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IRS Finalizes Regulations Addressing ‘Substantial Risk of Forfeiture’ Under IRC Section 83

Mar 6, 2014

Alwardt_PeterOn February 25, the Internal Revenue Service (IRS) finalized regulations addressing points of confusion and tightening some areas related to the ‘substantial risk of forfeiture’ provision under Internal Revenue Code (IRC) section 83 as it applies to property transferred to an employee in connection with the performance of services. The ‘property’ involved is typically restricted stock or stock options. The proposed regulations clarify three areas regarding conditions that may result in a ‘substantial risk of forfeiture,’ which impacts when an employee must include the value of the transferred property in her/his income. The final regulations are effective for property transfers made on or after January 1, 2013 (as were the proposed reliance regulations).


Generally, if an employee receives property, such as stock, from an employer in exchange for services, the transfer is treated as compensation for services. The amount of income recognized is the fair market value of the property on the date it is vested (transferable or no longer subject to substantial risk of forfeiture), less any amount paid by the employee for the property. Whether a substantial risk of forfeiture exists is based on the facts and circumstances of the arrangement.

Final Regulations

In determining whether a substantial risk of forfeiture exists, the regulations make clarifications in three areas. First, under current regulations, a substantial risk of forfeiture exists if the employee must perform substantial future services or the property is subject to conditions related to the purpose of the transfer of the property (typically future performance benchmarks applicable to the employee or to the employer’s business).  The regulations respond to the question of whether any other conditions imposed on the transfer of property would constitute a substantial risk of forfeiture by clarifying that a substantial risk of forfeiture arises only through a future service condition or a condition related to the purpose of the transfer.  In other words, a transfer restriction on its own does not defer the tax on a compensatory equity grant.

The second clarification in determining if a substantial risk of forfeiture exists is that the likelihood must be considered whether a condition of forfeiture related to the transfer will actually occur and that the forfeiture will actually be enforced. For example, assume that stock transferred by an employer to an employee was made nontransferable and also subject to a condition that the stock be forfeited if the gross receipts of the employer fell by 90% over the next three years. Assume further that the employer is a longstanding seller of a product and that there is no indication that there will be either a fall in demand for the product or an inability of the employer to sell the product.  Thus, it is extremely unlikely that the forfeiture condition will occur. Although arguably the condition is related to the purpose of the transfer because it would, to some degree, incentivize the employer to prevent such a fall in gross receipts, the IRS does not believe that such a condition was intended to defer the taxation of the stock transfer. Accordingly, the regulations clarify that, in determining whether a substantial risk of forfeiture exists based on a condition related to the purpose of the transfer, both the likelihood that the forfeiture event will occur and the likelihood that the forfeiture will be enforced must be considered.

Lastly, the regulations amend the regulations under section 83 to include certain holdings in IRS Revenue Ruling 2005-48.  While Congress intended section 83 to be interpreted in a way that precludes the use of transfer restrictions as a means of deferring taxable income, a specific exception in section 83(c)(3) provides that a substantial risk of forfeiture exists if the sale of property at a profit could subject a person to a suit under section 16(b) of the Securities Exchange Act of 1934 (Exchange Act). The revenue ruling clarified that this is the only provision of the securities laws that would delay taxation under section 83. Further, the final regulations clarify that the purchase of shares in a transaction not exempt from section 16(b) of the Exchange Act prior to the exercise of a stock option that would not otherwise give rise to a section 16(b) liability, would not defer the taxation of the stock option at exercise.  Other transfer restrictions -- including restrictions imposed by lock-up agreements, trading windows imposed by insider trading compliance programs, insider trading restrictions under rule 10b-5 of the Exchange Act, or transfer restrictions that create the potential for forfeiture or disgorgement of some or all of the property -- do not cause an employee’s rights to property to be subject to a substantial risk of forfeiture.


The final regulations apply to employees who participate in an employer’s equity compensation plan or who receive equity based awards for service to the employer. Accordingly, employers should review the forfeiture conditions in their plans to ensure compliance with the final regulations in order to avoid situations in which employees have taxable income, but do not have the cash to pay the income tax related the transfer of the property.

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