Prop. regs. clarify meaning of “substantial risk of forfeiture” under Sec. 83

The IRS on Tuesday issued proposed regulations that would clarify when a substantial risk of forfeiture exists on the transfer of stock to an employee that is treated as compensation under Sec. 83 (REG-141075-09). When a substantial risk of forfeiture exists, the employee does not yet have to recognize the income on the transfer.

Under current Regs. Sec. 1.83-3(c)(1), “a substantial risk of forfeiture exists where rights in property that are transferred are conditioned, directly or indirectly, upon the future performance (or refraining from performance) of substantial services by any person, or the occurrence of a condition related to a purpose of the transfer, and the possibility of forfeiture is substantial if such condition is not satisfied.”

The IRS believes that this language has created confusion about whether conditions other than those related to the purpose of the transfer give rise to a substantial risk of forfeiture and whether the likelihood that a condition will occur must be considered. To clarify that no other conditions should be considered, the proposed regulations would add the word “only” before the word “where” in the second sentence of Regs. Sec. 1.83-3(c)(1).

To clarify that only conditions that have some reasonable chance of occurring should be considered, the proposed regulations would eliminate the phrase “if such condition is not satisfied” at the end of the second sentence of Regs. Sec. 1.83-3(c)(1). The purpose of the deletion is to make clear 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 (Prop. Regs. Sec. 1.83-3(c)(1)).

A third change the proposed regulations would make involves incorporating the rule from Rev. Rul. 2005-48 that a transfer restriction, including a transfer restriction that carries the potential for forfeiture or disgorgement of some or all of the property or other penalties if the restriction is violated, does not create a substantial risk of forfeiture. This rule means that the only restrictions under the securities laws that will be considered to create a substantial risk of forfeiture will be the possibility of suit under Section 16(b) of the Securities and Exchange Act of 1934. The possibility of a suit under the insider trading restriction of Rule 10b-5 of the Securities and Exchange Act or from violation of a lock-up agreement will not result in a similar risk of forfeiture (Prop. Regs. Sec. 1.83-3(c)(1)).

The proposed regulations also add new examples to illustrate these rules. The regulations are proposed to apply as of Jan. 1, 2013, and will apply to property transferred on or after that date. Taxpayers also may rely on the proposed regulations for property transferred after May 30, 2012. 

—Sally P. Schreiber (sschreiber@aicpa.org) is a JofA senior editor.