Definition of “Substantial Risk of Forfeiture” Gets Murky?

Two recent developments related to the definition of “substantial risk of forfeiture” (SRF) for purposes of Section 83 of the Internal Revenue Code may have broader effects on compensation and benefits. 

The New Final Section 83 Regulations

The government recently released new final regulations under Section 83 that are intended to clarify positions the IRS has long held regarding what constitutes an SRF. The final regulations clarify that an SRF exists only where the vesting of property is conditioned on (i) a service condition, such as working for a certain period, or (ii) a performance-based condition, such as the achievement of some condition related to the purpose of the transfer. Whether a risk of forfeiture is substantial depends upon the particular facts and circumstances and will consider both (a) the likelihood that a forfeiture condition will occur and (b) the likelihood that the forfeiture condition will be enforced. Finally, transfer restrictions, such as lock-up provisions, blackout periods, Rule 10b-5 policies, and insider trading policies, generally do not qualify as an SRF, except transfer restrictions under Section 16(b) that avoid short-swing profit liability would qualify as an SRF. Most practitioners don’t view these new regulations as a change in the IRS’s position.

An Interesting Tax Court Case

Just weeks before the IRS issued the new regulations discussed above, the U.S. Tax Court issued a provocative opinion overruling one of the IRS’s long-standing interpretations of an SRF under Section 83. In Austin v. Commissioner, the Court found that a “discharge for cause” provision in an employment agreement did create an SRF under Section 83, even though the IRS regulation requires that stock be forfeited “if the employee is discharged for cause or for committing a crime will not be considered to result in a substantial risk of forfeiture.”

The employee/taxpayer was subject to an employment agreement and restricted stock award that provided that the employee/taxpayer would forfeit a substantial amount of the value of his stock upon termination for “Cause.” The definition of Cause included many conditions, one of which was the failure to diligently perform his duties and adhere to his employment agreement. The Court reviewed the history of the regulations and found that standard for Cause described in the regulations was tantamount to discharge for committing a crime, which would not be a substantial risk of forfeiture. However, the Court believed that the negotiated definition of Cause between the parties was much broader and thus did rise to the level of a substantial risk of forfeiture. 

What Now?

Compensatory agreements often include a definition of Cause that will result in forfeiture in some or all of a benefit. Moreover, the Internal Revenue Code uses the same phrase (“substantial risk of forfeiture”) in several different Code sections, albeit with different definitions. It is too early to overreact either way to the Austin decision, but there are a number of issues worth considering:

• Are we applying tax on restricted stock too early and should we be using Section 83(b) elections more often?
• Are we including FICA taxes and compensation expense on deferred compensation on RSUs too early? 
• Does the Austin decision have any effect on Section 409A, where the notion of SRFs plays an essential role in many important respects?

Again, it is too early at this point to predict how much of an effect the Austin decision will have on plan design and operation or whether those effects will have any impact on other Code Sections. However, parties drafting definitions of “Cause” may want to think through the potential implications.