The IRS has proposed regulations relating to “restricted property” (property transferred from an employer to an employee as compensation for the performance of services). The proposed rules would limit the types of restrictions that the IRS would view as imposing a “substantial risk of forfeiture” (SRF). Unless an employee’s rights to restricted property are subject to a substantial risk that the employee might have to forfeit the property in the future (such as a vesting schedule which requires the employee to perform additional service before becoming entitled to the property), the employee must pay income tax immediately on the property’s fair market value. While forfeiture restrictions remain in place and are substantial, the employee can defer paying federal income tax on the property’s value until the restrictions lapse sometime in the future.
Under IRS rules, a SRF exists where the employee’s rights to the property are conditioned, directly or indirectly, on the employee performing, or refraining from performing, substantial future services. Before the IRS’s new proposed regulations, there had been some doubt in the tax community as to whether any restriction, other than a requirement that the employee perform substantial future services, could create a substantial forfeiture risk and therefore delay taxation.
The new regulations make it clear that conditions that are unlikely to occur do not delay taxation of the employee, even if the restrictions are, arguably, “related to the purpose for which the property is transferred” (another exception to immediate taxation).
As an example of such an improbable restriction, the IRS cites as an example the situation where an employer grants the employee stock in the employer but provides that the grant will be revoked if the employer’s gross receipts from business drop 90% or more over the next three years. In the IRS’s view, even though such business reversals do occur, they are too unlikely to create a real risk that the employee may hagve to forfeit the stock in the future and therefore they will not delay the time at which the employee must pay tax on the property’s value.
The test is really a “facts and circumstances” test, but the new rules clearly warn employers and employees that the possibility that the employee may forfeit his or her rights to the property in the future must be substantial and realistic in order for taxation to be deferred.