As complex as the Internal Revenue Code is, many people still assume that the rules contain a great deal of specificity and precision, perhaps because of the mathematical nature of calculating taxes. They often are surprised to learn that the Code leaves a lot of room for discretion and subjectivity. A great example of this subjectivity is Code Section 83’s regulations governing the taxation of restricted stock (and other property). The underlying stock subject to these grants generally does not become taxable to the employee until the stock no longer is subject to a “substantial risk of forfeiture.” As you might guess, whether a risk is “substantial” can be quite a subjective determination.

In that backdrop, the IRS and Treasury recently issued final regulations that clarify the definition of substantial risk of forfeiture for purposes of Code Section 83. The final regulations will have the most direct impact on employers who have granted awards of restricted stock or other restricted property on or after January 1, 2013. That is because the regulations stress the need for these agreements to contain a service or performance-based vesting condition that is not substantially certain to be satisfied. The retroactive effective date of may seem strange at first. It is the same effective date that the IRS provided in proposed regulations from May 2012. The good news is that the final regulations generally offer “clarifications” of the former regulations rather than new guidance. Still, it is important that affected employers review their restricted stock arrangements and determine whether they should take additional action. 

As background, Code Section 83 generally describes the tax consequences when an employer transfers property (e.g., common stock of the employer) to the employee as compensation for the employee’s services. First, is explains that the amount of taxable income that the employee must recognize is equal to the excess of:

  1. the fair market value of the property over
  2. the amount (if any) paid for such property.

Second, Code Section 83 explains when the employee must recognize this income. Gross income inclusion occurs in the first taxable year in which the property becomes either:

  1. transferable or
  2. not subject to a substantial risk of forfeiture.

In other words, the property must be both non-transferrable and subject to a substantial risk of forfeiture in order for taxation to be deferred. Once the property either becomes transferrable or is no longer subject to a risk of forfeiture, the service provider must recognize taxable income. The IRS and Treasury felt that some key issues regarding nontransferability and nonforfeitability had become confusing, and offered the following “clarifications” in the final regulations:

  1. When Property is Subject to a Substantial Risk of Forfeiture. The regulations clarify that property is subject to a substantial risk of forfeiture “only” when it is subject to a service-based condition or a performance-based condition. Practitioners have long held this view, but apparently, the IRS and Treasury wanted to correct a First Circuit decision that is nearly 30 years old. The preamble to the regulations made a reference to Robinson v. Commissioner, 805 F.2d 38 (1st Cir. 1986), which explained that the regulations did not define the only conditions that create a substantial risk of forfeiture. In that decision, the First Circuit held that a condition designed to prevent insider trading also imposed a substantial risk of forfeiture, despite not being a service-based or performance-based condition. Although it seems odd that the IRS and Treasury would want to issue this “clarification” nearly 30 years later, most restricted stock agreements are prepared and administered in a manner consistent with the IRS and Treasury’s view. As a practical matter, this clarification should not cause any problems for employers or employees.
  2. Likelihood of the Occurrence and Enforcement of a Forfeiture Condition. The regulations clarify that, in determining whether a substantial risk of forfeiture exists, both the likelihood that the forfeiture event will occur and the likelihood that the forfeiture will be enforced must be considered. The clarification is consistent with the thoughts of most practitioners, but the preamble indicates that the facts and circumstances must show that the forfeiture condition is not likely to occur during the agreed upon service period. This clarification raises some concerns because it is not clear how heavily employers will need to scrutinize the probability that a performance-based vesting condition will be satisfied, and whether they will need to document their conclusions. It also is not clear how much deference the IRS will give to such determinations.
  3. Transfer Restrictions Generally Are Not Forfeiture Conditions. The regulations clarify that transfer restrictions, in and of themselves, typically do not create a substantial risk of forfeiture. Remember, in order to defer taxation, property (e.g., stock) must be both nontransferable and subject to a substantial risk of forfeiture. If property is not transferrable but becomes fully vested, it is taxable. This clarification means that transfer restrictions such as a lock-up agreement (e.g., an agreement not to dispose of shares within a period of time, such as within one year after an IPO), clawback provision, or insider trading compliance plan under Rule 10b-5 of the Securities Exchange Act do not create a substantial risk of forfeiture. Although such conditions may require the employee to forfeit or disgorge some or all of the property, or impose some other penalty, if the restriction is violated, they must be accompanied with a service or performance-based vesting condition in order to defer taxation.

This provision is important because clawback provisions in particular are becoming increasingly common parts of incentive compensation arrangements. The Securities and Exchange Commission also will issue rules under Section 954 of the Dodd-Frank Act with respect to clawback provisions. With this “clarification,” the IRS and Treasury are indicating that such clawbacks will not create a substantial risk of forfeiture, despite the fact that they create a risk that the grantee could have to return amounts received under.

Thus, besides the clawback provision, the employer will need to include an additional provision that constitutes a substantial risk of forfeiture. Which takes us back to the point that a facts and circumstances test introduces (so much) discretion and subjectivity. The regulations, prior to expansion, set forth (frustratingly few) examples of provisions that would constitute such a risk. For example, a provision that requires an employee who receives property to return it if total earnings of the employer do not increase, would constitute a substantial risk of forfeiture.

Effective Date and Next Steps

The restricted stock regulations apply to property transferred on and after January 1, 2013. The good news is that arrangements should have been prepared in a manner consistent with the new regulations. In other words, they should require the employee to perform services for a specified period or achieve an individual or business financial goal in other to vest in the stock. They also typically have a separate transfer restriction. Nevertheless, the regulations remind employers not to take these conditions too lightly. To the extent employers were relying on clawback or recoupment policies to serve as the arrangement’s risk of forfeiture, or if the vesting conditions were weak or easy to satisfy, employers may want to reexamine their grant practices. Affected employers should review these arrangements and consult with counsel to determine whether they need to correct any issues or issue new agreements to their employees.

Publicly held companies should note that the regulations also affect stock option grants that are subject to certain insider trading rules, as will be discussed in a future blog.

Tax-exempt and governmental employers that have entered into certain employment, severance, or deferred compensation arrangements that have not yet vested as of January 1, 2013, may want to review these arrangements in light of these final regulations, as will likewise be discussed in a future blog.