Internal Revenue Code section 83 governs property transferred in exchange for the performance of services. Section 83(a) includes in the transferee’s gross income the fair market value of such property at such time it is transferable or not at substantial risk of forfeiture, less the amount (if any) the transferee paid for such property.
A “substantial risk of forfeiture” can be established through a service condition (a direct or indirect condition on the future performance of the transferee), a condition related to the purpose of the transfer (e.g., customers buy products that generate commissions), or other conditions (e.g., a time-dependent sellback provision). See I.R.C. § 1.83-3(c).
On May 30, the Internal Revenue Service proposed changes to the “substantial risk of forfeiture” analysis. Under the proposed changes:
- A “substantial risk of forfeiture” could only be established through a service condition or a condition related to the purpose of the transfer. This language would largely supersede Robinson v. Comm’r, 805 F.2d 38 (1st Cir. 1986) (holding a one-year sellback provision was neither a service condition nor a condition relating to the purpose of the transfer, but that the risk of forfeiture was substantial nonetheless). The proposed regulations would clarify that a time-dependent forfeiture condition does not per se constitute a substantial risk of forfeiture. (In some circumstances a time-dependent condition may suffice. See point 3, below.)
- When the condition related to the purpose of the transfer is analyzed, both the likelihood that the condition will occur and the likelihood that forfeiture will be enforced must be considered. If a condition pertains to an employee’s sales volume, then increasing product demand, consistent employee performance, and prior employees’ retention of similar property despite violating their forfeiture conditions would all be relevant in determining whether a substantial risk of forfeiture exists.
- Except as specifically provided in section 83(c) (Special rules) and in regulation 1.83-3(j) (Sales which may give rise to suit under section 16(b) of the Securities Exchange Act of 1934) and (k) (Special rule for certain accounting rules), transfer restrictions do not create a substantial risk of forfeiture – even if the restrictions threaten forfeiture upon violation. This change is intended to preclude the use of transfer restrictions as tools for deferring otherwise taxable events. Note that section 16(b) of the Securities and Exchange Act of 1934 (governing profits from the purchase and sale of securities within six months) could still support substantial forfeiture conditions, and thus defer taxation, but other Exchange Act rules (including rule 10b-5, which governs insider trading or lock-up agreement conditions) could not.
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The proposed changes would affect relevant property transfers occurring on or after January 1, 2013.
Contact
Michael Wiesner practices in Royse Law Firm’s tax and M&A groups. If you would like to discuss the proposed changes to Internal Revenue Code section 83, please contact Michael at 650-813-9700 ext. 225, or by email at mwiesner@rroyselaw.com.
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