The Internal Revenue Service (IRS) recently released new final regulations under Section 83 of the Internal Revenue Code (the Code) that confirm  several positions  that it has successfully taken in litigation about what is  a substantial risk of forfeiture (SRF) under Section 83 of the Code.    The new regulations are substantially the same as proposed regulations issued in May 2012.  While these regulations became effective as of January 1, 2013, it is reasonable to expect that the IRS will enforce Section 83 in audits for prior periods consistent with these regulations.

The final regulations clarify the following:

1. A SRF may be established only through a service condition, a condition related to the purpose of the transfer or potential Section 16(b) “short swing” profit liability.
2. A risk of forfeiture will be an SRF only if both (a) the likelihood that the forfeiture event will occur is substantial and (b) enforcement of  the forfeiture condition is likely.  Whether these requirements are met depends on the facts and circumstances – drafting of the equity award, by itself, does not ensure an SRF.  A typical situation that requires a facts and circumstances analysis is when restricted stock is granted subject to employer-related performance conditions, such as sale of a company or meeting an operational or financial objective.
3. Transfer restrictions such as lock-up agreements, insider trading policies and potential liability under Rule 10b-5 do not create a SRF – in other words, they do not defer the taxable event – even if there is a potential for forfeiture or disgorgement of some or all of the property, or other penalties, if the restriction is violated.  Transfer restrictions under Section 16(b) that avoid short swing profit liability are only an SRF due to an amendment to Section 83 specifically providing for that treatment.

The regulations provide new examples illustrating when transfer restrictions will – and will not – constitute a SRF.  These regulations under section 83 apply to transfers of property on or after January 1, 2013.