Property transferred in connection with performance of services.

• Author: Elinsky, Peter I.

The recently proposed amendments to the regulations under Sec. 83(h) would eliminate a special rule that requires an employer to deduct and withhold income tax as a prerequisite for claiming a deduction for property transferred to an employee in connection with the performance of services. Under the existing regulations, employers have been denied a deduction for failure to withhold, even when the employee has reported the income and paid the tax.

Sec. 83(h) provides that, in the case of a transfer of property to which Sec. 83(a) applies, the person for whom services were provided may deduct an amount equal to the amount included in the service provider's gross income. In light of the difficulty a service recipient may have in demonstrating that an amount has actually been included in the service provider's gross income, the general rule under existing Regs. Sec. 1.83-6(a)(1) permits the deduction for the amount "includible" in the service provider's gross income. Thus, the deduction may be allowed to the service recipient even if the service provider does not properly report the includible amount.

However, when the service provider is an employee of the service recipient, Regs. Sec. 1.83-6(a)(2) provides a special rule; a deduction is allowed only if the service recipient (i.e., the employer) deducts and withholds income tax in accordance with Sec. 3402. This rule was designed to ensure that the service recipient's deduction is in fact offset by a corresponding inclusion in the service provider's gross income. The rule is limited to employer-employee situations; in other situations, there is no underlying withholding requirement on which the deduction could be conditioned.

Under Prop. Regs. Sec. 1.83-6(a)(2), the existing general rule and special rule would be replaced by a revised general rule that more closely follows the statutory language of Sec. 83(h). The service recipient would be allowed a deduction for the amount "included" in the service provider's gross income. For this purpose, the amount included means the amount reported on an original or amended return or included in gross income as a result of an IRS audit of the service provider.

Under the proposed amendments, if the service recipient timely complies with applicable Form W-2 or Form 1099 reporting requirements under Sec. 6041 or 6041A (as appropriate) as to the amount includible in income by the service provider, the service provider will be deemed to have included the...