Equity Compensation and Nonqualified Deferred Compensation: Reconciling What Constitutes a "substantial Risk of Forfeiture" Under Sections 83 and 409a of the Internal Revenue Code

• Publication year: 2022

51 Creighton L. Rev. 1. EQUITY COMPENSATION AND NONQUALIFIED DEFERRED COMPENSATION: RECONCILING WHAT CONSTITUTES A "SUBSTANTIAL RISK OF FORFEITURE" UNDER SECTIONS 83 AND 409A OF THE INTERNAL REVENUE CODE

EQUITY COMPENSATION AND NONQUALIFIED DEFERRED COMPENSATION: RECONCILING WHAT CONSTITUTES A "SUBSTANTIAL RISK OF FORFEITURE" UNDER SECTIONS 83 AND 409A OF THE INTERNAL REVENUE CODE

PETER M. LANGDON(fn*)

I. INTRODUCTION

Two provisions of the Internal Revenue Code ("Code") define "a substantial risk of forfeiture" regarding equity compensation and nonqualified deferred compensation.(fn1) Code § 83 states that the excess of the fair market value of property over the amount paid, if any, for such property that is conveyed in exchange for services is excluded from the gross income of the service provider in the year of the transfer if a substantial risk of forfeiture is included as a restriction to the enjoyment of the property and the rights to property are nontransferable.(fn2) Code § 409A similarly states that deferred compensation is excludable from a taxpayer's gross income if the compensation is subject to a substantial risk of forfeiture and has not previously been included in the gross income of the taxpayer, provided the requirements of § 409A are satisfied.(fn3) The Internal Revenue Service ("IRS") has asserted, contrary to commentator suggestions, in the preamble to regulations under Code § 409A that the definition of what constitutes a substantial risk of forfeiture under Code §§ 409A and 83 is not the same.(fn4) However, this Article will examine three specific examples where a substantial risk of forfeiture is interpreted inconsistently under Code §§ 83 and 409A, and will argue for a uniform interpretive approach as to the three specific examples of what may or may not constitute a substantial risk of forfeiture.

The three situations this Article contemplates are non-compete agreements, termination for cause provisions, and involuntary separation from service provisions. First, the regulations under Code § 83 intimate that a substantial risk of forfeiture may be present when two parties establish a non-compete arrangement.(fn5) However, in slight but pertinent distinction, the regulations under Code § 409A explicitly state that a non-com-pete agreement does not constitute a substantial risk of forfeiture.(fn6) Second, Code § 409A contains no indication as to whether a termination for cause provision creates a substantial risk of forfeiture. Conversely, Code § 83 states that a termination for cause provision does not constitute a substantial risk of forfeiture.(fn7) Finally, an involuntary separation from service without cause provision constitutes a substantial risk of forfeiture under Code § 409A,(fn8) but does not constitute a substantial risk of forfeiture under Code § 83.(fn9)

Although the statutory language in each Code section ostensibly defines a substantial risk of forfeiture, the reality is that Code §§ 83 and 409A do not define substantial risk forfeiture in the same manner.(fn10) As such, each Code section may carry a differing interpretation as to what constitutes a substantial risk of forfeiture in a given circumstance.(fn11) Under the current landscape, the practical significance of subtle distinctions as to what constitutes a substantial risk of forfeiture under Code §§ 83 and 409A may lead to burdensome consequences if a practical application method is incorrect.(fn12) Therefore, the IRS should apply a uniform interpretive approach to the application of what constitutes a substantial risk of forfeiture under Code §§ 83 and 409A.

First, this Article will discuss what constitutes a substantial risk of forfeiture under Code § 83.(fn13) Second, this Article will discuss the meaning of a substantial risk of forfeiture under Code § 409A.(fn14) Third, this Article will argue in favor of applying a uniform interpretive approach as to what constitutes a substantial risk of forfeiture under the aforementioned Code sections.(fn15)

II. BACKGROUND

A. SUBSTANTIAL RISK OF FORFEITURE UNDER CODE SECTION 83 1. Overview of Equity-Based Compensation Under Code Section 83

Section 83 of the Code regulates the income tax consequences of property transfers from service recipients to service providers, namely equity compensation.(fn16) Recently, equity-based pay, or mixed pay of cash and equity, has burgeoned, showing that the median values of total Chief Executive Officer ("CEO") compensation reached 62.9% in the S&P 500 and 56.3% in the S&P 1500.(fn17) What is more, the share of CEOs that received any type of equity-based compensation in 2013 was 75.7% in the S&P 500 and 63.8% in the S&P 1500.(fn18) Interestingly, the median performance-based equity compensation in the S&P 500 reached $3.4 million in 2013, an increase of 52% from 2009.(fn19)

Property in the form of equity compensation transferred to a service provider, pursuant to Code § 83, is includable in the gross income of the service provider once the property is no longer subject to a substantial risk of forfeiture or when the property becomes transferable, whichever occurs earlier.(fn20) Code § 83 statutorily defines a substantial risk of forfeiture, "[t]he rights of a person 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."(fn21) Numerous options are available to deliver equity compensation, which include, but are not limited to, nonqualified stock options, incentive stock options, stock appreciation rights, restricted stock, restricted stock units, or performance shares.(fn22) The characterization of the income, capital or ordinary, will depend on the type of equity at issue.(fn23) For purposes of this Article, and specifically this subsection, the focus is centered upon restricted stock. Under a restricted stock arrangement, once the stock is includable in the taxpayer's ordinary income, the service recipient is entitled to a deduction, in the same taxable year as the inclusion.(fn24) Under Code § 83(h), the service recipient that transfers the restricted stock is entitled to a deduction under Code § 162 in the year in which the earlier of two events occurs: (1) the stock becomes transferable, or (2) the stock is no longer subject to a substantial risk of forfeiture.(fn25) The amount of the deduction equals the amount included in the taxpayer's gross income.(fn26) The most notable characteristic of § 83 is an optional election for the service provider to incur the tax in a year preceding the date on which the tax would otherwise be imposed.(fn27)

Generally, an election under Code § 83(b) must occur in the year in which the stock is transferred.(fn28) The same rules under an 83(b) election also apply in the absence of an election; the amount included in the gross income of the taxpayer is characterized as ordinary, and the amount included in the service provider's gross income equals the excess of the fair market value of the property over the amount paid for the property, if any.(fn29) Furthermore, although the property at the time of inclusion, pursuant to an 83(b) election, is substantially not vested, the subsequent vesting of the restricted stock will not be included in the gross income of the taxpayer, and subsequent stock appreciation is disregarded in determining the tax liability of the service provider.(fn30) Since the taxpayer incurs a tax liability on the inclusion, the taxpayer will receive basis in the stock equal to the amount paid for the stock increased by the amount that is included in the gross income of the taxpayer upon the 83(b) election.(fn31) The basis determination is important because the taxpayer will likely sell or exchange the stock at a later date thereby incurring a capital gain or loss, provided the holding period is satisfied.(fn32) Although an 83(b) election is an effective financial planning tool for individuals who receive restricted stock as part of an equity-based compensation arrangement, such an election is not always advantageous. The 83(b) election cuts both ways; the service provider could elect the 83(b) tax, but the restricted stock could decrease in value after the inclusion, thus creating a tax liability on restricted stock with diminishing value below that which was taxed. In the absence of an 83(b) election, the substantial risk of forfeiture issue must be considered to determine what contractual provisions constitute an acceptable restriction that defers income tax.

2. Application of a Substantial Risk of Forfeiture Under Code Section 83

As previously mentioned, if a service provider receives property in connection with services rendered, the fair market value of the property transferred over the amount paid for such property, if any, is included in the gross income of the taxpayer, provided the rights in the property are not transferable or are not subject to a substantial risk of forfeiture.(fn33) Whether a risk of forfeiture is substantial depends upon the facts and circumstances of each situation.(fn34) A substantial risk of forfeiture arises only if the rights in the transferred property are either directly or indirectly conditioned on the performance, or refraining from the performance, of substantial services, or if a condition arises that is related to a purpose of the transfer.(fn35) Thus, the regulations essentially...