US Personal Tax Services: Good Leaver, Bad Leaver Shares

When an American manager leaves a private UK company and the articles force a transfer of the shares, two returns must report one event. A good leaver sold at market value usually shows a capital gain in both countries; a bad leaver sold at cost shows little or nothing in sterling yet can still produce a dollar gain or loss.

Specialist US personal tax services earn their place at exactly this point, because the leaver price written into the articles is read through two different statutes: Part 7 of ITEPA 2003, the UK employment income statute, for HMRC, and section 83 of the Internal Revenue Code for the IRS. At Jungle Tax we prepare both returns for departing executives, and the pattern we see is consistent: the UK side is handled by payroll and a self assessment entry, while the US side is either omitted or copied across from the UK figures in sterling logic. This guide deals only with the departure event itself. How the shares were acquired is covered in our separate guides to sweet equity and growth and hurdle shares.

What are good leaver and bad leaver provisions?

Leaver provisions are clauses in a private company's articles of association, or in a shareholders' agreement, that require a manager who stops working for the group to offer their shares for transfer. The buyer may be the company itself, the other shareholders or a purchaser nominated under the articles. The price depends on why the manager left:

• Good leaver - typically departure through ill health, redundancy or with board consent. The price is normally market value, sometimes described as fair value and fixed by an independent valuer.
• Bad leaver - typically dismissal for cause or voluntary resignation within a set period. The price is normally the lower of the amount originally paid and market value.
• Intermediate leaver - many articles vest the shares over time, so that a proportion is priced as good leaver and the balance as bad leaver.

Commercial articles on this subject concentrate on drafting and enforceability. Almost none explain the tax reporting, and we have found none that address the position of a US citizen or green card holder, who must report the same compulsory transfer to the IRS under rules that share no vocabulary with the UK ones.

How does HMRC treat a compulsory share transfer on leaving?

Leaver provisions make the shares restricted securities

Shares acquired by reason of employment are employment-related securities. Under section 423 of ITEPA 2003 they are also restricted securities if a provision reduces their market value and, among other things, requires a transfer or forfeiture for less than full market value on a specified event. A bad-leaver price at the lower of cost and market value is the textbook example, and HMRC sets out the definition in its Employment Related Securities Manual at ERSM30310. There is a narrow statutory exception: shares are not restricted merely because they must be sold back following misconduct. Where the bad-leaver definition also catches ordinary resignation, as it usually does, the exception does not help.

The classification matters on departure because a disposal of restricted securities while the restriction still applies is a chargeable event under Chapter 2 of Part 7. Where the manager and employer signed a section 431 election within 14 days of acquisition, the restrictions were ignored at the outset and no Chapter 2 charge arises on the leaver sale. Where no election was made and less than unrestricted market value was paid, a proportion of the sale proceeds is taxed as employment income instead of as a capital gain.

Is there an income tax loss on a bad-leaver sale at below market value?

No. A manager who gives up shares worth far more than cost receives no income tax relief for the value surrendered. Income tax already paid on acquisition is not refunded, and the difference between market value and the bad-leaver price is not a deductible employment loss. The only computation left is the capital gains one, and where the price equals the sterling amount originally paid that computation normally shows neither gain nor loss. If the price is below cost, a capital loss may arise, subject to the usual rules on transactions between connected persons.

What if the good-leaver price exceeds market value?

Chapter 3D of Part 7 taxes as employment income any amount by which the consideration for employment-related securities exceeds their market value. HMRC's overview is at ERSM80010. This is a live issue on good-leaver transfers because the "fair value" defined in articles is frequently a pro rata share of the whole company's value with no discount for a minority holding, whereas market value for tax purposes is the price a hypothetical purchaser would pay for that actual small holding. Where the contractual price is higher than the tax market value, the excess is employment income and only the balance enters the capital gains computation.

Capital gains tax on the remainder

Whatever is not taxed as employment income is a disposal for capital gains tax. The base cost is the sterling amount paid for the shares plus any amount that has been charged to income tax on them, whether at acquisition or on the leaver sale. Amounts taxed as income are excluded from the capital proceeds so that the same pounds are not taxed twice. The gain is reported on the capital gains pages of the self assessment return for the tax year ending 5 April in which the transfer takes place, and that return is due by the following 31 January.

One further point is easily missed. If the company itself buys the shares back, as opposed to another shareholder purchasing them, the amount paid above the original subscription price is by default a distribution taxed as dividend income. Capital treatment applies only where the statutory conditions for a purchase of own shares by an unquoted trading company are met. The identity of the buyer therefore changes which pages of the UK return are completed, and in turn which US foreign tax credit category the UK tax belongs to.

Loan notes and deferred payment of the price

Leavers are rarely paid in full on the day. Two mechanisms are common:

• Deferred cash consideration. Where the price is fixed but paid in instalments, UK capital gains tax is computed on the whole consideration in the year of disposal, with no discount for delay. Where payment extends beyond 18 months, HMRC may allow the tax to be paid in instalments.
• Loan notes. Where loan notes are issued in exchange for the shares, the UK reorganisation rules may treat the notes as standing in the shoes of the shares, so that the gain is deferred until the notes are redeemed. Whether that applies depends on the terms of the notes and on the commercial-purpose conditions.

When does PAYE apply to a leaver sale?

Any employment income arising under Chapter 2 or Chapter 3D is collected through PAYE, with National Insurance contributions, if the shares are readily convertible assets. Shares in a private company can fall within that definition where arrangements exist for them to be sold, or where the company would not be entitled to a corporation tax deduction for them, which is frequently the case for shares in a company under the control of another unlisted company. If PAYE applies and the manager does not reimburse the employer within 90 days of the end of the tax year, a further income tax charge can arise on the unreimbursed amount. Where the shares are not readily convertible assets, the manager reports the income on the employment pages of the self assessment return. Either way the employer includes the event on its annual employment-related securities return, due by 6 July after the tax year.

Is any of the price really a termination payment?

The termination payment rules, including the 30,000 pound threshold, are relevant only where part of what is described as share price is in substance compensation for loss of office. A settlement agreement that lifts a bad leaver to good-leaver pricing in return for a waiver of employment claims is the usual case. The return should follow the substance: the element that pays for the shares is proceeds, and the element that compensates for the departure is employment-related.

How does the IRS treat the same forced sale under section 83?

Substantial risk of forfeiture or non-lapse restriction?

Section 83 asks whether shares received in connection with services are "substantially vested". They are not vested while subject to a substantial risk of forfeiture, which exists where full enjoyment depends on future services. A clause requiring a manager who resigns within a stated period to sell back at the lower of cost and market value is generally a substantial risk of forfeiture until that period ends. Two refinements in the regulations matter for leavers:

• A requirement to sell back at full fair market value is not a risk of forfeiture at all, so a pure good-leaver clause does not delay vesting.
• A requirement to forfeit only on dismissal for cause or for committing a crime is not treated as substantial, which mirrors the UK misconduct exception.

A different category applies where the articles oblige every holder, permanently, to sell at a formula price such as book value or a multiple of earnings. That is a non-lapse restriction, and under Treasury Regulation 1.83-5 the formula price is ordinarily treated as the fair market value of the share. Restrictions that will lapse are ignored when the shares are valued.

If a section 83(b) election was made

An 83(b) election, filed within 30 days of acquisition, treats the shares as vested from the first day. The manager has owned a capital asset throughout, the holding period began at acquisition, and the dollar basis is the amount paid plus any amount included in income under the election.

• Good leaver. The sale at market value is a capital transaction. The gain is long-term if the shares were held for more than one year and is reported on Form 8949 and Schedule D.
• Bad leaver. A forfeiture of shares that were still unvested is treated as a sale. The loss is limited to the amount actually paid for the shares, less whatever is received on the transfer. Income that was reported under the election is not recoverable and does not increase the loss. Where the shares are sold back at exactly what was paid, the result in the currency of the transaction is nil.

If no section 83(b) election was made

Without an election, and where the leaver provision was a substantial risk of forfeiture, the manager has not yet been treated as the owner of unvested shares for US tax purposes. Two consequences follow. First, on a good-leaver departure the excess of the value received over the amount paid is compensation, taxed at ordinary rates and reported as wages on Form 1040, even though a UK employer issues no Form W-2. It is not capital gain. Second, on a bad-leaver forfeiture the difference between the amount paid and the amount received is ordinary gain or loss. Dividends received while the shares were unvested should also have been reported as compensation and not as dividends, which is a common finding when we review earlier years. IRS Publication 525 summarises the restricted property rules.

Where the shares had already vested before departure, because the bad-leaver period had expired, compensation was reportable in the year of vesting, and the leaver sale is then a capital transaction measured from the value at that date.

Compensation or capital gain on a good-leaver price?

The US analysis reaches a similar place to Chapter 3D by a different route. A payment for vested shares at fair market value is sale proceeds. To the extent the price exceeds fair market value, the excess is generally compensation for services. The two countries do not, however, share a definition of value, so the amount HMRC treats as employment income need not equal the amount the IRS treats as compensation.

Dollar basis, Form 8949 and the currency effect

Every US figure is computed in dollars. The amount paid is translated at the spot rate on the acquisition date and the proceeds at the spot rate on the date of sale. Consequently a bad-leaver sale at sterling cost, which is a nil event for HMRC, shows a dollar gain if sterling has strengthened and a dollar loss if it has weakened. The sale goes on Form 8949 in the category for transactions not reported on Form 1099-B, since no US broker is involved. A net capital loss can offset other capital gains and up to 3,000 dollars of ordinary income per year, with the remainder carried forward. Capital gain may also be subject to the 3.8 per cent net investment income tax, against which foreign tax credits are not allowed.

Deferred consideration needs its own decision on the US return. A sale of private company shares for payments falling in later years is reported under the installment method on Form 6252 unless the taxpayer elects out, and the method is not available for the part of the price that is compensation. Loan notes issued by the buyer are generally treated as consideration received in a taxable sale; the UK deferral described above has no direct US equivalent.

Form 8938 in the final year

Shares in a UK company held directly, not through a custodial account, are a specified foreign financial asset. For a single filer living abroad, Form 8938 is required when total specified foreign assets exceed 200,000 dollars on the last day of the year or 300,000 dollars at any time during it; for joint filers abroad the figures are 400,000 and 600,000 dollars. In the year of departure the shares are reported once more at their maximum value during the year, with the box ticked to show that the asset was disposed of. Loan notes issued by the UK buyer and a right to deferred consideration from a UK counterparty are themselves foreign financial assets and continue on the form in later years. Shares held directly are not reported on the FBAR, but the UK bank account receiving the proceeds is. A manager who held 10 per cent or more may additionally have had a Form 5471 obligation that ends with the transfer, and passive foreign investment company status is unusual for a trading group but should be confirmed for a cash-rich holding company.

US vs UK: where the two returns diverge on a leaver sale

Issue	UK (HMRC)	US (IRS)
Governing rules	ITEPA 2003 Part 7, Chapters 2 and 3D; capital gains legislation	IRC section 83 and its regulations; capital gain rules
Effect of leaver clause	Makes the shares restricted securities	Substantial risk of forfeiture, or a non-lapse restriction if a permanent formula price
Election and deadline	Section 431, joint with the employer, within 14 days; kept on file, not sent to HMRC	Section 83(b), by the individual, within 30 days; filed with the IRS
Good leaver at market value	Capital gain, unless a Chapter 2 charge applies because no election was made	Capital gain if vested or elected; otherwise compensation
Price above market value	Excess is employment income under Chapter 3D	Excess is generally compensation, measured against US fair market value
Bad leaver at cost	No gain, no loss; no income tax relief	Loss limited to amount paid less amount received; dollar gain or loss from exchange rates
Currency	Sterling throughout	Dollars at the spot rate on each date
Holding period	No short-term and long-term distinction	More than one year for long-term rates
Loan notes	Gain may be deferred until redemption	Generally a taxable sale, possibly on the installment method
Company buy-back	Distribution by default; capital only if conditions met	Tested under the US redemption rules, which are different conditions
Tax year and form	6 April to 5 April; self assessment employment and capital gains pages	Calendar year; Form 1040, Form 8949, Schedule D, Form 8938

Each row is a point at which the character, amount or timing of income can differ. Because the foreign tax credit on Form 1116 is computed separately by category of income and by year, UK tax paid on something HMRC calls employment income does not automatically line up with US tax on something the IRS calls capital gain, and tax paid in a UK year that straddles two US years has to be allocated with care. This is return preparation, not planning: the figures are fixed by what happened, and the task is to report them consistently.

Worked examples: a good leaver and a bad leaver

The figures below are hypothetical round numbers chosen for illustration. They are not valuations, and the exchange rates are invented.

Example 1: good leaver at market value

A US citizen resident in London subscribed 100,000 pounds for ordinary shares in a private UK company when the exchange rate was 1.30 dollars to the pound. Full unrestricted market value was paid, a section 431 election was signed and an 83(b) election was filed, so no income arose at acquisition in either country. Three years later the manager is made redundant, is classed as a good leaver, and another shareholder buys the shares for 400,000 pounds when the rate is 1.25.

• UK return: proceeds 400,000 pounds less base cost 100,000 pounds gives a chargeable gain of 300,000 pounds, before the annual exempt amount.
• US return: proceeds of 500,000 dollars less basis of 130,000 dollars gives a long-term capital gain of 370,000 dollars on Form 8949. The sterling gain translated at the sale-date rate would be 375,000 dollars; the 5,000 dollar difference is the currency effect on the original cost.
• Variation: if the articles had fixed the price at 460,000 pounds with no minority discount and the tax market value of the holding was 400,000 pounds, 60,000 pounds would be employment income under Chapter 3D and the UK capital gain would remain 300,000 pounds.
• Variation: if no 83(b) election had been filed and the shares were still unvested for US purposes, the 370,000 dollars would be compensation taxed at ordinary rates, while the UK still reported a capital gain. The same economic profit would then sit in different foreign tax credit categories.

Example 2: bad leaver at the lower of cost and market value

Same facts, except that the manager resigns to join a competitor, is classed as a bad leaver, and must transfer the shares for 100,000 pounds when they are worth 400,000 pounds. The rate on the transfer date is 1.20.

• UK return: proceeds 100,000 pounds less base cost 100,000 pounds gives no gain and no loss. There is no income tax relief for the 300,000 pounds of value given up.
• US return with an 83(b) election: the forfeiture is treated as a sale. The amount paid was 130,000 dollars and the amount received is 120,000 dollars, giving a capital loss of 10,000 dollars on Form 8949.
• US return without an election: the same 10,000 dollar difference is generally an ordinary loss, and any dividends received in earlier years should have been reported as compensation.
• Form 8938: the shares appear for the last time, at their maximum value during the year, marked as disposed of.

Had sterling instead risen to 1.40, the same bad-leaver sale at cost would have produced a 10,000 dollar gain on the US return, with no UK tax against which to claim a credit.

What records does the preparer need for the year of departure?

• The articles and any shareholders' agreement in force at acquisition and at departure, including the leaver definitions and vesting schedule.
• The leaver determination, the transfer notice and the stock transfer form or buy-back agreement, showing who bought the shares.
• The valuation or price determination, and any separate view on tax market value.
• Copies of the section 431 election and the 83(b) election, with proof of filing for the latter.
• The subscription date, amount paid and any income previously reported, in both sterling and dollars.
• Any settlement agreement, payroll records and the final payslips showing PAYE operated on share-related income.
• The terms of any loan notes or deferred consideration, and the dates of each payment.
• Dividend history for the full holding period.

What if earlier years were never reported to the IRS?

A leaver event is often the moment an executive realises that the shares never appeared on a US return: no Form 8938, no dividend reporting, sometimes no US return at all. Where the failure was non-willful, the IRS streamlined filing compliance procedures allow the last three years of returns and six years of FBARs to be filed together with a certification of the facts, and for those who meet the non-residency test under the Foreign Offshore Procedure there is no miscellaneous offshore penalty. Our IRS streamlined filing team prepares these submissions, and where the UK side also needs correcting, our UK tax return service handles the amended self assessment. It is generally better for the prior years to be regularised before, or together with, the return that reports the sale, so that the basis and vesting history relied on in the departure year is already on record.

Why prepare both returns together?

A leaver sale is one event with two characterisations, two currencies and two tax years. When the returns are prepared separately, the usual results are a US return that reports sterling figures converted at a single rate, a foreign tax credit claimed in the wrong category, or a Form 8938 that silently drops the shares without recording the disposal. As US and UK tax accountants working on both returns from one file, we reconcile each line of the UK computation to its US counterpart before either is filed. That discipline is central to the work we do for high-net-worth executives with private company equity.

If you have left, or are about to leave, a UK company in which you hold shares, and you want the departure reported correctly to both HMRC and the IRS, contact our cross-border team to arrange a confidential consultation. We will review the articles, the elections and your prior filings, and prepare the US and UK returns as a single, consistent set.