Executive Compensation: Tax and Other Considerations for Restricted Stock Awards

Transcription

1 Presenting a live 90-minute webinar with interactive Q&A Executive Compensation: Tax and Other Considerations for Restricted Stock Awards Strategies for Navigating Substantial Risk of Forfeiture Analysis, IRC 83(b) Elections, Interplay With Other IRC Rules and Regulations, and More THURSDAY, JUNE 25, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Stanley Baum, Of Counsel, Cary Kane, New York Joshua M. Miller, Proskauer Rose, Washington, D.C. The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 10. NOTE: If you are seeking CPE credit, you must listen via your computer phone listening is no longer permitted.

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5 RULES AND RECENT DEVELOPMENTS REGARDING PROPERTY TRANSFERRED IN CONNECTION WITH THE PERFORMANCE OF SERVICES UNDER INTERNAL REVENUE CODE SECTION 83 The information provided in this slide presentation is not, is not intended to be, and shall not be construed to be, either the provision of legal advice or an offer to provide legal services, nor does it necessarily reflect the opinions of the firm, our lawyers or our clients. No client-lawyer relationship between you and the firm is or may be created by your access to or use of this presentation or any information contained on them. Rather, the content is intended as a general overview of the subject matter covered. Proskauer Rose LLP (Proskauer) is not obligated to provide updates on the information presented herein. Those viewing this presentation are encouraged to seek direct counsel on legal questions. Proskauer Rose LLP. All Rights Reserved. Stanley Baum, Cary Kane LLP Joshua M. Miller, Proskauer Rose LLP Thursday, June 25, 2015

6 Outline A general overview of the rules and regulations under Section 83 Substantial risk of forfeiture and the timing of taxation under Section 83 Final regulations under Section 83 issued in February 2014 Section 83(b) elections and recent guidance from the IRS Comparison of restricted stock with other types of stock-based compensation (such as RSUs and profits interests) How the substantial risk of forfeiture concept and the timing of taxation under Section 83 compare and interact with other relevant provisions of the Code Practical considerations, practice pointers and drafting tips for implementing restricted stock awards 6

7 General Overview Section 83 Regulations Section 83(a): If, in connection with the performance of services, property is transferred to any person other than the person for whom such services are performed, the excess of (1) the fair market value of such property (determined without regard to any restriction other than a restriction which by its terms will never lapse) at the first time the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier, over (2) the amount (if any) paid for such property, shall be included in the gross income of the person who performed such services in the first taxable year in which the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever is applicable 7

8 General Overview Section 83 Regulations [continued] The taxable amount is compensation includible as ordinary income Prior to the transferred property becoming substantially vested, any amounts received by the recipient in respect of the nonvested property (e.g., dividends or interest on restricted stock) are treated as additional compensation that is immediately taxable to the recipient upon receipt at ordinary income rates. Reg (a) 8

9 Property Reg (e) Property generally includes real and personal property other than either money or an unfunded and unsecured promise to pay money or property in the future Section 83 does not apply to: Transactions subject to section 421 (incentive stock options and employee stock purchase plans) Transfers under qualified plans of deferred compensation subject to section 401(a) or 404(a)(2) Transfers of stock options without a readily ascertainable fair market value Transfers of property pursuant to the exercise of a stock option with a readily ascertainable fair market value Group-term life insurance to which section 79 applies 9

10 Property [continued] Types of Compensatory Property Subject to Section 83 Corporation: Restricted Common Stock Most common Partnership/LLC taxed as Partnership: Partnership Units Capital Interests Profits Interests 10

11 Property [continued] Types of Compensatory Payments Not Subject to Section 83 Cash Contingent rights to receive cash and/or shares in the future Incentive stock options and most nonqualified stock options Long-term cash incentive awards or rights to an allocation from a bonus pool Restricted stock units 11

12 Property [continued] Brief Note on Stock Options Generally the grant and vesting of compensatory options do not constitute transfers of property, unless the option itself is subject to section 83 This is because most compensatory options do not have a readily ascertainable fair market value since the options by contrast to the shares underlying the options typically are not traded on an established market 12

13 Property [continued] General Rule Property is not taxable under section 83(a) until it has been transferred to the employee or independent contractor (the recipient ) and has become substantially vested in that recipient 13

14 Transfer of Property A transfer of property occurs when the recipient acquires a beneficial ownership interest in the property (ignoring any lapse restriction ) Whenever a transfer has in fact occurred is based on all the facts and circumstances 14

15 Beneficial Ownership Interest A person acquires a beneficial ownership interest in property when he or she has been transferred both the right to share in an increase in the value of the property and the obligation to share in the risk of loss in its value. Rev. Ruling Under Reg (a)(3), a transfer may not have occurred if the property is transferred under conditions that require its return upon the happening of an event that is certain to occur, such as the termination of employment 15

16 Substantially Vested Property becomes substantially vested when it either ceases to be subject to a substantial risk of forfeiture or it is transferable. Reg (b) Property is substantially non-vested when it is subject to a substantial risk of forfeiture and is nontransferable. Reg (b) 16

17 Transferable The rights of a recipient in property are transferable if the recipient can transfer any interest in the property to any person (other than the initial transferor of the property), but only if the rights in the property of the transferee are not subject to a substantial risk of forfeiture, i.e., the transfer is made on a fully vested basis Accordingly, property is transferable if the recipient can sell, assign, or pledge (as collateral for a loan, or as security for the performance of an obligation, or for any other purpose) his interest in the property to any person (other than the initial transferor), and if the transferee is not required to give up the property or its value in the event the substantial risk of forfeiture materializes. Reg (d) 17

18 Risk of Substantial Forfeiture Whether a risk of forfeiture is substantial or not depends upon the facts and circumstances A substantial risk of forfeiture exists where rights in property that are transferred are conditioned, directly or indirectly, upon: (1) the future performance (or refraining from performance) of substantial services by recipient, or (2) the occurrence of a condition related to a purpose of the transfer, and the possibility of forfeiture is substantial if such condition is not satisfied. Reg (c) 18

19 Risk of Substantial Forfeiture [continued] Property is not transferred subject to a substantial risk of forfeiture to the extent that the employer is required to pay the fair market value of a portion of such property to the employee upon the return of such 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 nonlapse restriction, standing by itself, will not result in a substantial risk of forfeiture 19

20 Risk of Substantial Forfeiture [continued] Examples If the property is subject to a vesting schedule, under which a portion of the property vests for each year that the recipient remains in employment, such property is subject to a substantial risk of forfeiture If an employee receives property from an employer subject to a requirement that it be returned if the total earnings of the employer do not increase, such property is subject to a substantial risk of forfeiture A requirement that the property be returned to the employer if the employee is discharged for cause or for committing a crime generally will not be treated as a substantial risk of forfeiture 20

21 Risk of Substantial Forfeiture [continued] Examples [continued] Rights in property transferred to a retiring employee subject to the sole requirement that it be returned unless he renders consulting services upon the request of his former employer will not be considered subject to a substantial risk of forfeiture unless he is in fact expected to perform substantial services A requirement that the recipient cannot engage in competition with the employer (that is, a noncompetition agreement) is normally not a substantial risk of forfeiture, but could be treated as such depending on the recipient s age, the availability of alternate employment opportunities, the likelihood of securing other employment, the recipient s job skills and health, and the employer s practice of enforcing such requirement 21

22 Purchase of Property with a Loan Notably the purchase of property with a nonrecourse note secured only by the property may not be a transfer of such property In such a case, Reg (a)(2) treats the property like an option thus no transfer - since there is no personal liability to pay all or a substantial portion of the indebtedness Also note that reduction in principal or forgiveness of a recourse debt would be treated as compensation income Section (c) provides that if indebtedness treated as an amount paid for purposes of section 83 is later cancelled, forgiven or satisfied for an amount that is less than the outstanding indebtedness, the amount of indebtedness that is cancelled, forgiven or not paid is included in the gross income of the purchaser in the year that such cancellation, forgiveness or satisfaction occurs 22

23 Compensation Element The transfer of property is subject to section 83 whether such transfer is in respect of past, present, or future services Property transferred to an employee or an independent contractor (or beneficiary thereof) in recognition of the performance of, or the refraining from performance of, services is considered transferred in connection with the performance of services within the meaning of section 83 The existence of other persons entitled to buy stock on the same terms and conditions as an employee, whether pursuant to a public or private offering may, however, indicate that in such circumstances a transfer to the employee is not in recognition of the performance of, or the refraining from performance of, services 23

24 Compensation Element [continued] Once restricted property becomes substantially vested, the amount taxed generally equals the property s fair market value at the time of substantial vesting, less any amount paid for the property The taxable amount is compensation includible as ordinary income Prior to the transferred property becoming substantially vested, however, any amounts received by the recipient in respect of the non-vested property (e.g., dividends or interest) are treated as additional compensation that is immediately taxable to the recipient upon receipt at ordinary income rates. Reg (a) 24

25 Subsequent Sale, Forfeiture, or Other Disposition of Non-Vested Property Section 83(a) provides, in part, that the general rules shall not apply if such person sells or otherwise disposes of such property in an arm s length transaction before his rights in such property become transferable or not subject to a substantial risk of forfeiture If substantially non-vested property is exchanged for other non-vested property, there is generally no gain on the exchange, and the section 83 rules will apply to the non-vested property received If a recipient of a transfer of compensatory property subsequently sells or otherwise disposes of that property while substantially non-vested, then treatment under section 83 depends on the nature of the sale or other disposition 25

26 Subsequent Sale, Forfeiture, or Other Disposition of Non-Vested Property [continued] If pursuant to an arm's length transaction, then the sale closes the compensation element and the recipient realizes taxable income, treated as ordinary income compensation, equal to the amount realized in such sale or disposition, over the amount (if any) paid for the property. Following the sale, Section 83 no longer applies to the property If pursuant to a non-arm's length transaction (e.g., a gift or discounted sale to a relative), the recipient realizes taxable income, treated as compensation, equal to the sum of (x) any money received in the sale/disposition plus (y) the fair market value of any substantially vested property received, but not in excess of the fair market value of the property sold or disposed of (ignoring any lapse restriction ) minus any amount paid for the property. Further, section 83 continues to apply to the property until the restrictions lapse (except that any amounts previously includible in gross income are treated thereafter as amounts paid for the property) If upon the recipient s death, the property goes to his or her estate or beneficiary, then the income realized on or after death with respect to the property is income in respect of the decedent and generally taxable to the estate or beneficiary under the section 691 rules and in accordance with section 83 rules 26

27 Subsequent Sale, Forfeiture, or Other Disposition of Non-Vested Property [continued] Example: If in 2011 an employee pays $50 for a share of stock which has a fair market value of $100 and is substantially non-vested at that time and later in 2011 (at a time when the property still has a fair market value of $100 and is still substantially non-vested) the employee disposes of, in a transaction not at arm's length, the share of stock to his wife for $10, the employee realizes compensation of $10 in If in 2012, when the share of stock has a fair market value of $120, it becomes substantially vested, the employee realizes additional compensation in 2012 in the amount of $60 (the $120 fair market value of the stock less both the $50 price paid for the stock and the $10 taxed as compensation in 2011). Reg (c) 27

28 Sale or Transfer of Substantially Vested Property Assuming compensation element closed upon vesting (and taxes on the compensation includible in income): Once substantially vested (or if a section 83(b) election was made), sale generally results in recipient recognizing capital gain or loss equal to difference between amount received and basis The recipient s basis in the property is equal to the amount paid plus the compensation included in income upon vesting (or an 83(b) election) Holding period for determining whether the sale results in long- or short-term capital gain/loss begins when compensation element closes 28

29 Forfeiture of Unvested Property If no section 83(b) election has been made: If property is forfeited while still substantially unvested as a result of the applicable service or other forfeiture restrictions and no section 83(b) election (as described below) has been made, then the recipient generally recognizes ordinary loss or gain, equal to the difference (if any) between the amount paid for the property (if any) and the amount received upon forfeiture If a section 83(b) election has been made: Under Reg (a), if the property for which a section 83(b) election is in effect is forfeited while substantially non-vested, the forfeiture is treated as a sale or exchange upon which there is realized a capital loss equal to the excess (if any) of the amount paid (if any) for the property (including any tax paid when the section 83(b) election was made), over the amount realized (if any) upon the forfeiture 29

30 Forfeiture of Vested Property Under Reg (e) - if the recipient is taxable under section 83(a) when the property transferred becomes substantially vested, and - subsequently the property is nonetheless forfeited pursuant to a lapse restriction, then any loss incurred by the recipient (but not a beneficiary) is treated as an ordinary loss to the extent the basis in the property has been increased as a result of the recognition of income under section 83(a) 30

31 Section 83(b) Election Under Reg , if property is transferred to a recipient in connection with the performance of services, and the property is substantially non-vested, the recipient may elect under section 83(b) to include in gross income, as compensation for services, the excess (if any) of The fair market value of the property (ignoring any lapse restriction ) at the time of transfer, over, The amount (if any) paid for such property 31

32 Section 83(b) Election [continued] The fact that the property s fair market value does not exceed the amount paid for it, so there is no bargain element and no amount to include in gross income if the recipient makes the section 83(b) election, does not prevent the recipient from making the election After a timely and valid section 83(b) election is made, the tax rules of section 83 generally no longer apply to the property (e.g., future dividends on the stock are taxed as dividend income not compensation), even if it remains substantially non-vested Exception for cancellation of a non-lapse restriction 32

33 Section 83(b) Election Example With a timely 83(b) Election: Company A is a privately held corporation and no stock in Company A is traded on an established securities market. On April 1, 2012, in connection with the performance of services, Company A transfers to E, its employee, 25,000 shares of substantially non-vested stock in Company A. In exchange for the stock, E pays Company A $25,000, representing the fair market value of the shares at the time of the transfer. The restricted stock agreement provides that if E ceases to provide services to Company A as an employee prior to April 1, 2014, Company A will repurchase the stock from E for the lesser of the then current fair market value or the original purchase price of $25,000. E s ownership of the 25,000 shares of stock will not be treated as substantially vested until April 1, 2014 and will only be treated as substantially vested if E continues to provide services to Company A as an employee until April 1, On April 1, 2012, E makes a valid election under 83(b) with respect to the 25,000 shares of Company A stock. Because the excess of the fair market value of the property ($25,000) over the amount E paid for the property ($25,000) is $0, E includes $0 in gross income for 2012 as a result of the stock transfer and related 83(b) election. The 25,000 shares of stock become substantially vested on April 1, 2014 when the fair market value of the shares is $40,000. No compensation is includible in E s gross income when the shares become substantially vested on April 1, In 2015, E sells the stock for $60,000. As a result of the sale, E realizes $35,000 ($60,000 sale price - $25,000 basis) of gain, which is a capital gain. 33

34 Section 83(b) Election Example [continued] Absent an 83(b) Election: The facts are the same as in the prior example above, except that E does not make an election under 83(b). Under 83(a), E includes $0 in gross income in 2012 as a result of the transfer of stock from Company A because the stock is not substantially vested. When the shares become substantially vested on April 1, 2014, E includes $15,000 ($40,000 fair market value less $25,000 purchase price) of compensation in gross income. E s basis in the stock as of April 1, 2014 is $40,000 ($25,000 paid for the stock and $15,000 included in income under 83(a)). When the stock is sold in 2015 for $60,000, E realizes $20,000 ($60,000 sale price minus $40,000 basis) of gain, which is a capital gain. 34

35 Section 83(b) Election Example [continued] Comparison No Section 83(b) Election Ordinary Income $15,000 $0 Section 83(b) Election Capital Gain $20,000 $35,000 Total $35,000 $35,000 Example based on Revenue Ruling

36 Section 83(b) Election - Requirements Election must set forth the following information: (1) The name, address and taxpayer identification number of the taxpayer; (2) A description of each property with respect to which the election is being made; (3) The date or dates on which the property is transferred and the taxable year for which the election was made; (4) The nature of the restriction or restrictions to which the property is subject; (5) The fair market value at the time of transfer (determined without regard to any lapse restriction) of each property with respect to which the election is being made; (6) The amount (if any) paid for such property; and (7) A statement to the effect that copies have been furnished to the IRS and service recipient. 36

37 Section 83(b) Election Requirements [continued] Election must be filed with IRS not later than 30 days after the date of transfer However, if the 30 th day following the date of transfer falls on a Saturday, Sunday or legal holiday, the election will be considered timely filed if postmarked by the next business day Copies must be provided to the service recipient (e.g., the employer/company) and included with the recipient s income tax return for the tax year in which transfer occurs 37

38 Section 83(b) Election Requirements [continued] Generally mail to IRS office where federal income taxes are filed See IRS website for addresses at Professionals Practice Pointer: Use certified mail, return-receipt requested so you have proof of timely filing 38

39 Section 83(b) Election Model Election Revenue Procedure Model Election and Guidance Contains sample language that may be used (but is not required to be used) for making an election under 83(b) of the Internal Revenue Code Includes several examples of the income tax consequences of making an 83(b) election 39

40 Revocation of an 83(b) Election Generally not permitted except with the consent of the IRS and where there has been a mistake of fact must be requested within 60 days of knowledge of mistake. Reg (f) Neither a mistake as to the value (or decline in the value) of the property for which the election was made nor the failure of anyone to perform an act that was contemplated at the time of transfer of the property constitutes a mistake of fact for this purpose See Rev. Proc for guidance with respect to revoking a section 83(b) election 40

41 Cancellation of a Nonlapse Restriction Tax recognition may be required in the event of a cancellation of a nonlapse restriction. Reg (a) A nonlapse restriction is a permanent limitation on the transferability of property which: (1) will require the recipient to sell, or offer to sell, the property at a price determined under a formula, and (2) will continue to apply to and be enforced against the recipient. Reg (h) A lapse restriction means a restriction other than a nonlapse restriction, and includes (but is not limited to) a restriction that carries a substantial risk of forfeiture. Reg (i) 41

42 Cancellation of a Nonlapse Restriction [continued] Example of a nonlapse restriction -- A limitation subjecting the property to a permanent right of first refusal in a particular person at a price determined under a formula An obligation to resell or to offer to sell property transferred in connection with the performance of services to a specific person or persons at its fair market value at the time of such sale is not a nonlapse restriction 42

43 Cancellation of a Nonlapse Restriction [continued] Taxable Income Realized If a nonlapse restriction on the property is cancelled, the recipient must realize taxable income, as compensation, unless the recipient establishes that: (1) the cancellation was not compensatory under all facts and circumstances, and (2) the person who would otherwise be allowed a deduction will treat the cancellation as not compensatory 43

44 Cancellation of a Nonlapse Restriction [continued] Amount of Taxable Income If taxable income must be recognized, the amount of the taxable income will equal the excess of: (a) the fair market value of such property (computed without regard to the nonlapse restriction ) at the time of cancellation, over (b) the sum of (i) the fair market value of the property (computed by taking the nonlapse restriction into account) immediately before the cancellation, and (ii) the amount, if any, paid for the cancellation Reg (b)(1) 44

45 Stock Options Generally Grant of Options Statutory (i.e., incentive) stock options and employee stock purchase plans are not subject to section 83 Code 83(e) The grant of a nonstatutory option to purchase property does not constitute a transfer of that property. Reg (a)(2) However, the option itself may be subject to section 83 if it has a readily ascertainable fair market value at the time of grant. Reg (a) 45

46 Stock Options Generally [continued] Readily Ascertainable Defined Options have a value at the time they are granted, but that value is ordinarily not readily ascertainable unless the option is actively traded on an established market If an option is actively traded on an established market, the fair market value of such option is readily ascertainable for purposes of this section by applying the rules of valuation set forth in Established markets for example, the Chicago Board of Options Exchange or the American Stock Exchange In such a case, option is taxed as property under section 83 46

47 Stock Options Generally [continued] Readily Ascertainable Defined (continued) If an option is not actively traded on an established market, it does not have a readily ascertainable fair market value unless the recipient can show that all of the following conditions exist: The option is transferable by the recipient; The option is exercisable immediately in full by the recipient; The option or the property subject to the option is not subject to any restriction or condition (other than a lien or other condition to secure the payment of the purchase price) which has a significant effect upon the fair market value of the option; and The fair market value of the option privilege (the right to benefit from an increase in the value of the underlying property while holding the option) is readily ascertainable in accordance with Reg (b)(3) (requiring that the fair market value must be measurable with reasonable accuracy) 47

48 Stock Options - Taxation Taxation Generally - Treas. Reg (a) If a recipient is granted a nonstatutory option for the performance of services, the recipient realizes compensation: (1) at the time of grant, in the amount of option s fair market value at that time less any amount paid for it, if the option has a readily ascertainable fair market value at time of grant, or (2) if the option does not have a readily ascertainable fair market value at the time of grant, at the time the option is exercised or otherwise disposed of, in the amount equal to the fair market value of the property received on the exercise or disposition date less the exercise price. 48

49 Stock Options Taxation [continued] Sale of the Property Acquired Upon Exercise Of The Option If the property acquired upon exercise of an option is sold, then the recipient recognizes capital gain, equal to the excess of the amount of cash or other property received due to the sale, less the basis in the property Basis generally is the exercise price paid, plus any compensation realized under (1) or (2) above 49

50 Stock Options Taxation [continued] Substantial Risk of Forfeiture The above assumes that the property received upon exercise of the option was not subject to a substantial risk of forfeiture If the property underlying the option is subject to a substantial risk of forfeiture, tax treatment depends upon whether there is a readily ascertainable fair market value: If not, then tax is not recognized on the property until the time of exercise of the option. If yes, then section 83 would apply to the option itself (but not the underlying property) absent an 83(b) election as to the unvested option, taxation occurs when the restrictions lapse no compensation income upon exercise 50

51 Stock Options Sale of the Option If the option did not have a readily ascertainable value at grant, and then is sold in an arm s length transaction before exercise, the recipient realizes compensation equal to the amount received for the option, less any basis. Section 83 would cease to apply with respect to the property. If the sale is not at arm s length (e.g., a sale to a related party such as a spouse), presumably, section 83 continues to apply to the underlying property. If the option did have a readily ascertainable value at grant, and then is sold before exercise, the recipient realizes capital gain or loss equal to the difference between the amount received for the option and any basis. Reg (a) 51

52 Partnership Interests Generally Partnership interests generally constitute property Capital interests give the holder a right to participate in liquidation of the partnership from and after the date of issuance immediate entitlement to liquidation proceeds If unrestricted and compensatory, income on date of transfer rules of partnership income apply to future allocations and distributions after the compensation element is closed Profits interests -give the holder a right to share in distributions/gains above the liquidation value of the partnership on the date of issuance 52

53 Profits Interest Units IRS gives safe harbor for unvested profits interest units whereby if properly structured: Value of profits interests at issuance is $0 for tax purposes Neither issuance nor later vesting will be taxable if grantee is treated as owner from date of issuance and partnership does not claim deduction Safe harbor not available if disposed of within two years of receipt, if associated with interest in publicly traded partnership or if relate to a substantially certain and predictable stream of income Risk that carried interest legislation could change characterization of profits interests Query: What if fail to meet safe harbor requirements? Units taxable at later vesting? 53

54 Profits Interest Units [continued] Protective 83(b) elections Under Reg (a), the fact that the property s fair market value does not exceed the amount paid for it, so there is no amount to include in gross income if the recipient makes the section 83(b) election, does not prevent the recipient from making the election No requirement to make a section 83(b) election, but 83(b) election on restricted profits interests is available at the liquidation value of $0 on the date of grant 54

55 Service Recipient Tax Deduction Entitlement To A Deduction If property is transferred as compensation for service, or a nonlapse restriction on such property is cancelled while the property is substantially non-vested, the person for whom the service was performed is entitled to a tax deduction, under section 162 or 212 of the Code, in an amount equal to the compensation realized by the recipient of the property, but only to the extent the amount meets the ordinary and necessary and reasonableness requirements of section 162 or 212 The deduction arises at the same time that the recipient realizes the compensation To be entitled to the deduction, the recipient s compensation must be reported on Form W-2 or Form 1099, as applicable Reg (a) 55

56 Service Recipient Tax Deduction [continued] Gain or Loss - Reg (b) In general, at the time of a transfer of property (other than employer stock) in connection with the performance of services, the employer recognizes gain to the extent that the employer receives an amount for the property that exceeds the employer s basis in the property. In addition, at the time a deduction is allowed as above, gain or loss is recognized by the employer to the extent of the difference between: (1) the sum of the amount paid to the employer plus the amount allowed as a deduction as above, and (2) the sum of the employer's basis in the property plus any gain recognized on the initial transfer Code 1032(a) However, no gain or loss recognized to a corporation on the receipt of money or other property in exchange for stock (including treasury stock) of such corporation. No gain or loss shall be recognized by a corporation with respect to any lapse or acquisition of an option, or with respect to a securities futures contract, to buy or sell its stock (including treasury stock). 56

57 Service Recipient Tax Deduction [continued] Income Paid On Restricted Property Until the transferred property becomes substantially vested, any income (e.g., dividends or interest) the recipient obtains from the property is deductible by the employer, so long as the reasonableness requirement of section 162 is met Property Returned On Forfeiture If a deduction is allowable to the employer under the section 83 rules (disregarding the reasonableness of the amount of compensation) in respect of a transfer of property, and the property is subsequently forfeited by the recipient, the amount of such deduction becomes includible in the employer s gross income under Reg (c) Parent Company Stock When a subsidiary transfers the stock of its parent company for services rendered, then the subsidiary (not the parent) is entitled to the tax deduction 57

58 New Final Regulations Under Section 83 Generally On February 25, 2014, the Treasury Department and IRS issued final regulations clarifying the forfeiture provisions under Section 83, for transactions occurring after January 1, 2013 The regulations are consistent with prior guidance, except that they offer several clarifications on what constitutes a substantial risk of forfeiture The final regulations further clarify the impact of insider trading restrictions under Section 16(b) of the Securities Exchange Act of 1934 and involuntary separations from service on the Section 83 substantial risk of forfeiture analysis 58

59 New Final Regulations Under Section 83 [continued] More specifically, the new provision of the final regulations clarifies the meaning of a substantial risk of forfeiture for purposes of section 83 Absent a section 83(b) election, transferred unvested property becomes taxable to the recipient, under the section 83 regulations, when it becomes transferable by the recipient, or when it ceases to have a substantial risk of forfeiture 59

60 New Reg (c)(1): For purposes of section 83 and the these regulations thereunder, whether a risk of forfeiture is substantial or not depends upon the facts and circumstances. A Except as set forth in paragraphs (j) and (k) of this section, a substantial risk of forfeiture exists where `only if rights in property that are transferred are conditioned, directly or indirectly, upon the future performance (or refraining from performance) of substantial services by any person, or upon the occurrence of a condition related to a purpose of the transfer, and if the possibility of forfeiture is substantial if such. Property is not transferred subject to a substantial risk of forfeiture if at the time of transfer the facts and circumstances demonstrate that the forfeiture condition is not satisfied. Property unlikely to be enforced. Further, property is not transferred subject to a substantial risk of forfeiture to the extent that the employer is required to pay the fair market value of a portion of such property to the employee upon the return of such 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 nonlapse restriction, standing by itself, will not result in a substantial risk of forfeiture. A restriction on the transfer of property, whether contractual or by operation of applicable law, will result in a substantial risk of forfeiture only if and to the extent that the restriction is described in paragraph (j) or (k) of this section. For this purpose, transfer restrictions that will not result in a substantial risk of forfeiture include, but are not limited to, restrictions that if violated, whether by transfer or attempted transfer of the property, would result in the forfeiture of some or all of the property, or liability by the employee for any damages, penalties, fees, or other amount. 60

61 Substantial Risk of Forfeiture under the Final Regulations Facts and Circumstances Test The revised provision continues the idea that the existence of a substantial risk of forfeiture depends on all facts and circumstances For example, as indicated in the current regulations (Reg (c)(2)), in determining whether a covenant not to complete constitutes a substantial risk of forfeiture as to an employee, factors to be considered include: For an employee, the employee s age; The availability of alternative employment opportunities; The likelihood of the employee's obtaining such other employment; The degree of skill possessed by the employee; The employee's health; and The practice (if any) of the employer to enforce such covenants 61

62 Substantial Risk of Forfeiture under the Final Regulations [continued] The new provision indicates that a substantial risk of forfeiture will not exist, unless, at a minimum, the recipient s rights in the transferred property are either: (a) conditioned on the future performance, or future refraining from performance of substantial services, or (b) subject to a condition related to the purpose of the transfer if the possibility of not satisfying the condition is substantial 62

63 Substantial Risk of Forfeiture under the Final Regulations [continued] Likelihood of Occurrence and Enforcement : A substantial risk of forfeiture will not exist, if at the time of the property transfer the facts and circumstances demonstrate that the forfeiture condition is unlikely to occur or be enforced Implication for non-compete clauses? 63

64 Substantial Risk of Forfeiture under the Final Regulations [continued] Employer Does NOT Pay FMV For Property The new provision indicates that a substantial risk of forfeiture will not exist to the extent the employer is required to pay the fair market value of a portion of the transferred property to the employee if he or she returns the property No Substantial Risk Of Forfeiture Each of the following, by itself, will not result in a substantial risk of forfeiture The risk that the value of property will decline during a certain period of time; or The existence of a nonlapse restriction on the transferred property 64

65 Substantial Risk of Forfeiture under the Final Regulations [continued] A restriction on the transfer of property, whether contractual or by operation of applicable law, will result in a substantial risk of forfeiture only if and to the extent that the restriction is described in paragraph (j) or (k) of Reg Under paragraph (j), if the sale of the property at a profit, within six months after the transfer of the property to the recipient, could subject the recipient to suit under section 16(b) of the Securities Exchange Act of 1934, the recipient s rights in the property are treated as subject to a substantial risk of forfeiture and as not transferable until the earlier of (i) the expiration of such six-month period, or (ii) the first day on which the sale of such property at a profit will not subject the person to such suit Under paragraph (k), the property is subject to substantial risk of forfeiture and is not transferable so long as the property is subject to a restriction on transfer to comply with the Pooling-of-Interests Accounting rules set forth in Accounting Series Release Numbered

66 Substantial Risk of Forfeiture under the Final Regulations [continued] For these purposes, transfer restrictions that will not result in a substantial risk of forfeiture include restrictions that if violated, whether by transfer or attempted transfer of the property, would result in the forfeiture of some or all of the property, or liability by the recipient for any damages, penalties, fees, or other amount Such restrictions include insider-trading restrictions, Rule 10b-5 policies, lockup arrangements and blackout periods 66

67 Substantial Risk of Forfeiture under the Final Regulations [continued] Note that the rules under paragraph (j) will not be applicable if the recipient has made a section 83(b) election Also, as the new examples in the Final Regulations make clear, the six month period in paragraph (j) cannot be extended, at least for tax purposes, by making new purchases that may extend the period for security law purposes 67

68 Substantial Risk of Forfeiture under the Final Regulations - Examples (c)(4) Example 6. On April 3, 2013, Y corporation grants to Q, an officer of Y, a nonstatutory option to purchase Y common stock. Although the option is immediately exercisable, it has no readily ascertainable fair market value when it is granted. Under the option, Q has the right to purchase 100 shares of Y common stock for $10 per share, which is the fair market value of a Y share on the date of grant of the option. On August 1, 2013, Y sells its common stock in an initial public offering. Pursuant to an underwriting agreement entered into in connection with the initial public offering, Q agrees not to sell, otherwise dispose of, or hedge any Y common stock from August 1 through February 1 of 2014 ( the lock-up period ). Q exercises the option and Y shares are transferred to Q on November 15, 2013, during the lock-up period. The underwriting agreement does not impose a substantial risk of forfeiture on the Y shares acquired by Q because the provisions of the agreement do not condition Q s rights in the shares upon anyone s future performance (or refraining from performance) of substantial services or on the occurrence of a condition related to the purpose of the transfer of shares to Q. Accordingly, neither section 83(c)(3) nor the imposition of the lock-up period by the underwriting agreement precludes taxation under section 83 when the shares resulting from exercise of the option are transferred to Q. 68

69 Substantial Risk of Forfeiture under the Final Regulations Examples [continued] (c)(4) Example 7. Assume the same facts as in Example 6, except that on August 1, 2013, Y also adopts an insider trading compliance program, under which, as applied to 2013, insiders (such as Q) may trade Y shares only during a limited number of days following each quarterly earnings release ( a trading window ). Under the program, if Q trades Y shares outside a trading window without Y s permission, Y has the right to terminate Q s employment. However, the exercise of the nonstatutory options outside a trading window for Y shares is not prohibited under the insider trading compliance program. Q fully exercises the option, and Y shares are transferred to Q, on November 15, The exercise of the option occurs outside a trading window, and, on the date of exercise, Q is in possession of material nonpublic information concerning Y that would subject him to liability under Rule 10b 5 under the Securities Exchange Act of 1934 if Q sold the Y shares while in possession of such information. Neither the insider trading compliance program nor the potential liability under Rule 10b 5 impose a substantial risk of forfeiture on the Y shares acquired by Q because the provisions of the program and Rule 10b 5 do not condition Q s rights in the shares upon anyone s future performance (or refraining from performance) of substantial services or on the occurrence of a condition related to the purpose of the transfer of shares to Q. Accordingly, none of section 83(c)(3), the imposition of the trading windows by the insider trading compliance program, and the potential liability under Rule 10b 5 preclude taxation under section 83 when the shares resulting from exercise of the option are transferred to Q. 69

70 Substantial Risk of Forfeiture under the Final Regulations Examples [continued] (j)(2) Example 4. (i) On June 3, 2013, Y corporation grants to Q, an officer of Y, a nonstatutory option to purchase Y common stock. Y stock is traded on an established securities market. Although the option is immediately exercisable, it has no readily ascertainable fair market value when it is granted. Under the option, Q has the right to purchase 100 shares of Y common stock for $10 per share, which is the fair market value of a Y share on the date of grant of the option. The grant of the option is not one that satisfies the requirements for a transaction that is exempt from section 16(b) of the Securities Exchange Act of On December 15, 2013, Y stock is trading at more than $10 per share. On that date, Q fully exercises the option, paying the exercise price in cash, and receives 100 Y shares. Q s rights in the shares received as a result of the exercise are not conditioned upon the future performance of substantial services. Because no exemption from section 16(b) was available for the June 3, 2013 grant of the option, the section 16(b) liability period expires on December 1, Accordingly, the section 16(b) liability period expires before the date that Q exercises the option and the Y common stock is transferred to Q. Thus, the shares acquired by Q pursuant to the exercise of the option are not subject to a substantial risk of forfeiture under section 83(c)(3) as a result of section 16(b). As a result, section 83(c)(3) does not preclude taxation under section 83 when the shares acquired pursuant to the December 15, 2013 exercise of the option are transferred to Q. 70

71 Substantial Risk of Forfeiture under the Final Regulations Examples [continued] (j)(2) Example 4. (ii) Assume the same facts as in paragraph (i) of this Example 4 except that Q exercises the nonstatutory option on October 30, 2013 when Y stock is trading at more than $10 per share. The shares acquired are subject to a substantial risk of forfeiture under section 83(c)(3) as a result of section 16(b) through December 1,

72 Substantial Risk of Forfeiture under the Final Regulations Examples [continued] (j)(2) Example 4. (iii) Assume the same facts as in paragraph (i) of this Example 4 except that on November 5, 2013, Q also purchases 100 shares of Y common stock on the public market. The purchase of the shares is not a transaction exempt from section 16(b) of the Securities Exchange Act of Because no exemption from section 16(b) was available for the November 5, 2013 purchase of shares, the section 16(b) liability period with respect to such shares will last for a period of six months after the November 5, 2013 purchase of shares. Notwithstanding the non-exempt purchase of Y common stock on November 5, 2013, the shares acquired by Q pursuant to the December 15, 2013 exercise of the option are not subject to a substantial risk of forfeiture under section 83(c)(3) as a result of section 16(b). As a result, section 83(c)(3) does not preclude taxation under section 83 when the shares acquired pursuant to the December 15, 2013 exercise of the option are transferred to Q. 72