IRS Clarifies "Substantial Risk of Forfeiture"

by King & Spalding

[author: Donna Edwards]

The Internal Revenue Service ("IRS") recently issued final regulations clarifying whether a substantial risk of forfeiture exists in connection with a transfer of property, such as restricted stock, in connection with the performance of services under Section 83.1 The regulations are largely unchanged from the proposed regulations issued in 2012. The final regulations are effective for property transfers occurring on or after January 1, 2013.


Section 83 addresses the income tax consequences of the transfer of property, such as restricted stock, in connection with the performance of services. Substantial risk of forfeiture is important because income is generally deferred if the property transferred is subject to a substantial risk of forfeiture. For example, if an employer transfers restricted stock to an employee that is subject to a substantial risk of forfeiture, the employee will not have income attributable to the restricted stock until the forfeiture conditions lapse (and the stock is transferable).

Clarifications in Final Regulations

The final regulations clarify that except in certain narrow circumstances:

  • A substantial risk of forfeiture may be established only through a service condition (such as a requirement for an employee to work for a specified period to become vested) or a condition related to the purpose of the transfer (such as a performance-based condition, for example, the attainment of a certain share price);
  • In determining whether a substantial risk of forfeiture exists based on a condition related to the purpose of the transfer (such as a performance-based condition), both the likelihood that the forfeiture event will occur and the likelihood that the forfeiture will be enforced must be considered; and
  • Transfer restrictions (for example, a lock-up period following an initial public offering) generally do not create a substantial risk of forfeiture, including transfer restrictions that carry the potential for forfeiture or disgorgement of some or all of the property, or other penalties, if the restriction is violated.

The IRS illustrates through a series of examples that transfer restrictions resulting from lock-up periods, insider trading policies, and potential liability under Rule 10b-5 under the Exchange Act2 do not create a substantial risk of forfeiture.

For example, if restricted stock transferred to an employee vests during a period when the stock is subject to a lock-up period which prohibits the employee from selling the stock, the fact that the employee cannot sell the stock during the lock-up period does not constitute a substantial risk of forfeiture and therefore does not delay the recognition of income for the employee.

On the other hand, under Section 83(c) and the related regulations, a substantial risk of forfeiture would exist for so long as the sale or other transfer of the property could subject the seller to a suit under Section 16(b) of the Exchange Act, which applies to certain purchases and sales of stock during a 6-month period. The final regulations also include a revised example 4 to illustrate that the 6-month period is not tolled if there is a subsequent non-exempt acquisition during the 6-month period.

From the IRS's perspective, these regulations do not constitute a narrowing of the requirements to establish a substantial risk of forfeiture, but are consistent with its historical interpretations of Section 83.


Note that in determining whether a substantial risk of forfeiture exists based on a condition related to the purpose of the transfer (such as a performance-based condition), the parties are required to determine the likelihood that the forfeiture event will occur. However, the regulations do not address how the parties are to make this determination.

In addition, the regulations leave intact the possibility that a forfeiture condition tied to a covenant not to compete may constitute a substantial risk of forfeiture so long as there is a substantial likelihood that the non-competition covenant would be breached and that the forfeiture condition would be enforced. Contrast this with the rule under the Code Section 409A that a covenant not to compete cannot constitute a substantial risk of forfeiture.

Donna Edwards, Atlanta, +1 404 572 2701,

1Section 83 of the Internal Revenue Code of 1986, as amended (the "Code").

2The Securities Exchange Act of 1934.



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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