Today the IRS released final regulations under Section 83 of the Internal Revenue Code, substantially as proposed last year. The regulations are in effect for transfers of property on or after January 1, 2013.
The regulations make some relatively minor adjustments to the definition of “substantial risk of forfeiture,” which is a key concept under Section 83. As long as property (such as stock) that is transferred to an individual in connection with the performance of services is nontransferable and subject to a substantial risk of forfeiture, it is not taxable to the individual unless the individual files a special election (an 83(b) election) at the time of the transfer.
The regulations clarify that lock-up periods, insider trading policies, and potential liability under Rule 10b-5 under the Securities Exchange Act of 1934 (Exchange Act) do not create a substantial risk of forfeiture for purposes of Section 83. Thus, for example, if an employee exercises a stock option during a period when the employer’s insider trading policy prohibits the employee from selling the shares purchased under the option, the fact that the employee cannot sell the shares until the trading window opens does not constitute a substantial risk of forfeiture and therefore does not delay the taxable event for the employee. The employee must recognize taxable income at the time of exercise, even if he or she can not sell the shares at that time.
This is in contrast to how Section 83 works in the context of potential liability under Section 16(b) of the Exchange Act. Under Section 16(b), a non-exempt purchase and sale (or sale and purchase) of stock by an officer, director or 10% shareholder of a public company during a six-month period may result in the insider being liable to the company for disgorgement of any profit realized in the transaction. The Section 83 regulations provide that if an insider may not sell shares of stock previously acquired in a non-exempt transaction within the past six months due to potential liability under Section 16(b), the stock is subject to a substantial risk of forfeiture and (unless the taxpayer makes an 83(b) election) is not taxable until six months after the acquisition has passed.
Importantly, for Section 83 purposes, the six-month period is measured from the original acquisition date of the stock in question, and isn’t tolled if there is a subsequent non-exempt acquisition during this period. Thus, for example, if an insider receives a fully vested option grant on June 1, 2014 in a non-exempt transaction, and exercises the option on September 1, 2014, the shares acquired upon exercise will remain subject to a substantial risk of forfeiture until (about) December 1, 2014. However, if the insider purchases additional shares on the open market on November 1, 2014, the substantial risk of forfeiture on the option shares still lapses, and the option shares are still taxable, on December 1, 2014, even though the insider may have liability under Section 16(b) if he sells any of the shares within 6 months after the subsequent purchase on November 1.
Although most compensatory stock grants are designed to be exempt from Section 16(b), the special forfeiture rule governing sales which involve potential Section 16(b) liability may create some traps for the unwary in unusual circumstances, and should be observed whenever there has been a non-exempt transfer of stock for services.