareholder/Employee‘s basis in the
second portion would be $100, and Shareholder/Employee‘s holding period
in the second portion would begin anew at the time the restrictions lapse.104

                           (c)      Disposition of Acquirer Stock.
                          Upon the sale of stock late in Year 10,
Shareholder/Employee would recognize long-term capital gain to the extent
of the excess of the amount realized ($150), over his/her adjusted basis ($5),
or $145, with respect to the first portion. 105 This amount would be taxed at
a maximum rate of 20 percent. Shareholder/Employee would also recognize
short-term capital gain to the extent of the excess of the amount realized
($150), over/her his adjusted basis ($100), or $50, with respect to the
second portion.106 This amount could be taxed at ordinary rates of up to
39.6 percent.

                  4.       Conclusion.
                    The application of Section 83 to exchanges of restricted
stock in a reorganization without consideration of the reorganization
provisions results in inconsistent tax consequences. There is no definitive
guidance regarding how to properly integrate the Section 83 provisions with
the reorganization provisions to reconcile this inconsistency. However, a
method that bifurcates a transfer into a compensation component and a tax-
free exchange component seems reasonable. Official guidance is needed to

      103
            I.R.C. §§ 358(a)(1) & 1223(1).
      104
            Treas. Reg. § 1.83-4(b)(1)(modified); I.R.C. § 83(f); Treas. Reg. § 1.83-4(a).
      105
            I.R.C. §§ 1001(a)-(c) & 1222(3).
      106
            I.R.C. §§ 1001(a)-(c) & 1223(1).
                                                  38                                   James W. Chapman
                                                                                     Myron D. Mendelowitz
ensure that current gain will not be recognized upon the exchange of Target
stock for restricted Acquirer stock and that a tax-free step-up in basis will
not occur. This entire concern should be mitigated, however, by the better
view that Section 83 does not apply at all because the transfer of Acquirer
stock to Shareholder/Employee should be considered to have not occurred
in connection with the performance of services.

        E.       Continuity of Interest.

                 1.       Section 83(b) Election Controls.

                   There is an absence of definitive authority regarding the
proper treatment of substantially nonvested stock for continuity of interest
purposes.107 Nonetheless, a number of IRS officials and practitioners have
argued that substantially nonvested stock for which a timely Section 83(b)
election has not been made, should not be treated as outstanding, and thus
should not count toward continuity of interest. Along similar lines, these
officials and practitioners would treat substantially nonvested stock for
which a Section 83(b) election has been made as counting toward continuity
of interest. This view is based upon the effect of the election on the
ownership of substantially nonvested stock for other Federal income tax
purposes.108

                 2.       Substantially Nonvested Stock Should                                  Count
                          Regardless of Section 83(b) Election.
                   Many practitioners, however, embrace a different view,
and would favor treating substantially nonvested stock as stock for
continuity of interest purposes regardless of whether a Section 83(b)
election has been made. In our view, substantially nonvested stock is a
sufficient proprietary interest for continuity of interest purposes for the
following reasons.




        107
            IRS Officials Hope for New Guidance on Role of Section 83, Tax Notes (Feb. 7, 2001). For a
general discussion of continuity of interest, see Part II.B.2.c of this paper and accompanying notes.
        108
          See discussion of the ownership of substantially unvested stock in Part II.A.2.d. of this paper
and accompanying notes.
                                               39                                    James W. Chapman
                                                                                Myron D. Mendelowitz
                              (a)      Similarity to Unrestricted Stock.

                           The first reason is its similarity to unrestricted
stock. Restricted stock that is substantially nonvested, like unrestricted
stock, generally entitles the holder to possession, current voting rights, and
current dividend rights, and may be currently valued. In essence, it provides
shareholders with current control over the affairs of the issuing corporation.
Shareholders in a target corporation who own stock before the potential
reorganization have substantially continued their interest in the acquiring
corporation. This would be especially true where the target shareholders
have no plans to trigger the forfeiture restrictions on the acquirer stock
received in the transaction.109

                           Moreover, the purpose of the continuity of interest
requirement, ―to prevent transactions that resemble sales from qualifying for
nonrecognition of gain or loss available to corporate reorganizations,‖ 110 is
furthered by the receipt of both restricted stock and unrestricted stock. In
either case, the exchanging shareholder retains an ownership interest in the
corporation following the reorganization.          Arguably, the receipt of
substantially nonvested Acquirer stock makes the reorganization exchange
less similar to a sale than the receipt of substantially vested stock because
the holder of substantially nonvested stock may be prohibited by stock
restrictions from selling the stock until vesting. In contrast, the recipient of
substantially vested stock is free to dispose of such stock and discontinue
his interest in the Acquirer corporation at any time.

                              (b)      Relevance to Control.

                          The second reason supporting a conclusion that
substantially nonvested stock should count toward continuity of interest is
that substantially nonvested stock appears relevant for Section 368(c)
control purposes. Section 368(c) generally defines ―control‖ as ownership
of stock possessing at least 80 percent of all classes of stock by vote and by
number. Shareholder/employees holding substantially nonvested stock
usually possess current voting rights. Also, substantially nonvested stock
         109
            Before the final continuity of interest regulations were issued in 1998, the IRS required, for
advance ruling purposes, that both target shareholders owning at least 1 percent of target stock and target
management represent that there was no plan or intention to sell, exchange, or otherwise dispose of acquirer
stock received in the reorganization that would reduce continuity of interest to below 50 percent. Rev.
Proc. 86-42, § 7.08, 1986-2 C.B. 722.
         110
               Treas. Reg. § 1.368-1(e)(1)(i).
                                                  40                                  James W. Chapman
                                                                                    Myron D. Mendelowitz
constitutes outstanding stock for corporate law purposes. Therefore,
substantially nonvested stock should be recognized as outstanding for
continuity of interest purposes.

                            (c)      Treatment of Non-voting Preferred Stock.

                           A third reason supporting a conclusion that
substantially nonvested stock should count toward continuity of interest is
the treatment of non-voting preferred stock. According to a landmark
continuity of interest case, non-voting preferred stock constitutes a definite
and substantial interest although it will not allow the holder to participate in
the management of the acquiring corporation. 111 If non-voting preferred
stock counts toward continuity of interest, then substantially nonvested
common stock, which is a superior form of ownership interest allowing
participation through a voting right, arguably should be so counted.

                            (d)      Final Continuity of Interest Regulations.

                          A fourth reason supporting a conclusion that
substantially nonvested stock should count toward continuity of interest is
provided by the final continuity of interest regulations. Before these
regulations were issued, only stock that was required to be received without
a preconceived plan or arrangement for disposing of any of the stock and
with at least five years of unrestricted rights of ownership counted toward
continuity of interest.112 However, in 1998 Treasury Regulation Section
1.368-1(e) relaxed these requirements by disregarding dispositions of stock
of the acquiring corporation received in a potential reorganization to
persons not related to the acquiring corporation even where the exchanging
shareholders had a preexisting binding commitment to sell their stock.
Shareholders of substantially nonvested stock have more of a continuing
ownership interest in the acquiring corporation than do shareholders with
unrestricted stock subject to a binding commitment to sell. Therefore,
substantially nonvested stock should count toward continuity of interest.




        111
              John A. Nelson Co. v. Helvering, 296 U.S. 374, 377 (1935).
        112
            Rev. Proc. 86-42, § 7.08, 1986-2 C.B. 722; Rev. Rul. 66-23, 1966-1 C.B. 67, obsoleted by,
T.D. 8760, 1998-14 I.R.B. 4.
                                               41                                 James W. Chapman
                                                                               Myron D. Mendelowitz
                             (e)     Similarity to Escrowed Stock.

                         A fifth reason supporting a conclusion that
substantially nonvested stock should toward continuity of interest is its
similarity to escrowed stock. Escrowed stock generally is acquiring
corporation stock placed in escrow as security for breaches of
representations, warrantees, or covenants of the target corporation. If no
claims for such breaches are made by a designated date, then the escrow
agent will release the shares to the former target shareholders; if not, then
the agent will return them to the acquiring corporation. Like persons
holding substantially nonvested stock, persons entitled to escrowed stock
often possess current voting rights and dividend rights. Moreover, the
substantially nonvested stock holder's right to receive stock, like that of
escrowed stock holder, is dependent on a condition related to a valid
business purpose.

                            Escrowed stock is generally treated as stock of the
shareholder recipient for Federal income tax purposes if the shareholder
recipient is entitled to current voting and dividend rights with respect to the
escrowed stock.113 Authority regarding contingent stock provides further
support for this proposition. Contingent stock is stock that target
shareholders will be entitled to receive in the future provided that certain
conditions are met, usually related to the determination of the fair market
value of target or acquiring corporation stock. Because escrowed stock is a
greater proprietary interest than contingent stock due to its current
possession, voting, and dividend rights, authority regarding contingent stock
should be all the more applicable to escrowed stock. Although the issue is
far from clear, contingent stock has been determined (albeit in dicta) in
Carlberg v. United States114 to satisfy the continuity of interest requirement
because it can produce nothing other than stock. Further, contingent stock

         113
               Rev. Rul. 72-256, 1972-1 C.B. 222; Rev. Rul. 70-120, 1970-1 C.B. 124.
         114
             281 F. 2d 507, 518-19 (8th Cir. 1960). In Carlberg, Long-Bell Lumber Corporation (―Long-
Bell‖) merged into International Paper Company (―International‖) in a statutory reorganization under
Section 368(a)(1)(A). Id. at 510-11. Long-Bell shareholders received whole and fractional shares of
International common stock as well as Certificates of Contingent Interest (―contingent stock‖), which
provided for the issuance of a number of Reserved Shares of International common stock depending on the
resolution of several Long-Bell liabilities. Id. The court considered whether this contingent stock was
―stock‖ entitled to tax-free treatment under Section 354(a)(1) or ―other property‖ subject to tax. Id. at 509.
One of the four grounds on which the Court held that the contingent stock constituted stock was that such
stock ―provide[d] ‗continuity of interest‘ in the surviving corporation just as [did] the taxpayer‘s whole
shares and fractional share.‖ Id. at 518-20.

                                                   42                                    James W. Chapman
                                                                                       Myron D. Mendelowitz
does not violate the solely for voting stock requirement of some tax-free
reorganizations.115

                          In addition, Rev. Proc. 84-42116 allows, for
advance ruling purposes, some of the stock that is to be issued in an
exchange for stock or property in a reorganization to be held back or to be
placed in escrow. Substantially nonvested stock arrangements may be
covered by Rev. Proc. 84-42.117 Nonetheless, the revenue procedure
presents several obstacles discouraging reliance upon it. As to escrowed
stock, no shares may be subject to restrictions requiring their return to the
issuing corporation because of a failure to continue employment or similar
restrictions. As to contingent stock, Rev. Proc. 84-42 requires that the stock
issuance will not be triggered by an event the occurrence or nonoccurrence
of which is within the control of shareholders. In addition, Rev. Proc. 84-42
does not apply to stock issued as compensation, royalties or any
consideration not received in the reorganization.

                          Substantially nonvested stock is, by its very
nature, linked to the shareholder/employee‘s continued employment by the
company.       Moreover, the performance of services by a target
shareholder/employee is within his control. It might also be contended that
the shareholder/employee‘s stock is, at least in part, received as
compensation and therefore outside of the reorganization. Even though
shareholder/employees of a target corporation are not likely to receive a
favorable advance ruling, in our view, Carlberg and the rationale of earlier
rulings indicate that substantially nonvested stock should count toward
continuity of interest.

                            (f)      Public Policy Issues.

                         A sixth reason supporting a conclusion that
substantially nonvested stock should count toward continuity of interest is
public policy favoring small businesses and entrepreneurship. High
technology companies have contributed disproportionately to the growth of
the economy in the last decade. These companies are also more likely than
        115
              Rev. Rul. 73-205, 1973-1 C.B. 188; Rev. Rul. 67-90, 1967-1 C.B. 79; Rev. Rul. 66-112, 1966-
1 C.B. 68.
        116
              § 2.01-.02, 1984-1 C.B. 521.
        117
              PLR 200049026 (Sept. 7, 2000)(including a taxpayer representation that the terms of a
restricted stock arrangement will comply with Rev. Proc. 84-42.)
                                                 43                              James W. Chapman
                                                                              Myron D. Mendelowitz
other companies to issue or have issued substantially nonvested stock or
other equity-based compensation. Now that public markets for raising
capital are diminishing, high-tech companies must consider other avenues
for attracting investment, including acquisitions. Potential acquirers are
likely to insist on issuing substantially nonvested stock or similar equity-
based compensation in an effort to retain key employees of target
companies. Not counting substantially nonvested stock toward continuity
of interest in the absence of a Section 83(b) election could substantially
impair the ability of high technology companies to participate in the
reorganizations that would allow them to adjust to recent economic changes.

                 3.       Treatment as Securities.

                    An exchange of debentures of parties to a reorganization
in pursuance of a plan of reorganization is treated as tax-free exchange of
securities separate from a tax-free reorganization.118 Since warrants are
treated as securities having no principal amount for purposes of certain
reorganization non-recognition provisions, their exchange in a
reorganization is similarly treated.119        Substantially nonvested stock
represents more of a proprietary interest in an issuing corporation than do
debentures and warrants due to the current rights to vote and receive
dividends possessed by substantially nonvested stock. Therefore, in the
event that substantially nonvested stock is determined not to count toward
continuity of interest, its transfer in a reorganization should be treated as a
separate tax-free exchange.

                 4.       Conclusion.

                    A number of IRS officials and practitioners have
accepted the position that the presence or absence of a Section 83(b)
election controls whether or not substantially nonvested stock will be
considered for continuity of interest purposes. However, there is no
definitive IRS or judicial guidance on this issue. Our view is that
substantially nonvested stock should count toward continuity of interest
regardless of whether a Section 83(b) election has been made, based upon
(1) the similarity of substantially nonvested stock to unrestricted stock, (2)
the relevance of substantially nonvested stock for Section 368(c) control
purposes, (3) the treatment of non-voting preferred stock for continuity of
      118
            Rev. Rul. 98-10, 1998-1 C.B. 643.
      119
            Treas. Reg. §§ 1.354-1(e), 1.355-1(c) & 1.356-3(b).
                                                 44                 James W. Chapman
                                                                  Myron D. Mendelowitz
interest purposes, (4) the final continuity of interest regulations, (5) the
similarity of substantially nonvested stock to escrowed stock, and (6) public
policy.

                    In the event that substantially nonvested stock for which
no Section 83(b) election was made is not counted for continuity of interest
purposes, such stock should be treated like securities exchanged in
pursuance of a plan of reorganization rather than as boot. If this position
were to prevail, in order for the transaction to qualify as a reorganization in
many cases, employee/shareholders would need to be advised to make
Section 83(b) elections with respect to substantially nonvested stock
received in a reorganization exchange. Moreover, potential acquirers and
non-employee        shareholders       would      often      require     target
employee/shareholders to make Section 83(b) elections as a condition to the
reorganization because not counting substantially nonvested shares could
destroy tax-free treatment for all parties to the reorganization. Such
treatment would therefore result in a significant administrative burden for
all parties to the reorganization. Given these potentially severe
consequences, guidance is requested to clarify the treatment of substantially
nonvested stock for continuity of interest purposes.

IV.   PROPOSALS.

      A.     Imposition of Restrictions.

             1.    Legislative Action – None.

                   The Committee does not recommend any legislative
action with respect to this issue.

             2.    Regulatory Action – Amendment                to   Treasury
                   Regulation Section 1.83-3(a)(1).

                   Treasury Regulation Section 1.83-3(a)(1) currently
provides as follows:

                    (a) Transfer—(1) In general. For purposes of
             section 83 and the regulations thereunder, a transfer of
             property occurs when a person acquires a beneficial
             interest in such property (disregarding any lapse
             restriction, as defined in § 1.83-3(i)).

                                    45                         James W. Chapman
                                                             Myron D. Mendelowitz
The Committee recommends that a second sentence be added to Treasury
Regulation Section 1.83-3(a)(1) providing substantially as follows:

            The mere imposition of a substantial risk of forfeiture or
            a limitation on transferability on substantially vested
            stock owned by a person does not constitute a transfer of
            property if the stock was originally acquired by such
            person in a previous and unrelated transaction.

      B.    In Connection With the Performance of Services.

            1.    Legislative Action.

                  (a)   Amendment to Section 83(e)

                        Section 83(e) currently provides as follows:

                        (e) APPLICABILITY      OF   SECTION.—This section
                        shall not apply to—

                        (1) a transaction to which Section 421
                        applies,

                        (2) a transfer to or from a trust described
                        in section 401(a) or a transfer under an
                        annuity plan which meets the requirements
                        of section 404(a)(2),

                        (3) the transfer of an option without a
                        readily ascertainable fair market value,

                        (4) the transfer of property pursuant to
                        the exercise of an option with a readily
                        ascertainable fair market value at the date of
                        grant, or

                        (5) group-term life insurance to which
                        section 79 applies.

                         The Committee recommends               adding     new
paragraph (6) that would substantially provide as follows:


                                   46                          James W. Chapman
                                                             Myron D. Mendelowitz
                        (6) the transfer by a shareholder of stock in a
                        corporation (the first corporation) in exchange for
                        stock of another corporation (the second
                        corporation) in pursuance of a plan of
                        reorganization described in Section 368(a)
                        provided that

                               (A) both corporations are parties to the
                               reorganization,

                               (B) the stock received is substantially
                               nonvested,

                               (C) the stock received is of equal fair
                               market value (determined without     regard
                               to any restriction other than a restriction
                               which by its terms will never lapse) to the
                               stock exchanged, and

                               (D) the stock received corresponds to the
                               shareholder‘s proportional ownership of
                               stock in the first corporation.

                  (b)   Amendment to Section 83(b).

                        Paragraph 83(b)(2) currently provides as follows:

                               (2) ELECTION.—An election under
                        paragraph (1) with respect to any transfer of
                        property shall be made in such manner as
                        the Secretary prescribes and shall be made
                        not later than 30 days after the date of such
                        transfer. Such election may not be revoked
                        except with the consent of the Secretary.

                         If other Committee recommendations on this issue
are not adopted, the Committee believes that a provision deeming the
Section 83(b) election to be made where substantially nonvested acquiring
corporation stock is exchanged in a reorganization would be appropriate. A
deemed election would eliminate the severe consequences that could accrue
due to the inadvertent failure to make a timely election to the exchanging
shareholder and possibly to other parties to an intended tax-free exchange.
                                  47                        James W. Chapman
                                                          Myron D. Mendelowitz
The Committee recommends that paragraph 83(b)(3) be added to provide
substantially as follows:

                               (3)      DEEMED          ELECTION.—If
                        substantially nonvested stock is received in
                        an exchange that otherwise constitutes a
                        reorganization as defined in section 368(a)
                        for stock of equal fair market value
                        (determined without regard for any
                        restriction other than a restriction which by
                        its terms will not lapse), then the election
                        under paragraph (1) shall be deemed to have
                        been timely made with respect to the receipt
                        of such substantially nonvested stock unless
                        the recipient affirmatively elects, not later
                        than 30 days after the date of such transfer,
                        to not have such election deemed to have
                        been made.

            2.    Regulatory Action.

                  (a)   Amendment to Treasury Regulation Section
                        1.83-3(f).
                          Treasury Regulation Section 1.83-3(f), sentence
two, currently provides as follows:

                        The existence of other persons entitled to
                        buy stock on the same terms and conditions
                        as an employee, whether pursuant to a
                        public or private offering may, however,
                        indicate that in such circumstances a
                        transfer to the employee is not in
                        recognition of the performance of, or the
                        refraining from performance of, services.

                         The Committee recommends that the Treasury
promulgate proposed regulations that redesignate Treasury Regulation
Section 1.83-3(f) as Treasury Regulation Section 1.83-3(f)(1), move
sentence two of pre-existing Treasury Regulation Section 1.83-3(f) to new

                                  48                        James W. Chapman
                                                          Myron D. Mendelowitz
Treasury Regulation Section 1.83-3(f)(2), and then add the following after
sentence two:

                        Property is not transferred in connection
                        with the performance of services where a
                        shareholder transfers substantially vested
                        stock in a corporation (the first corporation)
                        in exchange for stock of another corporation
                        (the second corporation) in pursuance of a
                        plan of reorganization described in section
                        368(a) provided that (1) both corporations
                        are parties to the reorganization, (2) the
                        stock received is substantially nonvested,
                        (3) the stock received is of equal fair market
                        value (disregarding any lapse restriction, as
                        defined in § 1.83-3(i)) to the stock
                        exchanged, and (4) the terms of the
                        exchange correspond to the shareholder‘s
                        proportional ownership of stock in the first
                        corporation.

The Committee further recommends the addition of several examples
applying proposed Treasury Regulation Section 1.83-3(f)(2).

                  (b)   Amendment to Treasury Regulation Section
                        1.83-2(a).
                           Treasury Regulation    Section     1.83-2(a),     in
pertinent part, currently provides as follows:

                        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.

The Committee recommends that the Treasury promulgate new regulations
that add after this sentence the following sentence:

                        The election does not apply where full value
                        is paid for property in an exchange

                                  49                          James W. Chapman
                                                            Myron D. Mendelowitz
                         described in Section 83(e)(6) and § 1.83-
                         3(f)(2).

                  (c)    Amendment to Treasury Regulation Section
                         1.83-2(c)
                         Treasury Regulation Section 1.83-2(c) currently
                         provides as follows:

                                (c) Manner of making election. The
                         election referred to in paragraph (a) of this
                         section is made by filing one copy of a
                         written statement with the internal revenue
                         officer with whom the person who
                         performed the services files his return. In
                         addition, one copy of such statement shall
                         be submitted with his income tax return for
                         the taxable year in which such property was
                         transferred.

If other Committee recommendations on this issue are not adopted, the
Committee believes that a provision deeming the Section 83(b) election to
be made where substantially nonvested acquiring corporation stock is
exchanged in a reorganization would be appropriate. The Committee
recommends that the first two sentences of Treasury Regulation Section
1.83-2(c) be redesignated as paragraph (1) ―Generally.‖, and that paragraph
(2) be added substantially as follows:

                                (2) Deemed election. If substantially
                         nonvested stock is received in an exchange
                         that otherwise constitutes a reorganization
                         as defined in section 368(a) for stock of
                         equal value (disregarding any lapse
                         restriction, as defined in § 1.83-3(i)), then
                         the election under paragraph (1) shall be
                         deemed to have been timely made with
                         respect to the receipt of such substantially
                         nonvested stock unless the recipient
                         affirmatively elects, not later than 30 days
                         after the date of such transfer, to not have
                         such election deemed to have been made.
                                   50                        James W. Chapman
                                                           Myron D. Mendelowitz
      C.    Integration of Section 83 and the Reorganization
            Provisions.

            1.    Legislative Action – None.
                   The Committee does not recommend any legislative
action with respect to this issue.
            2.    Regulatory Action – Amendment              to   Treasury
                  Regulation Section 1.83-4(a)-(b).
                    In the event that the recommended ―in connection with‖
guidance described above is not adopted, the Committee recommends that
the Treasury issue regulations under Treasury Regulation Section 1.83-4(a)
and (b) regarding the integration of Section 83 and the reorganization
provisions where restricted stock is exchanged in a reorganization so that
the purposes of both are achieved.            The Committee recommends
consideration of the bifurcated basis and holding period approaches as
possible solutions.

      D.    Continuity of Interest.

            1.    Legislative Action – Amendment to Section 83(b).
                  Paragraph 83(b)(2) currently provides as follows:

                         (2)   ELECTION.—An        election     under
                  paragraph (1) with respect to any transfer of
                  property shall be made in such manner as the
                  Secretary prescribes and shall be made not later
                  than 30 days after the date of such transfer. Such
                  election may not be revoked except with the
                  consent of the Secretary.

                 In the event that the amendment to Treasury Regulation
Section 1.368-1(e) proposed below is not adopted, the Committee
recommends that paragraph 83(b)(3) be added to provide substantially as
follows:

                        (3) DEEMED ELECTION.—If substantially
                  nonvested stock is received in an exchange that
                  otherwise constitutes a reorganization as defined
                  in section 368(a) for stock of equal fair market
                                  51                        James W. Chapman
                                                          Myron D. Mendelowitz
value (determined without regard for any
restriction other than a restriction which by its
terms will not lapse), then the election under
paragraph (1) shall be deemed to have been timely
made with respect to the receipt of such
substantially nonvested stock unless the recipient
affirmatively elects, not later than 30 days after the
date of such transfer, to not have such election
deemed to have been made.




                 52                          James W. Chapman
                                           Myron D. Mendelowitz
            2.     Regulatory Action.

                   (a)   Amendment to Treasury Regulation Section
                         1.368-1(e)
                          The continuity of interest regulations, Treasury
Regulation Section 1.368-1(e), do not currently address whether restricted
stock that is substantially nonvested should count toward continuity of
interest. The Committee recommends that the Treasury promulgate
regulations under Treasury Regulation Section 1.368-1(e)(1)(iii) providing
substantially as follows:

                               (iii) Substantially nonvested stock.
                         Stock that is substantially nonvested, as
                         defined in § 1.83-3(b), constitutes a
                         proprietary interest for purposes of § 1.368-
                         1(e) if such stock currently entitles the
                         holder to possession of the stock, voting
                         rights with respect to the stock, and
                         dividend rights with respect to the stock,
                         regardless of whether or not a timely section
                         83(b) election has been made.

                   (b)   Amendment to         Treasury    Regulation
                         Section 1.83-2(c).

                         Treasury Regulation Section 1.83-2(c) currently
provides as follows:

                                (c) Manner of making election. The
                         election referred to in paragraph (a) of this
                         section is made by filing one copy of a
                         written statement with the internal revenue
                         officer with whom the person who
                         performed the services files his return. In
                         addition, one copy of such statement shall
                         be submitted with his income tax return for
                         the taxable year in which such property was
                         transferred.


                                   53                        James W. Chapman
                                                           Myron D. Mendelowitz
In the event that the recommended amendment to Treasury Regulation
Section 1.368-1(e) is not adopted, the Committee recommends that the first
two sentences of Treasury Regulation Section 1.83-2(c) be redesignated as
paragraph (1) ―Generally.‖, and that paragraph (2) be added substantially as
follows:

                                (2) Deemed election. If substantially
                         nonvested stock is received in an exchange
                         that otherwise constitutes a reorganization
                         as defined in section 368(a) for stock of
                         equal value (disregarding any lapse
                         restriction, as defined in § 1.83-3(i)), then
                         the election under paragraph (1) shall be
                         deemed to have been timely made with
                         respect to the receipt of such substantially
                         nonvested stock unless the recipient
                         affirmatively elects otherwise, not later than
                         30 days after the date of such transfer, to not
                         have such election deemed to have been
                         made.




                                   54                          James W. Chapman
                                                             Myron D. Mendelowitz

								
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