Under Section 83, of the Internal Revenue Code (the “Code”) restricted stock and other property that is transferred to a service provider (e.g.,an employee or director) for services is taxable when the service provider’s rights in the property are no longer subject to a substantial risk of forfeiture. The Department of Treasury recently issued final regulations under Section 83 that clarify what events constitute a “substantial risk of forfeiture.” The final regulations provide that a substantial risk of forfeiture may be established only if a service provider’s rights in transferred property are either (i) conditioned on the performance, or refraining from performance (e.g., as a result of a non-competition agreement), of substantial services, or (ii) subject to a condition related to the purpose of the transfer (e.g., performance-based awards). In addition, to determine if a substantial risk of forfeiture exists, both the likelihood that a forfeiture event will occur and the likelihood that it actually will be enforced must be established by the underlying facts and circumstances.
The final regulations provide several examples of risks of forfeiture that, subject to certain exceptions, are not substantial, including transfer restrictions on securities (e.g., lock-up arrangements, blackout periods, buy-back provisions and insider-trading restrictions). Such restrictions alone do not create a substantial risk of forfeiture. However, a key exception to this rule is available if an insider is subject to sale restrictions (and possible suit) due to potential liability under Section 16(b) of the Securities Exchange Act.
Additionally, the preamble to the final regulations makes it clear that a right to receive property or cash in the future following an involuntary separation from service is not property for purposes of Section 83, and thus is not taxable until the property or cash is actually received (assuming compliance with Section 409A of the Code). However, the final regulations continue to allow the possibility that a non-competition clause may constitute a substantial risk of forfeiture under Section 83. This is in stark contrast to Section 409A of the Code, which does not treat a non‑competition clause as a substantial risk of forfeiture.
While this is useful guidance, there are still many uncertainties regarding the various definitions of a substantial risk of forfeiture under the Code, including the long-awaited guidance under Section 457(f) of the Code dealing with deferred compensation plans for certain nonprofit and governmental entities. Given these uncertainties, many traps remain for the unwary when drafting compensation arrangements.