On May 29, 2012, the United States Internal Revenue Service (IRS) issued proposed regulations1 under Section 83 of Internal Revenue Code (Section 83) that are intended to clarify the circumstances under which property will (or will not) be treated as subject to a substantial risk of forfeiture (SROF) (i.e., subject to a vesting condition) under Section 83.
By way of background, Section 83 requires an individual who receives property in connection with the performance of services to include the fair market value of the property (less the amount, if any, paid for such property) in his or her gross income during the first year in which it becomes substantially vested (i.e., the first year in which the property is no longer subject to a SROF or in which it is transferable to a third party who is not bound by the SROF). Under the existing Section 83 regulations, a SROF generally exists when a recipient’s rights in the property are subject to either (i) the future performance of substantial services by the recipient (or agreement to abstain from providing future services) or (ii) the occurrence of a condition relating to the purpose of the transfer. Whether a risk of forfeiture is “substantial” generally depends on the relevant facts and circumstances.
The proposed regulations would make the following clarifications as to SROFs:
- Conditions Constituting a Substantial Risk of Forfeiture. The current Section 83 regulations can arguably be read to suggest that a variety of types of conditions may constitute SROFs. The proposed regulations would clarify that only the following two conditions will be respected as SROFs: (i) “service conditions” (e.g., requiring continued employment for a certain period of time) and (ii) conditions related to the “purpose of the transfer” (e.g., requiring the achievement of financial or performance goals).
- Likelihood That a Condition Will Occur and Likelihood of Enforcement of Forfeiture Must Both Be Considered. The proposed regulations would further clarify that, for purposes of determining whether a condition constitutes a SROF, both the likelihood that the condition will occur and the likelihood that the forfeiture condition will be enforced must be taken into account. Under the current regulations, it is less clear that this assessment requires a consideration of the likelihood that the condition will occur.
- A Transfer Restriction Is Not a Substantial Risk of Forfeiture. The proposed regulations would also clarify that, by contrast to transfer limitations necessary to avoid “short-swing” liability under Section 16 of the Exchange Act (which limitations are defined statutorily to constitute SROFs), the imposition of other transfer restrictions on securities does not, by itself, create a SROF. For example, the proposed regulations indicate that property subject to lockup, insider trading or similar restrictions will not be treated as unvested solely because of the existence of such restrictions, even though a violation of such restrictions may result in an actual forfeiture of all or part of the property.
The proposed regulations, if implemented, would apply to transfers of property occurring on or after January 1, 2013 (but should presumably be considered informative for purposes of analyzing SROFs currently). While the proposed regulations remain subject to comment, employers should take particular care in drafting future compensation arrangements to ensure that any substantial risk of forfeiture will meet the heightened standard set forth in the proposed regulations.