Under tax code Section 83, you don’t have to tax employees who receive company stock, stock options or other property that is subject to a substantial risk of forfeiture until the risk lapses and the property vests.
Proposed regulations now define what counts as a substantial risk of forfeiture. The regs also confirm a 2005 revenue ruling in which the IRS concluded that the only provision of the securities law that qualifies as a substantial risk of forfeiture was Section 16(b) of the Exchange Act.
These proposed regs will apply to property transferred to employees beginning Jan. 1, 2013, but you may rely on them before that date. (77 F.R. 31783, 5-30-12)
Risky business. According to the IRS, there is some confusion about what counts as a tax-delaying substantial risk of forfeiture. Under the proposed regs, a substantial risk of forfeiture may be established only through a service condition (for example, an employee must work for five years before the stock vests) or through a condition related to the purpose of the transfer (e.g., the employee must return the stock if it drops in value over a set time period).
The regs also clarify that, in determining whether a substantial risk of forfeiture exists based on a condition related to the purpose of the transfer, both the likelihood that the forfeiture will occur and the likelihood that the forfeiture will be enforced must be considered.
What that means: Say, for example, that an employee is awarded restricted stock that she must return if the company’s gross receipts drop 90% over the next three years. There would be no substantial risk of forfeiture if the nature of the business makes it unlikely that gross receipts would drop 90%.
Finally, the regs follow up on Rev. Rul. 2005-48, in which the IRS concluded that trading restrictions imposed by the securities laws, which prevented employees from trading company stock during lock-up periods or restricted trading to specific trading windows, don’t qualify as a substantial risk of forfeiture.
Under the proposed regs, the only trading restriction that qualifies as a substantial risk of forfeiture is Section 16(b) of the Securities Exchange Act of 1934.
BE REALISTIC: The IRS didn’t specify whether you must re-evaluate the likelihood that a forfeiture will occur and be enforced. But it’s a safe bet that auditors will. You can eliminate uncertainty for the company by having the employee make an 83(b) election, which triggers payroll taxes. However, the employee must still satisfy the restriction.