Substantial Risk of Forfeiture

A substantial risk of forfeiture is a condition attached to compensation that creates a genuine possibility the recipient will lose it. Internal Revenue Code section 83(c)(1) puts it this way: rights in property are subject to a substantial risk of forfeiture "if such person's rights to full enjoyment of such property are conditioned upon the future performance of substantial services by any individual." The ordinary example is a grant of employer shares that must be given back if the employee leaves before a vesting date.

Its importance is entirely about timing. Section 83(a) taxes property transferred in connection with services in the first year in which the recipient's rights are either transferable or no longer subject to a substantial risk of forfeiture, whichever comes first. So the existence of the risk is what postpones the tax bill, and the moment it lapses is the moment ordinary income is recognized, measured at that later value.

Two regulations define the phrase, for two different bodies of rules, and their wording does not quite match. Treasury Regulation 1.83-3(c)(1), under section 83, reaches rights conditioned "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 if the possibility of forfeiture is substantial." Treasury Regulation 1.409A-1(d)(1), governing nonqualified deferred compensation, uses nearly the same formula but drops the refraining-from-performance branch and then excludes it by name. Both regulations reach further than the bare statutory sentence at section 83(c)(1), and the places where they differ from each other are where arrangements fail.

What section 83 says, and what its regulation adds. Paragraph (c)(1) of the statute is the service condition and nothing more. The regulation goes further: 1.83-3(c)(1) extends the test to a condition on refraining from performing substantial services and to a condition related to a purpose of the transfer, and it attaches two limits worth knowing. Property is not subject to a substantial risk of forfeiture where the facts at the time of transfer show the forfeiture condition is unlikely to be enforced, and it is not at risk to the extent the employer must pay fair market value for part of the property when it comes back. The statute has two further parts people skip. Paragraph (c)(2) defines transferability in terms of the same idea: rights in property are transferable only if a transferee's rights would not themselves be subject to a substantial risk of forfeiture. That circularity is deliberate, and it closes the obvious workaround of selling the shares while the forfeiture condition still binds. Paragraph (c)(3) adds a narrow rule for insiders: so long as selling at a profit could expose the person to suit under section 16(b) of the Securities Exchange Act of 1934, the rights are both subject to a substantial risk of forfeiture and not transferable.

The 409A definition covers much the same ground from a different angle. The regulation's own words are that compensation is subject to a substantial risk of forfeiture "if entitlement to the amount is conditioned on the performance of substantial future services by any person or the occurrence of a condition related to a purpose of the compensation, and the possibility of forfeiture is substantial." It then tells you what a purpose-related condition means: it must relate to the service provider's performance for the employer or to the employer's business activities or organizational goals, and the examples given are the attainment of a prescribed level of earnings or equity value, or the completion of an initial public offering. Separately, and with no counterpart in the section 83 regulation, it provides that where entitlement turns on the service provider's involuntary separation from service without cause, the right is subject to a substantial risk of forfeiture if the possibility of forfeiture is substantial. A severance arrangement can therefore carry a risk of forfeiture even though no one is being asked to keep working.

Two things the 409A definition rules out, and the first is where the two regulations part company. A covenant not to compete does not create a risk of forfeiture for 409A purposes: "An amount is not subject to a substantial risk of forfeiture merely because the right to the amount is conditioned, directly or indirectly, upon the refraining from the performance of services." The section 83 regulation is softer. An enforceable requirement that the property be returned if the employee accepts a job with a competing firm "will not ordinarily be considered to result in a substantial risk of forfeiture unless the particular facts and circumstances indicate to the contrary", and the regulation lists what those facts are: the employee's age, the availability of alternative employment and the likelihood of obtaining it, the degree of skill possessed, the employee's health, and whether the employer has a practice of enforcing such covenants. A non-compete is a weak reed under section 83 and no reed at all under 409A. Second, adding a forfeiture condition after the legally binding right to the compensation has already arisen is disregarded, and so is extending the period an existing condition runs for, subject to one carve-out for certain transaction-based compensation tied to a change in control event. Deferral by retrofitted strings is not available.

The salary-deferral limit. The regulation also provides that an amount will not be treated as subject to a substantial risk of forfeiture beyond the date the recipient could otherwise have elected to receive it, unless the present value of the at-risk amount, ignoring the risk itself, is materially greater than the present value of what they could have taken instead. Its own illustration is blunt: deferring salary generally cannot be made subject to a substantial risk of forfeiture, because the employee could simply have taken the salary. But where a bonus plan offers a choice between cash and restricted stock units worth materially more that will be forfeited without continued service, the units generally do carry a real risk of forfeiture.

"Substantial" is a factual question, and ownership makes it a harder one. The regulation directs that where the person receiving the compensation owns a significant amount of the employer's equity, measured with section 318 attribution for a corporation, all the facts and circumstances are weighed in deciding whether the employer would really enforce the forfeiture, including that person's relationship to the other equity holders and the extent of their control. A founder who writes her own vesting schedule and could rewrite it tomorrow has a weaker case than an employee at arm's length. A stock right gets its own rule: an option stops being subject to a substantial risk of forfeiture at the earlier of the first date it may be exercised for substantially vested stock and the first date it carries no qualifying forfeiture condition, so an immediately exercisable option is not protected by the fact that it lapses on departure.

1. Find the condition. Read the grant or plan document for what has to happen before the money or property is unconditionally the recipient's.

2. Ask which body of rules you are in. Property transferred for services is tested under section 83(c). Deferred compensation subject to section 409A is tested under the 409A regulation, which is broader.

3. Check that the condition is of a qualifying kind. Continued substantial service qualifies under both regulations, and so does a condition tied to a business purpose such as an earnings target or a completed offering. A non-compete is excluded outright for 409A and will not ordinarily qualify under section 83.

4. Check that the risk is substantial in fact, taking account of who would have to enforce it and whether they realistically would.

5. Check the timing of the condition itself. A condition added after the right to the compensation already existed, or an extension of one already running, is generally ignored for 409A purposes.

6. Apply the consequence. Under section 83(a), the property is included in income in the first year the rights become transferable or the risk lapses, valued at that point.

Take an example, with invented figures. Chen receives 6,000 shares of her employer's stock as compensation when the shares are worth $3.00 each. The grant provides that she forfeits every share if she leaves before the third anniversary. That is a condition on the future performance of substantial services, so the shares are subject to a substantial risk of forfeiture and nothing goes on her return at grant.

Three years later the condition lapses and the shares are worth $11.00. Because the risk has ended and the shares are now freely transferable, section 83(a) brings them into income then: 6,000 x $11.00 = $66,000 of ordinary compensation income, rather than the 6,000 x $3.00 = $18,000 she would have reported had the shares been unconditionally hers from the start. The risk of forfeiture bought three years of deferral and cost her tax on the $66,000 - $18,000 = $48,000 of appreciation at ordinary rates rather than capital rates. Had the grant instead said she forfeits the shares only if she went to work for a competitor, 1.83-3(c)(2) would ordinarily treat that as no qualifying condition at all, so the shares would have been taxable at grant unless the particular facts pointed the other way.

Why the condition is used

• It postpones the tax. While the risk exists, section 83(a) has nothing to include, so the recipient is not taxed on value they might never receive.
• It aligns the employer's payment with the thing being bought, whether that is years of service, an earnings target or a completed transaction.
• Both regulations let a business milestone satisfy it, which lets a company reward the outcome rather than only the attendance.
• It is what makes the 83(b) election available on restricted property, since without a risk of forfeiture there is nothing to elect out of.

Where it goes wrong

• Deferral is not free. The tax arrives at the later value, so a grant that appreciates sharply is taxed on the whole appreciation at ordinary rates.
• The two definitions are not the same, and an arrangement designed against the section 83 test can still fail the 409A test, whose penalties are severe.
• The condition must be substantial in fact, which is a judgment call, and it is weakest exactly where the recipient has the most control over the employer.
• It cannot be created retroactively. A forfeiture condition added after the right already arose is generally disregarded.
• A non-compete, the condition employers most often think of as a forfeiture risk, is excluded outright under 409A and will not ordinarily count under section 83 either.