United States

Substantial risk of forfeiture further clarified under new regulations

TAX ALERT  | 

An employee who receives property as compensation for services provided may be entitled to defer income recognition on the value of the property received (less any amount the employee paid for the property) if two conditions are met, per section 83(a)(1). The two conditions required for income deferral are: (1) the property must be subject to a substantial risk of forfeiture, and (2) the property must have transfer restrictions. Newly revised Reg. section 1.83-3(c)(1) clarifies the definition of substantial risk of forfeiture.

The regulations do not reflect a change in the IRS’ understanding and application of the law, nor do they narrow the requirements to establish a substantial risk of forfeiture. Rather, the new regulations are intended to simply clarify the existing law’s application. 

The language within the prior regulations generated confusion as to what conditions establish a substantial risk of forfeiture. Generally, property is subject to substantial risk of forfeiture if rights to the property depend on future performance (or refraining from performance) or the occurrence of a condition related to the purpose of the transfer. However, taxpayers were found to be conditioning property outside the intended scope of the regulations to take advantage of the deferral rules. 

The revised regulations aim to resolve this confusion by clarifying that a substantial risk of forfeiture may be established only through a service condition or a condition related to the purpose of the transfer, except as specifically provided in section 83(c)(3) and Reg. sections 1.83-3(j) and (k). Taxpayers must consider, based upon all facts and circumstances, whether the condition is “related to the purpose of the transfer” and the likelihood that the forfeiture event will occur and be enforced. Therefore, transfer restrictions alone generally will not be sufficient to establish that a substantial risk of forfeiture exists.

To determine if forfeiture risk exists, the new regulations look to the likelihood of the condition. For example, if an employee receives noncash property based on a performance benchmark (i.e., sales, profit margin, etc.) that will undoubtedly be met, the IRS likely will argue no forfeiture risk exists. The IRS will also scrutinize if the company has a history of not enforcing or intent to not enforce the condition. Unless facts and circumstances support that the conditions establish genuine forfeiture risk, the property will be taxable immediately as compensation.

Section 83(c)(3) and Reg. sections 1.83-3(j) and (k) provide that certain transfer restrictions, indicate the presence of sufficient forfeiture risk. These restrictions require no further conditions for deferral as long as the sale of property at a profit could subject a person to suit under section 16(b) of the Securities Exchange Act of 1934 (SEC) and such person’s rights in such property are subject to a substantial risk of forfeiture and not transferable. Not all SEC restrictions quality for the exception, as the regulations specifically excludes insider trading restrictions and Rule 10b-5.

Though issued Feb. 26, 2014, the new section 83 regulations apply to transfers occurring on or after Jan. 1, 2013. Businesses should carefully draft future restricted property agreements to insure the agreements meet the standards provided in the new regulations. Failure to comply with the regulations may negate income deferral, therefore generating negative tax consequences such as underreported income for the recipient or lost deductions for the company. 

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