The IRS has issued proposed regulations that would make it more difficult to defer taxation on restricted property that is subject to conditions unrelated to the performance of future services.

Compensation in the form of restricted property (such as employer stock) is generally not taxable while it is subject to a substantial risk of forfeiture (SRF). Usually, the SRF is a service condition, i.e., a promise to forfeit the stock if the employee fails to complete a specified term of service with the employer. However, the IRS and courts have recognized that other types of conditions may create an SRF and allow the recipient of restricted property to delay taxation.

Under Prop. Regs. §1.83-3(c)(1), an SRF would be created only by a service condition or a condition related to the purpose of the transfer of the restricted property. Further, the IRS would evaluate whether a condition is related to the purpose of the transfer based on the likelihood that it would ever occur or be enforced. So, for example, conditions such as insider trading restrictions under securities law might not be sufficient and it’s unclear from the proposed rules whether a noncompete agreement would suffice.

It appears that the proposed rule would prevent decisions such as Robinson v. Comr., which the IRS specifically cited in the preamble. In Robinson, the court held that a sell-back provision created an SRF because it served a substantial business purpose. Under the proposed rules, such a condition would likely not create an SRF, unless the recipient successfully argued that the condition was related to the purpose of the transfer.

--Vanessa Walts

Tax Law Editor (Compensation Planning)