IRS Prop. Regs Would Tighten Rules as to When a Substantial Risk of Forfeiture Exists. (Parker Tax Publishing June 10, 2012)

Under proposed regulations under Code Sec. 83, 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 event will occur and the likelihood that the forfeiture will be enforced must be considered. REG-141075-09 (5/30/12).

Code Sec. 83(a) provides that if, in connection with the performance of services, property is transferred to any person other than the person for whom such services are performed, the excess of (1) the fair market value of the property (determined without regard to lapse restrictions) at the first time the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier, over (2) the amount (if any) paid for such property, is included in the gross income of the service provider in the first tax year in which the rights of the person having the beneficial interest in the property are transferable or are not subject to a substantial risk of forfeiture.

Code Sec. 83(c)(1) provides that the rights of a person in property are subject to a substantial risk of forfeiture if that person's rights to full enjoyment of the property are conditioned upon the future performance of substantial services by any individual. Reg. Sec. 1.83-3(c)(1) provides that, whether or not a risk of forfeiture is substantial depends on the facts and circumstances. Reg. Sec. 1.83-3(c)(1) further provides that a substantial risk of forfeiture exists where rights in property that are transferred are conditioned, directly or indirectly, upon (1) the future performance (or refraining from performance) of substantial services by any person, or (2) the occurrence of a condition related to a purpose of the transfer, and the possibility of forfeiture is substantial if the condition is not satisfied.

According to the IRS, in addition to providing that a person's rights in property are subject to a substantial risk of forfeiture if conditioned upon the future performance of substantial services by any individual, the legislative history of Code Sec. 83 indicates that the drafters intended that in other cases the question of whether there is a substantial risk of forfeiture depends upon the facts and circumstances. The current regulations, the IRS said, adopt this approach by finding that a substantial risk of forfeiture may also arise if the rights to the property are subject to a condition related to the purpose of the transfer.

According to the IRS, some confusion has arisen as to whether other conditions may also give rise to a substantial risk of forfeiture. As a result, the IRS has issued proposed regulations that would clarify that a substantial risk of forfeiture may be established only through a service condition or a condition related to the purpose of the transfer. The IRS also said that confusion has arisen as to whether, in determining whether a substantial risk of forfeiture exists, the likelihood that a condition related to the purpose of the transfer will occur must be considered. According to the IRS, a conclusion that such likelihood need not be considered would lead to anomalies not intended by the statute. For example, assume that stock transferred by an employer to an employee was made nontransferable and also subject to a condition that the stock be forfeited if the gross receipts of the employer falls by 90 percent over the next three years. Assume further that the employer is a longstanding seller of a product and that there is no indication that either there will be a fall in demand for the product or an inability of the employer to sell the product, so that it is extremely unlikely that the forfeiture condition will occur. Although, arguably, the condition is a condition related to the purpose of the transfer because it would, to some degree, give the employee incentive to prevent such a fall in gross receipts, the IRS does not believe that such a condition was intended to defer the tax on the stock transfer. Accordingly, the proposed regulations would 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 event will occur and the likelihood that the forfeiture will be enforced must be considered.

Finally, the proposed regulations would clarify that, except as specifically provided in Code Sec. 83(c)(3) and Reg. Sec. 1.83-3(j) and (k), transfer restrictions 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. According to the IRS, this position is supported by the legislative history of Code Sec. 83. The IRS stated that the legislative history shows that Congress intended for Code Sec. 83 to be interpreted in such a way that precludes the use of transfer restrictions as a means of deferring the taxable event.

These regulations under Code Sec. 83 are proposed to apply as of January 1, 2013, and would apply to property transferred on or after that date. Taxpayers may rely on the proposed regulations for property transferred after May 30, 2012.

For a discussion of what constitutes a substantial risk of forfeiture under Code Sec. 83, see Parker Tax ¶124,515. (Staff Contributor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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