Substantial Risk of Forfeiture – Delaying the Taxation of Compensation
By Monte S. Colbert, Director, Tax & Business Services
Employers often supplement and incentivize the compensation packages offered to their employees by the transfer of non-cash remuneration. The transfer is often in the form of employer stock that is restricted, stock options, or other types of real and personal property. One of the benefits of these forms of non-cash payments includes the ability to design a plan in order to achieve favorable tax consequences. With the inclusion of key elements into the plan, such as substantial risk of forfeiture (“SROF”) and transferability restrictions, one can control whether or not the employee has income and the employer has a corresponding deduction, in what year the income is taxed, and how much income will result from the transfer.
SROF is vital to the determination of whether or not the transferred property will be included in the income of the employee. SROF creates a restriction on the property that prevents it from being taxed until the property becomes unrestricted. In February 2014, the Treasury Department issued final regulations under Internal Revenue Code Section 83, to clarify what constitutes a SROF. This article will discuss the highlights of that legislation.
SROF is created in one of two ways. The receipt of the property must be conditioned on future performance of substantial services, or refraining from such performance by the service provider (employee or independent contractor). This is commonly known as an “earn-out” restriction. SROF is also created by a condition related to the purpose of the transfer. If the forfeiture condition is tied to some performance index of the employer, then the relationship between the forfeiture condition and the purpose of the transfer is satisfied. For example, if a key employee is granted stock, but they must forfeit the stock if the earnings do not increase by some factor over a set period of time, this would establish a condition related to the purpose of the transfer. While the employee in this example is not required to perform any substantial future services, the grant of the stock is an incentive for them to raise the earnings of the company, or risk losing the stock.
The final regulations emphasize the following:
- Under both SROF scenarios above, forfeiture risk will only be created if the possibility of forfeiture is substantial.
- Property is not subject to a SROF if at the time the property is transferred, the facts and circumstances indicate that the forfeiture condition is unlikely to be enforced.
- Property is not subject to a SROF to the extent that the employer is required to pay fair market value to the employee for the return of the property.
- The risk that the value of property will decline during a certain period of time does not constitute a substantial risk of forfeiture.
- A non-lapse restriction (any permanent restriction to which the property is subject), standing by itself, will not result in a substantial risk of forfeiture. These types of restrictions however may affect the value of the property.
- The ability to transfer the property during the restricted period including restrictions that carry the potential for the forfeiture of the property, liability for damages, penalties, fees, or some other amount, do not create a SROF. Therefore, lock-up agreements, insider trading compliance programs, and Rule 10b-5 insider trading restrictions do not create a SROF.
There are only two regulatory exceptions that do create a SROF as follows:
- Property is subject to a substantial risk of forfeiture and is not transferable so long as the property is subject to a restriction on the transfer in order to comply with the “Pooling-of-Interests Accounting” rules set forth in Accounting Series Release Number 130.
- A SROF due to Section 16(b) of the SEC Act of 1934 short –swing liability only applies to the initial six month period after a compensatory award is granted. This section was enacted by Congress recognizing that insiders may have access to information about their corporations not available to the rest of the investing public. By trading on this information, these persons could reap profits at the expense of less well informed investors. Section 16(b) enables the issuer to recover these profits by bringing suit against these insiders. If an individual exercises an option that is not exempt from 16(b), no SROF exists with regard to the stock, if the option is exercised after the end of the 16(b) liability period.
The final regulations contain examples of the rules highlighted above, amplifying the treatment under various theoretical facts and circumstances. The regulations are effective for property transferred on or after January 1, 2013.
Because the combination of SROF and non-transferability restrictions has the ability to delay a taxable event upon the transfer of restricted property, it is a powerful tool in the arsenal of designing compensation plans. Inherent in any new legislation, complexities, unanswered questions, and untested positions arise, and government scrutiny is always present. On the other hand, new opportunities may present themselves and a fresh look approach at an organization’s current compensation structure is advisable. Because of the many possible variations and combinations of strategies available to compensate employees beyond regular pay and bonus plans, it has become even more critical to understand and design compensation plans taking these new regulations and other considerations into account. Our compensation team stands ready to consult with you, and design a plan that is appropriate to meet your objectives.