New Internal Revenue Service Regulation Clarify when Property is Subject to a Substantial Risk of Forfeiture
On February 26, 2014, the Internal Revenue Service published a final regulation clarifying the meaning of “substantial risk of forfeiture” under section 83 of the Internal Revenue Code. The new guidance will help taxpayers who receive property, other than money, in exchange for services determine when they must recognize the difference between the fair market value of the property and the price, if any, they pay for the property as income for tax purposes.
Generally, section 83 is intended to allow service providers who have received an uncertain and unalienable property interest in exchange for services to delay recognition of the value of the property (in excess of what the service provider paid for the property) until it is clear the service provider will, in fact, receive some benefit from owning the property. Thus, under section 83, the difference between the fair market value of the property and what the service provider paid for it is not includable in the service provider’s income until the property is either no longer subject to a substantial risk of forfeiture or not subject to transfer restriction (i.e. is freely alienable).[i] In the new regulation, the IRS elaborates on when property is subject to a substantial risk of forfeiture.
First, the Service explains, except in limited circumstances, property is only subject to a substantial risk of forfeiture when the transfer of property is subject to a service condition, meaning the service provider’s right to the property only vests upon the performance (or restraint from performance) of services in the future, or the property interest is subject to a condition related to the purpose of the transfer; for example, the recipient of the service maintains a certain level of revenue in the future. Not only must the service provider’s property interest be subject to a service condition or condition related to the purpose of the transfer for the property interest to be subject to a substantial risk of forfeiture, but the facts and circumstances at the time of the property transfer must establish the likelihood that the condition leading to forfeiture will occur, and that the service recipient is likely to enforce the forfeiture.
Second, the new guidance states that restrictions on the transfer of property alone cannot make that property subject to a substantial risk of forfeiture. Thus, service providers who receive property subject to onerous transfer restrictions cannot defer recognition of taxable income from receipt of the property unless the property is also subject to a service condition or a condition related to the purpose of the transfer. This is the case even if violating the transfer restriction results in the service provider losing the property. The new regulation does, however, grant two exceptions to this rule by providing that if sale of the property at a profit would open the service provider to a suit under section 16(b) of the Securities Exchange Act of 1934, the property is treated as if it is subject to a substantial risk of forfeiture for the period such a sale could result in a section 16(b) suit; and that property subject to a restriction on transfer to comply with the “Pooling-of-Interests Accounting” rules (the so-called “lock-up” period after certain acquisitions or an IPO) is also considered subject to a substantial risk of forfeiture.
The new regulation applies to any property transferred after January 1, 2013.
[i] A service provider may, however, elect to include the difference between the price it paid for the property and its fair market value in its income when it receives the property, in accordance with section 83(b).