Substantial risk of forfeiture (SRF) is a crucial concept in the tax code (Section 83), as it determines whether and when compensation is taxable. If there is a chance you can lose compensation, whether stock or cash, and thus you don't really own it in the traditional sense, it is not taxable to you. However, once that restriction lapses and the risk of loss disappears, the property is considered to be transferred to you. Its value at that time is then taxable.
In stock compensation, the most common example of a substantial risk of forfeiture occurs with restricted stock. For you to receive the underlying shares, the restricted stock grant must vest; otherwise, you lose the grant—i.e. a risk of forfeiture exists. If, for example, you were to leave your company before vesting, you would forfeit your right to receive the shares. Only when vesting occurs is the value of the shares taxable. The tax concept for restricted stock units is similar, although RSUs are taxed under a different code provision, and only the actual delivery of the shares triggers taxes. RSUs also can have a feature that lets you elect to defer share delivery, and thus the related income tax, until a future date.
In May, the IRS issued proposed regulations to clarify when a substantial risk of forfeiture exists for stock compensation. In general, the proposed regulations confirm and clarify previous IRS revenue rulings, private letter rulings, court decisions, and the generally accepted understanding of what constitutes a forfeiture risk. The proposed regulations do tweak the tax-code definition in areas that the IRS, we can perhaps assume, found concerning or potentially confusing. For example, the wording now makes it completely clear that the reason for the restriction creating the SRF must involve your job and the services you provide in your job. In other words, if your restricted stock vesting depends upon a World Series victory by the Chicago Cubs, that condition alone cannot defer taxation unless you actually work for the Cubs.
Also, the IRS proposal modifies the regulations to clarify that a transfer restriction—such as a clawback requiring stock disgorgement, a lockup period at an IPO company, an insider-trading blackout, or a stock-buyback provision for at least fair market value—do not create a substantial risk of forfeiture. A delay in the taxation is allowed only if the immediate sale of the stock received would trigger a short-swing profit violation under Section 16(b) because the grant is a nonexempt under the Section 16 rules. Again, this is not a dramatic shift (perhaps apart from the addition of clawbacks to the non-SRF list), as the proposal is here consistent with prior revenue rulings and cases.
Situations involving time-based vesting are straightforward. What is most interesting about the proposed regulations is that they also address performance-based vesting, as with performance shares. The example in the background section of the proposed regulations indicates that the IRS wants the condition which triggers vesting (and thus taxation) to have some teeth, i.e. to be truly a meaningful measure of performance, or at least not a performance goal that appears to have been already satisfied at the time of grant. As the IRS explains, it cannot be "extremely unlikely that the forfeiture condition will occur." This point is also raised in two other sources worth looking at for additional details on the proposed IRS regs: see the compensation and benefits blog of Winston & Strawn partner Michael Melbinger and a memo from PricewaterhouseCoopers.
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