Last week, IRS and Treasury released final regulation on Code Section 83 and the definition of a “substantial risk of forfeiture.” IRS took pains to emphasize that it did not intend the new regulations to change the law only to clarify it. Indeed, the new regulations mostly state settled law and common understanding. (Interestingly, these final regulations come on the heels of a Tax Court decision in December 2013, which found that a “discharge for cause” provision in an employment agreement creates a substantial risk of forfeiture under Section 83, despite regulations to the contrary. I’ll blog on this later in the week.)
For those keeping score at home, the new regulations amended Section 1.83-3 by revising paragraph (c)(1) (additions shown below), which generally sets forth the meaning of “substantial risk of forfeiture” and add three illustrative examples Example 6 and Example 7 to Section 1.83-3(c)(4) and Example 4 to paragraph 1.83-3(j)(2). The new regulations apply to property transferred on or after January 1, 2013.
The regulations reemphasize the IRS’ long-held position that a provision or clause that may result in forfeiture of property transferred to an individual must be sufficiently likely to actually result in forfeiture in order to prevent taxation of the property upon transfer (or vesting).
(c) Substantial risk of forfeiture. (1) In general. For purposes of section 83 and these regulations, whether a risk of forfeiture is substantial or not depends upon the facts and circumstances. Except as set forth in paragraphs (j) and (k) of this section, a substantial risk of forfeiture exists only if rights in property that are transferred are conditioned, directly or indirectly, upon the future performance (or refraining from performance) of substantial services by any person, or upon the occurrence of a condition related to a purpose of the transfer and if the possibility of forfeiture is substantial
if such condition is not satisfied.
Property is not transferred subject to a substantial risk of forfeiture if at the time of transfer the facts and circumstances demonstrate that the forfeiture condition is unlikely to be enforced. Further, property is not transferred subject to a substantial risk of forfeiture to the extent that the employer is required to pay the fair market value of a portion of such property to the employee upon the return of such property. The risk that the value of property will decline during a certain period of time does not constitute a substantial risk of forfeiture. A nonlapse restriction, standing by itself, will not result in a substantial risk of forfeiture. A restriction on the transfer of property, whether contractual or by operation of applicable law, will result in a substantial risk of forfeiture only if and to the extent that the restriction is described in paragraph (j) or (k) of this section. For this purpose, transfer restrictions that will not result in a substantial risk of forfeiture include, but are not limited to, restrictions that if violated, whether by transfer or attempted transfer of the property, would result in the forfeiture of some or all of the property, or liability by the employee for any damages, penalties, fees, or other amount.
Examples 6 and Example 7 to Sec. 1.83-3(c)(4) involve a corporation’s grant of a non-qualified stock option to an officer. The options are immediately exercisable, but any stock acquired upon exercise would be subject to a lock-up period under an underwriting agreement. Example 6 concludes that this restriction does not impose a substantial risk of forfeiture on the stock that may be acquired on exercise because the provisions do not condition the officer’s rights in the stock upon future performance of substantial services or on the occurrence of a condition related to the purpose of the transfer of the stock.
In example 6, the corporation also maintains an insider trading compliance program, under which officers may trade stock only during a trading window after the corporation’s quarterly earnings release. If an officer violates the trading program, the corporation has the right to terminate the officer’s employment. Example 7 concludes that neither the insider trading compliance program nor the potential liability to the officer under Rule 10b-5 of the 1934 Act impose a substantial risk of forfeiture on the stock acquired by the officer.
Example 4 in Sec. 1.83-3(j)(2) highlights the significance of the addition of the references to “paragraphs (j) and (k)” to Section (c)(1). The heading of paragraph (j) is “Sales which may give rise to suit under section 16(b) of the Securities Exchange Act of 1934.” This example also involves a corporation’s grant of non-qualified stock options to an officer. In this example, the grant of the option is not one that satisfies the requirements for a transaction that is exempt from section 16(b) of the 1934 Act.Example 4 concludes that, if the officer exercises the option after the six-month section 16(b) liability period expires, the stock will not be deemed subject to s substantial risk of forfeiture. However, if the officer exercises the option before the six-month 16(b) liability period expires the stock acquired would be subject to a substantial risk of forfeiture under Section 83(c)(3) as a result of section 16(b), until the expiration of the 16(b) liability period.
This example 4 goes on to clarify that if the officer were to purchase the corporation’s stock in the public market (by definition, a non-exempt transaction under section 16(b)), which had the effect of extending the 16(b) liability period, that extended period would not further postpone taxation as a substantial risk a forfeiture.
Practitioners have understood this to be the true for as long as I can remember (30-plus years). Nonetheless, at least twice each year a taxpayer/award recipient challenges this understanding in court – and loses. Apparently, the IRS determined that it was time to reassert its position.