Earlier this year, the IRS issued final regulations making it more difficult for taxpayers to defer taxation on property received for services. These final regulations are intended to clarify when substantial risk of forfeiture exists for property that is transferred for the performance of services under Section 83 of the Internal Revenue Code. However, in application these final regulations simply make it more difficult to defer taxation.
Under Section 83 of the Code, the technical rule provides that if property, such as restricted stock, is transferred to a taxpayer for the performance of services, then the amount of the fair market value of the property that exceeds the amount paid by the taxpayer, if any, is included in that taxpayer's gross income in the first year the taxpayer's rights to that property are either transferable or are not subject to a substantial risk of forfeiture. Because of this rule, restricted stock transferred by a corporation to compensate an employee for the services he provided is not currently taxable if such stock is subject to a substantial risk of forfeiture.
Rights to property are subject to a substantial risk of forfeiture if such rights are conditioned, directly or indirectly, on: (i) the future performance (or the refraining from the performance) of substantial services; or (ii) the occurrence of a condition related to a purpose of the transfer if the possibility of forfeiture is substantial. For example, a corporate transfer of restricted stock to an employee for his services is subject to a substantial risk of forfeiture if the employee is not allowed to sell or transfer the restricted stock until he has worked for the corporation for two additional years. Since the employee's rights to the transferred stock is conditioned on his performance of two additional years of service, such stock is subject to a substantial risk of forfeiture and thus, is not subject to taxation until the end of the two year period when the employee is allowed to sell and/or transfer such stock.
The Code provides a specific carve out of the definition of substantial risk of forfeiture for the sales of transferred property that would cause the taxpayer to be sued under Section 16(b) of the Securities Exchange Act of 1934. Thus, if the sale of transferred property at a profit could subject the taxpayer to lawsuit under Section 16(b) of the Exchange Act, then that taxpayer's rights to the transferred property are treated as subject to a substantial risk of forfeiture and as nontransferable. This carve out allows transferred property subject to Section 16(b) of the Exchange Act to defer taxation until either the substantial risk of forfeiture or transfer restriction lapses.
Prior to the final regulations, for a forfeiture condition that is related to the purpose of the transfer to be subject to a substantial risk of forfeiture, the Treasury Regulations required only that the possibility of forfeiture be substantial. The final regulations clarify that transferred property is not subject to a substantial risk of forfeiture if at the time of the transfer the facts and circumstances indicate that forfeiture is unlikely to be enforced when the forfeiture condition is not met. This requirement imposes an additional level of analysis so that in determining whether transferred property is subject to a substantial risk of forfeiture, both the likelihood that the forfeiture event will occur, and the likelihood that the forfeiture will be enforced must be considered.
Let's look at the following example. A corporation transfers restricted stock to its employee for his services. The employee is not allowed to transfer the stock for three years and is required to forfeit the stock if the corporation's gross receipts fall by 75% over the next three years. The corporation has a long history of success in its business and there is no indication that demand for its business will diminish or the corporation will be unable to sell its products over the next three years. Even though the forfeiture condition is related to the corporation's purpose, it is unlikely to occur and thus, the transferred stock should not be treated as subject to a substantial risk of forfeiture.
The final regulations further tighten the definition of substantial risk of forfeiture by restricting it to transferred property conditioned only on the future performance of substantial services or the occurrence of a condition related to a purpose of the transfer. No other conditions will subject transferred property to a substantial risk of forfeiture so that transfer restrictions, such as restrictions imposed by lock-up agreements or restrictions relating to insider trading under Rule 10b-5 of the Exchange Act will not cause transferred property to be subject to a substantial risk of forfeiture under Section 83 of the Code. The final regulations provide new examples that address these issues in more detail.
Moving forward, when a corporation transfers property for services to its employees, it should review the terms of the transfer carefully, and make sure the terms clearly satisfy these final regulations, so to ensure its employees the ability to defer tax on such property and avoid protracted negotiations with its employees. Even though these final regulations tighten the definition of substantial risk of forfeiture, and make the analysis of whether such property is subject to a substantial risk of forfeiture more complex, if the transaction is properly structured, restricted stock and similar awards continue to be powerful compensation tools that provide for meaningful opportunities to defer tax.
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