The IRS recently issued regulations clarifying the answers to some long-standing questions regarding the taxation of restricted stock. However, these clarifications do not answer and indeed may raise new questions concerning the IRS positions on certain cash-based deferred compensation vesting issues.
Section 83 of the Internal Revenue Code governs the taxation of a transfer or grant of restricted property, typically stock, as compensation. (Separate tax rules, including Sections 409A, 457, and 457A, apply to cash-based deferred compensation.)
In general, the transfer of stock or other property is only taxable when the property is no longer subject to a “substantial risk of forfeiture.” A typical vesting restriction is service-based, e.g., the granted stock is forfeited if the recipient terminates service before a specified number of years have elapsed. Whether other non-service types of restrictions are effective to defer taxation has always been determined based on the facts and circumstances. The IRS has now clarified under what circumstances non-service restrictions would be considered a substantial risk of forfeiture.
First, the IRS has clarified that any non-service based vesting condition must be “related to the purpose of the transfer.” For example, a vesting condition based upon the company achieving a specified level of earnings would be a condition related to transfer or grant of the company stock.
Second, the likelihood of the forfeiture occurring and the likelihood that the forfeiture will be enforced must be considered. For example, if stock is granted subject to a condition that the stock is forfeited if the gross receipts of the employer fall by 90% over three years, the likelihood of such a percentage fall must be considered. If the employer were a long-standing seller of a product and there was no indication that there would either be a fall in demand or an inability of the employer to sell the product, the IRS would take the position that the transfer was taxable when granted, rather than after the three-year period had elapsed.
Third, a mere restriction on transferring the stock does not create a substantial risk of forfeiture, even if the stock would be forfeited if the employee attempted to transfer it. For example, if an employee is awarded stock subject only to the condition that the employee not sell or otherwise transfer the stock for five years, the stock is taxable at the time of transfer, even if the recipient were to forfeit the stock if he or she did attempt such a transfer.
Also, the regulations now clarify that the only provision of the securities law that delays taxation under Section 83 is Section 16(b) of the Securities Exchange Act. Section 16(b) restricts “certain” insiders from selling their company stock within six months of a covered purchase of company stock. Other types of transfer restrictions in connection with securities transactions, such as restrictions imposed by lock-up agreements or restrictions related to fraudulent or deceptive insider trading under Rule 10b-5 of the Exchange Act, will not cause the stock to be substantially unvested.
These clarifications under Section 83 are not particularly new, and were foreshadowed in prior IRS rulings. However, other tax deferral techniques are also dependent on whether there is a vesting condition that is a “substantial risk of forfeiture.” In particular, Sections 409A and 457A use the same phrase to determine the taxation of deferred compensation. Moreover, for executives of tax-exempt organizations, Section 457(f) determines whether a potential deferred compensation arrangement is taxable based on when it is subject to a “substantial risk of forfeiture.”
Even though the phrase “substantial risk of forfeiture” is in each of these statutes, the IRS has so far not chosen to interpret the phrase identically. For example, the IRS has said that a covenant not to compete never results in a substantial risk of forfeiture under Section 409A, but may in limited circumstances qualify as a substantial risk of forfeiture under Section 83. The IRS has also previously announced an intention to issue final regulations on Section 457(f) that would interpret this phrase, but not necessarily in a manner identical to other tax code sections. As a result, when designing non-service-based vesting restrictions for deferred compensation arrangements, employers need to be careful in comparing and contrasting the alternative meanings of the phrase “a substantial risk of forfeiture.”