Press Room: Tax Release

March 13, 2014

Final Substantial Risk of Forfeiture Regulations Released

Regulations have been finalized clarifying when a substantial risk of forfeiture exists under Sec. 83 on the transfer of property in connection with the performance of services. Generally, these rules apply to employees who receive restricted stock and/or exercise options and receive stock subject to restrictions.

If property is transferred to an employee subject to a substantial risk of forfeiture, the employee does not recognize compensation income at the time of the transfer (unless a Sec. 83(b) election is made), but recognizes compensation income at the time the substantial risk of forfeiture lapses.

The regulations clarify that (1) a substantial risk of forfeiture may be established only through a service condition or a condition related to the purposes of the transfer, (2) in determining whether a substantial risk of forfeiture exists based on a condition related to the purposes of the transfer, both the likelihood that the forfeiture event will occur and the likelihood that the forfeiture will be enforced must be considered, and (3) transfer restrictions, whether contractual or by operation of law, (other than sales that may give rise to suit under Sec. 16(b) of the Securities Exchange Act of 1934 (Act) or property subject to a restriction on transfer to comply with the pooling-of-interest accounting rules) 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.

As indicated above, one of the changes made by the final regulations is clarifying that certain contractual transfer restrictions, such as lock-out periods, are not treated as a substantial risk of forfeiture. For example, individuals who vest in stock as a result of an IPO may be prohibited from selling/transferring those shares for a period of time post-IPO (lock-out period). In the absence of any other substantial risk of forfeiture terms related to the stock, the individuals would recognize compensation as of the IPO date because the selling/transfer restriction is not deemed to be a substantial risk of forfeiture.

With IRS clarification to the regulations, employers who use performance measures for vesting purposes must consider whether the risk of not satisfying the performance criteria is substantial. Not satisfying the substantial-risk test would result in the employee recognizing compensation on the date of transfer. 

The final regulations, effective for transfers of property on or after January 1, 2013, include three additional examples dealing with lock-up periods and individuals subject to Sec. 16(b) of the Act.