IRS Issues Final Regulations under Internal Revenue Code Section 83 Regarding Substantial Risk of Forfeiture Analysis

Companies that compensate their employees with annual or long-term awards of restricted property such as restricted stock grants should take note of the final regulations relating to property transferred in connection with the performance of services under Internal Revenue Code Section 83 issued by the Internal Revenue Service on February 25, 2014 (the “Final Regulations”). These rules impact the timing of taxation of restricted stock grants and other compensatory transfers of property.

The Final Regulations are substantially similar to the proposed regulations issued by the IRS in May 2012, which we discussed in our June 2012 Client Alert, “IRS Issues Proposed Regulations under Internal Revenue Code Section 83 Regarding Substantial Risk of Forfeiture Analysis,” available here, but further clarify the impact of insider trading restrictions under Section 16(b) of the Securities Exchange Act of 1934 and involuntary separations from service on the Section 83 “substantial risk of forfeiture” analysis.

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Generally, Section 83 requires the inclusion in gross income of property transferred in connection with the performance of services when the property is no longer “subject to a substantial risk of forfeiture.” Section 83 regulations provide that whether a risk of forfeiture is “substantial” depends upon the particular facts and circumstances. Under these regulations, a substantial risk of forfeiture may exist where vesting of property is subject to (i) a service condition (e.g., employee must work for a specified period to become vested) or (ii) a condition related to the purpose of the transfer (e.g., a performance-based condition).

The Final Regulations make three important clarifications relevant to “substantial risk of forfeiture” analysis:

  • A substantial risk of forfeiture generally may only be established through a service condition or a condition related to the purpose of the transfer (except as otherwise specifically provided in the Section 83 regulations with regard to a sale or other transfer of securities that could subject the seller to a suit under Section 16(b) of the Securities Exchange Act of 1934).
  • In determining whether a substantial risk of forfeiture exists, both (1) the likelihood that a forfeiture condition will occur and (2) the likelihood that the forfeiture condition will be enforced must be taken into consideration.
  • Transfer restrictions on securities (such as lock-up provisions, buyback provisions, blackout periods and limited trading windows insider trading compliance programs) generally do not create a substantial risk of forfeiture; however, a substantial risk of forfeiture would exist for so long as the sale or other transfer of the property not exempt from Securities Exchange Act Section 16(b) could subject the seller to a suit under Section 16(b).

The Final Regulations make clear that, although Section 16(b) liability may constitute a substantial risk of forfeiture, the purchase of stock subject to Section 16(b) in an open market transaction separate from the exercise of an option cannot create a substantial risk of forfeiture as to the shares acquired upon the exercise of the option. Taxation of compensatory stock options ordinarily occurs upon the exercise of the option, but such taxation could be delayed for so long as the underlying shares remain subject to a substantial risk of forfeiture by virtue of potential Section 16(b) insider trading liability. 

While most companies make exempt stock option grants, if an option was not granted pursuant to an exemption, then the shares underlying the option generally would be subject to Section 16(b) restrictions for six months from the date of grant. This is because the “purchase” of the option shares (which, for Section 16(b) purposes, occurs on the date of grant of the option) could be matched for Section 16(b) purposes with any non-exempt sales occurring within six months of the option grant date. By adding a new example, the Final Regulations highlight than an option holder may not use a non-exempt open market purchase of stock after the date of a non-exempt option grant to defer taxation of option shares subsequently acquired upon the exercise of the option on the grounds that there is Section 16(b) risk from the “match” of the future sale of such option shares against the open market purchase. Instead for purposes of 83(b) and stock options, the relevant Section 16(b) six-month time frame commences on the date of grant of the non-exempt option, and the period during which option shares acquired upon exercise remain subject to a substantial risk of forfeiture by virtue of Section 16(b) risk is limited to this six-month period.

Finally, in response to comments received on the Proposed Rules, the preamble to the Final Regulations restates the principle that the right to receive property or cash in the future is not “property” for purposes of Section 83, and thus cannot be taxable unless and until the property is received. As a result, a right to receive property or cash in the future, such as upon an involuntary termination of employment without cause, does not give rise to a substantial risk of forfeiture under Section 83. The preamble acknowledges that this is the case under Section 83 notwithstanding the fact that a right to receive property in the future (such as a share-settled restricted stock unit) might otherwise be deemed to be subject to a substantial risk of forfeiture for purposes of Section 409A regarding nonqualified deferred compensation.

The Final Regulations do not change the principle that property that is conditioned upon refraining from service, such as a covenant not to compete, can constitute a service condition establishing a substantial risk of forfeiture under Section 83. Under the Section 83 regulations, whether a covenant not to complete constitutes a substantial risk of forfeiture depends upon such factors as the employee’s age, health and skill set, the availability of other obtainable employment opportunities and the likelihood that the restrictive covenant will be enforced.

Topics:  Forfeiture, IRC Section 83(b), IRS, SEC, Securities Exchange Act

Published In: Business Torts Updates, General Business Updates, Labor & Employment Updates, Securities Updates, Tax Updates

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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