IRS Issues Final Regulations on Substantial Risks of Forfeiture under Code Section 83

by Sherman & Howard L.L.C.
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On February 25, 2014, the Treasury Department issued final regulations identifying the circumstances in which a substantial risk of forfeiture would exist under Section 83 of the Internal Revenue Code (the “Code”).

Code Section 83 states that, when property (such as restricted stock) is transferred to an employee (or other service provider) in connection with the employee’s performance of services, the excess of the fair market value of the property over the amount, if any, paid for the property will be included in the employee’s taxable income upon the earlier of (A) when the property is no longer subject to a substantial risk of forfeiture, and (B) when the property becomes transferable.[1]

Whether a substantial risk of forfeiture exists still depends on the facts and circumstances of the situation under the final regulations.  However, the regulations clarify that:

  1. A substantial risk of forfeiture may ONLY be established through a service condition or a performance condition.To create a substantial risk of forfeiture, the property must either be conditioned on future substantial services (or refraining from performing services) or be subject to a condition related to the purpose of the transfer (for example, a performance condition). Other conditions (such as a requirement that employees sell shares back to the company at fair market value) do not create a substantial risk of forfeiture.

    In determining whether a substantial risk of forfeiture exists with respect to a condition related to the purpose of the transfer, both (i) the likelihood that the forfeiture event will occur and (ii) the likelihood that the forfeiture will be enforced must be considered.

  2. Transfer restrictions generally do not create a substantial risk of forfeiture. The regulations clarify that transfer restrictions (such as lock-up agreements, insider-trading compliance programs or Rule 10b-5 insider-trading restrictions) generally do not create a substantial risk of forfeiture even if violating the transfer restrictions carries the potential for forfeiture or disgorgement of some or all of the property, or other damages, penalties or fees. The only exception to this rule as specified in Code Section 83(c)(3) is related to Section 16(b) short-swing liability, described below.

  3. A substantial risk of forfeiture resulting from Section 16(b) short-swing liability only applies for the initial six-month period after an award is granted. The final regulations clarify that a substantial risk of forfeiture exists if the sale of the transferred property within six months of the transfer could subject the employee to suit under section 16(b) of the Securities Exchange Act of 1934. In this situation, the substantial risk of forfeiture will not extend past the six-month period immediately following the grant. Note that, if an equity award includes a vesting period in excess of six months, this means that the potential for Section 16(b) short-swing liability will not impact the substantial risk of forfeiture analysis.

Note that the guidance in the final regulations will carry over to other tax rules such as (1) the timing of the imposition of FICA taxes on deferred compensation under Code Section 3121(v), because Code Section 3121(v) applies the Code Section 83 regulations in determining when amounts are vested, and (2) the determination of how Code Section 280G (the golden parachute rules) applies to payments that vest upon a change in control, because the Code Section 280G regulations define vesting using the Code Section 83 definition.

The final regulations are applicable to property transferred on or after January 1, 2013. Employers will need to review how these final regulations impact the forfeiture provisions in equity compensation arrangements and employment agreements. 


] An employee may make an election under Code Section 83(b) within 30 days of receipt of the grant to include the fair market value of the grant in the employee’s taxable income in the year of the grant.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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