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The Section 83(b) Election and the Fallacy of “Earned Income”

[Editors Note: This post is part of a series by authors in the forthcoming edition of the Berkeley Business Law Journal, which in conjunction with the Berkeley Center for Law, Business and the Economy, sponsors this blog. Professor Melone teaches graduate and undergraduate courses at Lehigh University’s College of Business and Economics. His research interests include federal income taxation and corporate governance. He has written extensively about comparative forms of doing business, executive compensation, partnership taxation, and accounting standards.]

The controversy over the taxation of income derived from “carried interests” and the apparent consensus that the taxation of such income unjustifiably converts erstwhile labor income into favorably taxed capital gains provide stark evidence of the degree to which a consensus has emerged that equity gains during the course of one’s employment are attributable to labor and should be taxed accordingly. Critics of the taxation of “carried interests” have also set their sights on what they believe is the corporate counterpart to such interests – the section 83(b) election. This election allows the recipient of non-vested stock to lock in the compensatory element of the transaction at the time that the stock is granted. Post-grant appreciation is taxed at capital gain rates. I agree that the election should be eliminated, but not because it fails to capture the essence of the transaction, but because it does precisely that. Therefore, the current elective treatment should be made mandatory. 

The current taxation of restricted equity grants is premised on the notion that stock price appreciation is somehow labor income and reinforces a relatively new social norm that has resulted in the abdication of hard decisions in corporate governance in favor of a reflexive belief in equity as a panacea for bringing out management’s better angels.

Various economic, tax, and accounting developments have contributed to the ubiquity of equity-based compensation – at first favoring the use of stock options and, more recently, the use of restricted stock.  Outside the context of start-up or early-stage companies, the advantages of the section 83(b) election are somewhat limited. However, in situations where the election is clearly advantageous, criticism of the election is misplaced because such criticism is based entirely on the belief that post-grant stock appreciation is attributable to labor efforts and, therefore, should be taxed accordingly. The motivations for the use of equity-based compensation are varied and many of the motivations behind such equity issuances have little or nothing to do with employee performance.

Moreover, the motivations for such issuances that do implicate future performance fail, for several reasons, to provide justification for upsetting long-standing tax law principles that do not carve out an erstwhile labor component from gains derived from capital.  Whatever incentive alignment properties are attributable to the stock’s issuance are captured in the value of the stock at the time of issuance. Moreover, stock price is a very poor metric for measuring labor performance as evidenced by the very necessity of vesting restrictions and by the use of hedging techniques. Finally, equity compensation has not ameliorated agency costs. At best, it has substituted one form of agency cost for another and, at worst, has exacerbated the very agency cost problems it was designed to solve. The seemingly endless parade of corporate scandals over the past two decades belies the effectiveness of such compensation in reducing agency costs.

The current elective treatment should be made mandatory. The tax law should reflect the economic reality that stock price gains are attributable to capital. This would be a small step in the long-overdue re-assessment of compensation practices that have resulted in an unprecedented – and unwarranted – transfer of wealth from shareholders to management.

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