Editor: Mark G. Cook, CPA, MBA
Gross Income
In May 2012, the IRS issued proposed regulations (REG-141075-09) to clarify specifically which conditions result in a substantial risk of forfeiture under Sec. 83. In the preamble to the proposed regulations, the IRS expressed a concern that confusion exists over the types of conditions that result in a substantial risk of forfeiture to a taxpayer’s rights over the property received for performing services. According to the preamble, the proposed regulations modify the current regulations to limit such conditions only to a condition based on the performance of future services and to a condition related to the purpose of transferring the property. In addition, the proposed regulations distinguish themselves from the holding in Robinson , 805 F.2d 38 (1st Cir. 1986), and adopt the guidance provided by Rev. Rul. 2005-48. These regulations are proposed to become effective on Jan. 1, 2013.
The Current Rules
The timing for a taxpayer to recognize income when property is received for performing services is generally based on when the property is either no longer subject to a substantial risk of forfeiture or is transferable under Sec. 83(a). Sec. 83(c) provides definitions of both substantial risk of forfeiture and transferability. According to this subsection, a substantial risk of forfeiture exists when the recipient’s rights to full enjoyment of the property are conditioned upon the future performance of substantial services by any individual, and the property is transferable when the recipient’s rights to the property are no longer subject to a substantial risk of forfeiture.
The current regulations provide an additional condition that results in a substantial risk of forfeiture. According to Regs. Sec. 1.83-3(c)(1), a substantial risk of forfeiture exists when rights to the property are conditioned on the satisfaction of a condition related to the purpose of transferring the property and the possibility of forfeiting the property is substantial if the condition is not met. As an illustration, Regs. Sec. 1.83-3(c)(2) provides a situation where an employee receives property from an employer under the requirement that the property will be returned if the employer’s total earnings do not increase. In this case, the property is subject to a substantial risk of forfeiture since the possibility of not meeting the earnings requirement and, thus, forfeiting the property is considered substantial.
In addition, Robinson provided another condition that results in a substantial risk of forfeiture. According to the court, a taxpayer must consider all the facts and circumstances. The taxpayer in Robinson had an option to purchase his employer’s stock with the restriction that he was required to sell the stock back to his employer at the original cost if he wanted to dispose of it less than one year after exercising the option. In this case, the court rejected the IRS’s argument that the probability of the taxpayer’s disposing of the stock within one year was not high enough to result in a substantial risk of forfeiting the stock. Rather than basing it on the probability that an event triggering forfeiture would occur, the court instead found that the probability should be measured by the likelihood of the forfeiture’s taking place once the triggering event occurs. Thus, the court looked to see if there was a business purpose that was significant enough for the employer to enforce the restriction if the taxpayer sold the stock. Noting how the restriction prevented the taxpayer from committing insider trading, the court found a significant business purpose for the employer and determined the risk of forfeiting the stock in case of such a transfer was indeed substantial to the taxpayer.
The Proposed Regs.
As mentioned above, the proposed regulations limit the conditions resulting in a substantial risk of forfeiture only to a condition based on performing services in the future and to a condition related to the purpose of transferring the property (Prop. Regs. Sec. 1.83-3(c)(1)). In other words, a condition based on facts and circumstances according to Robinson would not result in a substantial risk of forfeiture. Under the proposed regulations, the taxpayer in Robinson would have been required to recognize income in the year he exercised the option instead of one year later when the restriction expired.
Prop. Regs. Sec. 1.83-3(c)(1) also modifies Regs. Sec. 1.83-3(c)(1) to make it clear the possibility of the occurrence of an event subjecting the property to a substantial risk of forfeiture is an important consideration for determining whether a substantial risk of forfeiture exists. This was the IRS’s argument in Robinson, which the court rejected. The preamble to the proposed regulations provides an example where an employee receives property from an employer with a restriction that the property be returned if the employer’s gross receipts decrease by 90% in the following three years. Assuming it is highly unlikely gross receipts will decrease by that amount, the IRS believes that the property is not subject to a substantial risk of forfeiture.
In addition, Prop. Regs. Sec. 1.83-3(c)(1) adopts the guidance provided by Rev. Rul. 2005-48 that a transfer restriction on the property would not result in a substantial risk of forfeiture, with limited exceptions. In this revenue ruling, an employee was granted an option to purchase the employer’s stock. The option was subsequently exercised. This compensation arrangement was subject to various restrictions, including an underwriting agreement that imposed a lockup period; an insider trading compliance program; and Rule 10b-5 under the Securities Exchange Act of 1934 (SEA) if the employee sold the stock while in possession of confidential information of the employer, which may result in a potential liability to the employee. Lastly, the six-month period under SEA Section 16(b) expired prior to the exercise.
The revenue ruling held that the stock was not subject to a substantial risk of forfeiture on the exercise date since the restrictions mentioned above were not conditions on performing services in the future nor were they conditions related to a purpose of transferring the stock to the employee. Unlike Robinson , Rev. Rul. 2005-48 did not consider whether the restrictions above served a significant business purpose based on the employer’s facts and circumstances. This aspect of the revenue ruling is illustrated in the proposed regulations in two examples based on the facts of the revenue ruling (Prop. Regs. Sec. 1.83-3(c)(4), Examples 6 and 7).
The proposed regulations also adopt the guidance provided by the revenue ruling on the application of an exception under Regs. Sec. 1.83-3(j)(1), where a transfer restriction would actually result in a substantial risk of forfeiture. According to the current regulations, the potential liability imposed under SEA Section 16(b) for selling property at a profit within a six-month period after the date of purchase or the date of the grant in the case of most options would result in a substantial risk of forfeiture. In the revenue ruling, the six-month period expired prior to the employee’s exercise of the option. Therefore, the employee was not subject to potential liability under SEA Section 16(b) when the employee exercised the option, and the exception under the regulations did not apply. To further clarify the application of this exception, the proposed regulations include an example based on the facts of the revenue ruling and in addition specify that, if the employee exercises within the six-month period, the stock would then be subject to a substantial risk of forfeiture only until the end of the six-month period (Prop. Regs. Sec. 1.83-3(j)(2), Example 4).
Implications
The proposed regulations limit the conditions that may result in a substantial risk of forfeiture. A taxpayer in circumstances similar to Robinson would be required to include the value of stock received through an exercise of options in the year of exercise instead of a year later when the transfer restriction expires, since a condition based on facts and circumstances not related to the purpose of the transfer would not result in a substantial risk of forfeiture under the proposed regulations. In fact, the proposed regulations may cause more taxpayers to accelerate the recognition of income for the property received for performing services. This calls for taxpayers and their tax advisers to proactively review compensation arrangements and ensure they are not surprised when the proposed regulations become effective on Jan. 1, 2013.
EditorNotes
Mark Cook is a partner at SingerLewak LLP in Irvine, Calif.
For additional information about these items, contact Mr. Cook at 949-261-8600, ext. 2143, or mcook@singerlewak.com.
Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.
