The Treasury Department (Treasury) and Internal Revenue Service (IRS) have issued final regulations clarifying the forfeiture provisions under Section 83 of the Internal Revenue Code of 1986, as amended, for transactions occurring after January 1, 2013. The regulations were issued on February 25, 2014. Section 83 provides that property transferred to an employee as compensation (such as the issuance of employer stock or property other than cash) is not taxable until the property is no longer subject to a substantial risk of forfeiture or until the property is freely transferable, whichever is earlier. The regulations are consistent with prior guidance, but offer several clarifications on what constitutes a “substantial risk of forfeiture.” Employers who did not evaluate the impact of the regulations when they were originally proposed in 2012 will need to consider how the final regulations affect existing arrangements.
The Final Regulations confirm that a “substantial risk of forfeiture” may be established only if a recipient’s rights in transferred property are either (1) conditioned on the performance, or refraining from performance (e.g., as a result of a non-compete agreement), of substantial services, or (2) are subject to a condition related to the purpose of the transfer (e.g., recipient must achieve a certain level of performance, such as maintaining specified revenue levels). Additionally, the facts and circumstances at the time of the property transfer must establish the likelihood that a forfeiture event will occur and that the forfeiture condition will be enforced.
The Final Regulations clarify that, subject to certain exceptions, transfer restrictions on securities (such as lock-up arrangements, blackout periods, and insider-trading restrictions) alone do not create a substantial risk of forfeiture because rights in these securities are not subject to future service conditions or conditions related to the purpose of the transfer. This is true even if a violation of the transfer restriction carries the potential for forfeiture or disgorgement of some of the property, or other damages, penalties, or fees.
An exception to this rule arises 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) of the Securities Exchange Act. Under the Final Regulations, unless the taxpayer has made a Section 83(b) election -- i.e., an election to be taxed at the time of the stock issuance -- the stock is subject to a substantial risk of forfeiture and is not taxable until six months after the acquisition date; this period is not tolled if there is a subsequent non-exempt acquisition.
While a non-compete clause never constitutes a substantial risk of forfeiture with respect to deferred compensation subject to Code Section 409A (which does not consider refraining from performance a service condition), the Final Regulations retain the possibility that a non-compete clause may constitute a substantial risk of forfeiture under Section 83 depending on factors such as an employee’s age, health, other employment opportunities, and the likelihood that the restrictive condition will be enforced.
Finally, the preamble to the Final Regulations addresses a comment requesting that an involuntary termination without cause be treated as a substantial risk of forfeiture, similar to the Section 409A rule. The IRS and Treasury concluded that a right to receive property in the future, such as upon an involuntary termination without cause, is not “property” for purposes of Section 83 and does not give rise to a substantial risk of forfeiture under Section 83.