IRS Clarifies "Substantial Risk of Forfeiture" Under Internal Revenue Code Section 83

• Substantial Risk of Forfeiture—A substantial risk of forfeiture exists only where rights in the property are conditioned on future performance or upon a condition related to the purpose of the transfer. The preamble recognizes that there is currently some confusion about whether other conditions may give rise to a substantial risk of forfeiture, and the proposed change would make clear they would not. The preamble cites Robinson v. Commissioner, 805 F.2d 38 (1st Cir. 1986), which held that a substantial risk of forfeiture could be established under the facts and circumstances without a service condition or a condition related to the purpose of the transfer. The decision held that a "sellback provision" in a stock option agreement—by which an individual was required to sell his shares back to the employer at his original cost if he sought to dispose of them within a year after he exercised the stock option—created a substantial risk of forfeiture. This was because the likelihood the employer would enforce the provision was high (although the likelihood the individual would trigger the event was very low). While not a service condition or a condition related to the purpose of the transfer, the sellback provision served a significant business purpose, the court reasoned, since it would cause the individual to disgorge any profit he made on a short term sale, similar to Rule16(b) of the Securities Exchange Act of 1934. As such, the condition met the criteria for a substantial risk of forfeiture, the court ruled.
• Condition Related to the Purpose of the Transfer—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. The preamble gives the example of an employer that transfers to an employee stock that is nontransferable and subject to forfeiture if the employer's gross receipts fall by 90 percent over the next three years. Even though the purpose of the condition is to incentivize the employee (and, thereby, to impose a condition related to the purpose of the transfer), if the employer is a longstanding seller of the product and there is no indication that future demand will fall or the employer will lose its ability to sell the product, the condition would not constitute a substantial risk of forfeiture, the preamble explains. This is because both the likelihood that the forfeiture event will occur and the likelihood the forfeiture will be enforced must be considered.
• Transfer Restrictions—Transfer restrictions do not create a substantial risk of forfeiture except as specifically provided under Code section 83(c)(3) and related regulations. Code section 83(c)(3) provides that as long as a sale may give rise to suit under Section 16(b) of the of the Securities Exchange Act of 1934, the person's rights in the stock are subject to a substantial risk of forfeiture and not transferable. Other transfer restrictions that carry the potential for forfeiture or disgorgement of some or all of the property, or other penalties, do not establish a substantial risk of forfeiture, the preamble explains. New examples are provided in the proposed regulations. A lock-up provision in an underwriting agreement entered into in connection with an initial public offering, by which an employee agrees not to sell, dispose of or hedge common stock of the company during the prescribed period, would not establish a substantial risk of forfeiture under a new example. This change incorporates the holding in Revenue Ruling 2005-48.

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Copyright 2012, Deloitte.

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