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IRS Clarifies Requirements for Substantial Risk of Forfeiture in Final Regs.
(Parker Tax Publishing March 12, 2014)

Final regulations provide several clarifications regarding whether a substantial risk of forfeiture exists in connection with property received in exchange for services. T.D. 9659.

Generally, under Code Sec. 83(a), if a service provider (who can be either an employee or independent contractor) or a beneficiary of a service provider receives property in connection with the performance of services, the service provider must include all or a portion of the property's fair market value in income in the year he or she receives the property. However, if the property is subject to certain restrictions (as in the case of certain restricted stock), its value is generally not included in income until it becomes "substantially vested." Property is substantially vested when it is either transferable or not subject to a substantial risk of forfeiture.

Regulations that had been in place under Code Sec. 83 caused considerable confusion over what constitutes a substantial risk of forfeiture. The IRS addressed issues that were causing that confusion in proposed regulations issued in 2012. On February 26, the IRS finalized those regulations in T.D. 9659.

OBSERVATION: The final regulations apply to property transferred on or after January 1, 2013, and thus are relevant for 2013 tax returns.A

According to the IRS, the revised final regulations are intended to clarify the definition of a substantial risk of forfeiture and are consistent with the interpretation that the IRS historically has applied. Thus, from the IRS's perspective, they do not constitute a narrowing of the requirements to establish a substantial risk of forfeiture.

Background on Code Section 83(a)

Code Sec. 83(a) provides that if, in connection with the performance of services, property is transferred to any person other than the person for whom such services are performed, the excess of (1) the fair market value of the property (determined without regard to lapse restrictions) at the first time the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier, over (2) the amount (if any) paid for such property, is included in the gross income of the service provider in the first tax year in which the rights of the person having the beneficial interest in the property are transferable or are not subject to a substantial risk of forfeiture. Thus, if the property received is subject to a substantial risk of forfeiture and is nontransferable, the person receiving the property does not have current taxable income from the transaction.

Under Code Sec. 83(c)(1), the rights of a person in property are subject to a substantial risk of forfeiture if that person's rights to full enjoyment of the property are conditioned upon the future performance of substantial services by any individual.

Code Sec. 83(c)(3) provides that so long as the sale of property at a profit could subject a person to suit under Section 16(b) of the Securities Exchange Act of 1934 (the Exchange Act), that person's rights in the property are subject to a substantial risk of forfeiture, and are not transferable. Reg. Sec. 1.833(j) further provides that, for purposes of Code Sec. 83, if the sale of property at a profit within six months after the purchase of the property could subject a person to suit under Section 16(b) of the Exchange Act, the person's rights in the property are treated as subject to a substantial risk of forfeiture and as not transferable until the earlier of (1) the expiration of that six-month period, or (2) the first day on which the sale of such property at a profit will not subject the person to suit under Section 16(b) of the Exchange Act.

Consistent with Code Sec. 83(c)(3) and Reg. Sec. 1.833(j), Rev. Rul. 200548 provides that the only provision of the securities law that would delay taxation under Code Sec. 83 is Section 16(b) of the Exchange Act. The ruling further provides that other transfer restrictions (such as restrictions imposed by lock-up agreements or restrictions relating to insider trading under Rule 10b5 of the Exchange Act) do not cause rights in property taxable under Code Sec. 83 to be substantially nonvested. Rev. Rul. 200548 notes that the IRS intends to amend the Code Sec. 83 regulations to explicitly set forth the holdings in the ruling.

Reg. Sec. 1.83-3(k) provides a special rule under which property is subject to substantial risk of forfeiture and is not transferable so long as the property is subject to a transfer restriction to comply with certain pooling-of-interests accounting rules.

Confusion Caused by Prior Regulations

The prior regulations under Code Sec. 83 provided that, whether or not a risk of forfeiture was substantial depended on the facts and circumstances, and a substantial risk of forfeiture existed where rights in property transferred were conditioned, directly or indirectly, upon (1) the future performance (or refraining from performance) of substantial services by any person, or (2) the occurrence of a condition related to a purpose of the transfer, and the possibility of forfeiture was substantial if the condition was not satisfied.

Confusion arose under these regulations as to whether other conditions might also give rise to a substantial risk of forfeiture. Confusion also arose as to whether, in determining if a substantial risk of forfeiture existed, the likelihood that a condition related to the purpose of the transfer would occur had to be considered. According to the IRS, a conclusion that such likelihood need not be considered would lead to unintended anomalies. For example, assume that stock transferred by an employer to an employee was made nontransferable and also subject to a condition that the stock would be forfeited if the employer's gross receipts fell by 90 percent over the next three years. Assume also that the employer is a longstanding seller of a product, and that there is no indication there will be a fall in demand for the product or an inability of the employer to sell the product, so that it is extremely unlikely that the forfeiture condition will occur. Although, arguably, the condition is a condition related to the purpose of the transfer because it would, to some degree, incentivize the employee to prevent such a fall in gross receipts, the IRS said it did not believe that such a condition was intended to defer the taxation of the stock transfer.

Clarifications in Revised Regulations

The final regulations issued in February provide several clarifications on whether a substantial risk of forfeiture exists in connection with property subject to Code Sec. 83.

First, the final regulations clarify that, except as specifically provided in Code Sec. 83(c)(3) and Reg. Sec. 1.833(j) and Reg. Sec. 1.83-3(k), a substantial risk of forfeiture may be established only through a service condition or a condition related to the purpose of the transfer.

Second, the final 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.

Finally, the final regulations state that, except as specifically provided in Code Sec. 83(c)(3) and Reg. Sec. 1.833(j) and Reg. Sec. 1.83-3(k), transfer restrictions do not create a substantial risk of forfeiture, including transfer restrictions that carry the potential for forfeiture or disgorgement of some or all of the property, or other penalties, if the restriction is violated. This additional language incorporates the IRS's holding in Rev. Rul. 200548. Therefore, Rev. Rul. 200548 is obsolete as of February 26, 2014. (Staff Contributor Parker Tax Publishing)

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Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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