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New Proposed Section 83 Regulations Clarify What Constitutes a Substantial Risk of Forfeiture

Posted in Executive Compensation

by Joseph S. Adams and Andrew C. Liazos

Earlier today, the Internal Revenue Service (IRS) released new proposed Section 83 regulations, which clarify several points including:

  1. A substantial risk of forfeiture (SRF) may be established only through a service condition or a condition related to the purpose of the transfer.  Citing the U.S. Court of Appeals for the First Circuit’s opinion in Robinson, the preamble noted that “[s]ome confusion has arisen as to whether other conditions may also give rise to a substantial risk of forfeiture.”  The proposed regulations retain the language from Section 83 final regulations that refraining from service may be a service condition.
  2. In determining whether a SRF exists, it is necessary to consider both (a) the likelihood that the forfeiture event will occur, and (b) the likelihood that the forfeiture will be enforced.  All of the facts and circumstances must be evaluated to determine whether a performance-based vesting condition for a restricted stock award will be treated as a substantial risk of forfeiture for purposes of Section 83.
  3. Transfer restrictions such as lock-up agreements, Rule 10b-5 insider trading restrictions) do not create a SRF – in other words, they do not defer the taxable event – even if there is a potential for forfeiture or disgorgement of some or all of the property, or other penalties, if the restriction is violated.  The only exception to this rule is with respect to Section 16(b) “short swing” profit liabilities.  The proposed regulations provide three new examples illustrating when transfer restrictions will – and will not – constitute a SRF.  The proposed regulations incorporate the IRS’ position in Revenue Ruling 2005-48.

These regulations under section 83 are proposed to apply to transfers of property on or after January 1, 2013. Taxpayers may rely on the proposed regulations for property transfers occurring after the publication of the proposed regulations until further notice.  Comments are due by August 28, 2012.

Further details on the newly proposed regulations will be provided in subsequent McDermott publications.