Earlier this week, the Treasury Department issued proposed regulations clarifying the meaning of the phrase “substantial risk of forfeiture” for purposes of Section 83 of the Internal Revenue Code. The proposed regulations could affect when employees and other service providers include in income the value of restricted stock, stock received upon exercise of options, and other property transferred to them in connection with the performance of services. In particular, the proposed regulations clarify three main points:

  • That service- and performance-based conditions are the only conditions that will create a substantial risk of forfeiture;
  • That performance conditions must be meaningful to create a substantial risk of forfeiture; and
  • That transfer restrictions (even those that carry the possibility of forfeiture) generally will not create a substantial risk of forfeiture.  

Section 83 governs the taxation of property transferred in connection with the performance of services (such as restricted stock or stock acquired upon the exercise of an option). It provides that the person receiving the property is required to include the fair market value of the property (less any amount paid for the property) in gross income on the date that the person’s rights in the property either become transferable or are no longer subject to a substantial risk of forfeiture.  

Service and Performance Conditions Sole Means of Establishing a Substantial Risk of Forfeiture

The existing Section 83 regulations have long provided that “whether a risk of forfeiture is substantial or not depends on the facts and circumstances.” The existing regulations further provide that a substantial risk of forfeiture is present where rights in property are conditioned upon the future performance of substantial services (i.e., a service condition) or on the occurrence of a condition related to a purpose of the transfer of property (i.e., a performance condition). Citing the First Circuit case of Robinson v. Commissioner, the preamble to the proposed regulations notes that there has been some confusion as to whether other conditions may also give rise to a substantial risk of forfeiture. The proposed regulations address this by providing that a substantial risk of forfeiture can exist only in the case of a service condition or performance condition as described above.

Performance Conditions Must Be Meaningful

The proposed regulations also clarify that for a performance condition to create a substantial risk of forfeiture, both the likelihood that the forfeiture event will occur (for instance, by establishing a performance goal that is not substantially certain to occur) and the likelihood that the forfeiture will be enforced (for instance, by requiring an employee to forfeit unvested stock if the relevant performance goals are not met) must be substantial. The regulations’ existing language suggested that only the likelihood that the forfeiture event will be enforced must be substantial. But, given the general “facts and circumstances” requirement under the existing regulations, many practitioners would already have advised that performance conditions must be meaningful, and, in this regard, this change is characterized in the preamble to the proposed regulations as a “clarification” of the existing rule. The change would also bring the Section 83 definition in line with the existing definition under Section 409A, which governs nonqualified deferred compensation plans.  

Most Transfer Restrictions Do Not Create a Substantial Risk of Forfeiture

Finally, the proposed regulations provide that transfer restrictions generally do not create a substantial risk of forfeiture. This is true even if the transfer restrictions carry the possibility of forfeiture, disgorgement of the property, or other penalties if the restriction is violated. Examples of transfer restrictions that do not create a substantial risk of forfeiture (and therefore do not delay income inclusion) include (i) lock-up periods imposed by a managing underwriter in connection with an initial public offering and (ii) Rule 10b-5 insider trading restrictions. These concepts are not entirely new, having been the subject of a revenue ruling published by the IRS in 2005, but are now being officially incorporated into the regulations. The proposed changes, including the addition of new examples, clarify that Section 16(b) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is the only provision of the securities laws that can delay taxation under Section 83. If a person receives stock the sale of which at a profit could subject the person to suit under Section 16(b) of the Exchange Act, the person’s rights in the stock will be considered subject to a substantial risk of forfeiture and nontransferable under Section 83 (and therefore will not be taxable to the person) until such time as the possibility of suit expires under Section 16(b).

The proposed regulations would apply to property transferred on or after January 1, 2013.