On May 29, 2012, the IRS issued proposed regulations (the “Proposed Regulations”) regarding property transferred in connection with the performance of services under Internal Revenue Code Section 83 (“Section 83”). Section 83 controls the timing and amount of income that must be included with respect to property transferred to an employee or other service provider subject to restrictions and forfeiture provisions, such as restricted stock.

General Information

Under Section 83, when property is transferred in connection with the performance of services, the service provider must include, in gross income, (i) the fair market value of the property as of the first time the property is transferable or no longer “subject to a substantial risk of forfeiture,” over (ii) the amount (if any) paid for the property. This amount must be included in gross income in the first year that the property is transferable or is no longer subject to a substantial risk of forfeiture (unless an election is made under Section 83(b) to include the fair market value of the property in gross income at the time of transfer). Whether or not a substantial risk of forfeiture exists depends on the facts and circumstances. Property is considered to be subject to a substantial risk of forfeiture if the recipient’s rights in the property are conditioned on the performance (or refraining from the performance) of substantial additional services (a “service condition”), or upon a condition related to the purpose of the transfer, such as a performance goal.

Clarification of Substantial Risk of Forfeiture Definition

The Proposed Regulations clarify the following three issues related to the determination of whether property has been transferred subject to a substantial risk of forfeiture:

1. A substantial risk of forfeiture may only be established through a service condition or a condition related to the purpose of the transfer;
2. In determining whether a condition related to the purpose of the transfer creates a substantial risk of forfeiture, the likelihood both that the condition will occur and that the forfeiture will be enforced must be considered; and
3. A substantial risk of forfeiture is not created by transfer restrictions on securities, such as lock-up agreements or insider trading restrictions under Rule 10b-5 of the Securities Exchange Act of 1934 (the “Exchange Act”), except with respect to the period during which a sale of the securities for a profit could subject the seller to a suit under Section 16(b) of the Exchange Act.

The preamble to the Proposed Regulations provides that there is confusion under the current regulations as to whether conditions other than service conditions and conditions related to the purpose of the transfer can establish a substantial risk of forfeiture. The Proposed Regulations provide that other types of conditions cannot establish a substantial risk of forfeiture. Thus, for example, a provision that allows an employer to repurchase restricted stock in the event that an employee attempts to transfer the stock, will not constitute a substantial risk of forfeiture.

The Proposed Regulations also provide that, in determining whether a substantial risk of forfeiture exists based on a condition related to the purpose of the transfer, the likelihood both that the condition will occur and that the forfeiture will be enforced must be considered. The Proposed Regulations provide the example of a restricted stock grant to an employee that will be forfeited if gross receipts of the employer fall by 90% over the following three years, where the employer is a longstanding seller of its product and there is no indication of a fall in demand or inability of the employer to sell the product. Even though the forfeiture restriction is a condition related to the purpose of the transfer (the employee would be at least loosely incentivized not to allow gross revenues to drop), the IRS will not consider this to create a substantial risk of forfeiture because the condition is unlikely to occur. Outside of this example, however, the Proposed Regulations do not provide guidance regarding how employers and employees are to determine whether a forfeiture condition is likely to occur.

The revision to provide that a substantial risk of forfeiture is not created by transfer restrictions on securities is being made to explicitly set forth in the regulations the holdings of a previous IRS ruling (Revenue Ruling 2005-48). However, the Proposed Regulations do not change the rule under the current regulations that, if a sale of securities at a profit could subject the seller to a suit under Section 16(b) of the Exchange Act, this will constitute a substantial risk of forfeiture until the earlier of (i) the end of six months after the purchase of the securities by the seller, or (ii) the date a sale of the securities at a profit would no longer subject the seller to a potential suit under Section 16(b).

Effective Date

The Proposed Regulations are effective for property transferred on or after January 1, 2013, although taxpayers may begin relying on the Proposed Regulations for property transferred after May 30, 2012. A copy of the proposed regulations can be obtained by clicking here.

For more information, please contact your SGR Executive Compensation and Employee Benefits Counsel.