Background. Internal Revenue Code section (“Section") 83 provides rules for timing of inclusion in income of compensation consisting of restricted “property” payments, such as employer securities. Under Section 83, an equity-based award generally is not includible in income of the executive in the tax year of the grant if it is subject to a “substantial risk of forfeiture” (an “SRF"), or in other words, is nonvested. On the other hand, Section 457(f) is applicable in general to nonqualified deferred compensation plans (“ineligible plans”), which are unfunded promises by governmental or tax-exempt entities to pay compensation to their executives in a future tax year. Section 457(f) allows deferral of taxation of the principal amounts only until vesting and employs the definition of an SRF in Section 83. However, Section 409A, which also applies to ineligible plans but not to compensatory property subject to Section 83 and causes inclusion in income of and imposition of penalties and interest on vested amounts for failure to comply with its rules governing deferral elections and timing and form of payment of unfunded deferred compensation, uses a slightly different definition of an SRF.
Under the recently issued final regulations under Section 83 (T.D. 9659 (Feb. 25, 2014), 79 Fed. Reg. 10,663 (Feb. 26, 2014)), Treasury and the IRS amended Treas. Reg. section 1.83-3(c)(1) to clarify that an SRF is present only if the payment of compensation is contingent on the future performance (or refraining from performance) of substantial services or on a condition related to the purpose of the transfer. The possibility of forfeiture upon the occurrence of a condition related to the purpose of the transfer must be both likely to occur and likely to be enforced. The Service did not define "likelihood of occurrence" but merely provided an example in the preamble to the proposed regulations (77 Fed. Reg. 31,783, 31,784 (May 30, 2012), in which attaching the forfeiture condition to an equity award that gross receipts of the employer fall by 90 percent over the next three years, which based on its business record would be “extremely unlikely to occur”, meant that the possibility of forfeiture was not substantial.
Issues Presented Under the Final Section 83 Regulations. The preamble to the final regulations (the “Preamble”) did not address explicitly whether an involuntary separation from service without cause was a condition related to the purpose of the transfer that established a valid SRF. It is unclear whether a profit-making company granting equity-based awards or a not-for-profit institution sponsoring an “ineligible plan” may condition vesting of the compensation on an involuntary separation from service without cause.
Application of the Section 83 Definition of an SRF to For-Profit Enterprises. The answer appears to be that, in the for-profit context, an involuntary separation from service without cause, whether as a stand-alone condition or in conjunction with another vesting factor, would not establish an SRF necessary to defer taxation of the award. Under Section 409A regulations, an involuntary separation from service is defined generally as a separation from service due to the independent exercise of the unilateral authority of the service recipient to terminate the services of the service provider who is willing and able to continue performing the services. Even a voluntary resignation, if triggered by actions of the employer or express conditions in the plan, may constitute an involuntary separation from service under Section 409A. By contrast, under the Section 83 regulations and consistent with Tax Court interpretation, a condition that would be very unlikely to occur, such as a termination for cause or for committing a crime, would be too remote to constitute an SRF.
An involuntary separation from service without cause may be employed as an exclusive event the occurrence of which would result in the lapse of an SRF of a restricted stock award. Alternatively, an involuntary separation from service without cause may be required in conjunction with the future performance of substantial services, or an “earnout restriction”, to trigger vesting of an equity-based grant. The Preamble provides that, in the latter instance such an involuntary separation from service without cause, or otherwise as a result of death or disability "would not cause a requirement of substantial services that otherwise would be treated as a[n SRF] to fail to qualify as a[n SRF], provided that facts and circumstances do not demonstrate that the occurrence of an involuntary separation from service without cause is likely to occur during the agreed upon service period."
This language implies that an involuntary separation from service without cause by itself would not establish an SRF. Otherwise, it is unclear why the Service would find it significant to specify that an involuntary departure would not invalidate a service condition as an SRF in certain circumstances. Likewise, the language means that, conversely, an involuntary separation from service without cause would cause a service condition to fail as an SRF if the involuntary departure were likely to occur during the agreed upon service period. The rationale appears to be that, by occuring, an involuntary departure would interfere with the performance of substantial services by the executive, causing the individual to be unable to meet the continued service requirement to become vested in the award. Therefore, an involuntary separation from service without cause also may not be applied to accelerate the vesting of an award, which is subject to a service condition.
Prohibiting an involuntary separation from service without cause as an SRF under Section 83 conflicts with prior IRS guidance. In Private Letter Ruling 9712029 (Dec. 23, 1996), the Service concluded that shares transferred under a Restricted Stock Plan were subject to an SRF during the "Restricted Period". The Plan provided in part that if, during the Restricted Period, an involuntary separation from service without cause or a termination of service after age 55 after at least five years of service occurred, the employee would be vested in 75 percent of the fair market value of the shares computed as of the date of the grant. Accordingly, under this ruling, the IRS deemed an involuntary separation from service without cause as at minimum a valid SRF factor that accelerated the vesting of restricted shares in conjunction with a service condition.
In sum, unlike under Section 409A, for purposes of deferring equity-based awards, in light of the language in the Preamble, an involuntary separation without cause appears to fail as an SRF either as an exclusive condition for vesting or in conjunction with an earnout restriction despite existing IRS guidance to the contrary. In this view, a narrower issue is, how likely does the occurrence of a prohibited involuntary departure have to be to cause the service condition to fail as an SRF? Absent any guidance to the contrary, it appears that the same criteria would apply to determine whether an involuntary departure were sufficiently likely to occur so as to cause a service condition to fail as an SRF as the criteria that would apply in determining whether the possibility of forfeiture of a permitted SRF condition was substantial.
Application of the Section 83 Definition of an SRF to Tax-Exempt Organizations. The answer is less clear regarding the use of an involuntary separation from service without cause as a vesting condition to defer remuneration under an ineligible plan. Treasury and the IRS stated that, by contrast to allowance of an SRF lapse conditioned on an involuntary separation from service without cause for purposes of Section 409A, the same condition cannot establish an SRF under Section 83 if the property was not transferred until after the separation from service occurred. Although relevant to equity-based compensation, there is no transfer of property under an ineligible plan. As an arrangement subject to both Sections 457(f) and 409A, an ineligible plan is a mere promise to pay compensation in the future, albeit subject to the rules for determining the existence of an SRF under Section 83.
So what is the result if there is no compensatory transfer but the Section 83 definition of an SRF nevertheless applies? The Preamble is silent on the applicable rule concerning the determination of an SRF in this situation. First, existing guidance indicates that an involuntary separation from service without cause may serve as a valid SRF for deferring compensation under an ineligible plan. In Private Letter Ruling 9211037 (Dec. 17, 1991), the IRS concluded that an award under an ineligible plan the vesting of which was conditioned on attaining the age of 55 and additional 10 years of qualified service, attaining the age of 65, disability or death, was subject to an SRF. Accordingly, an involuntary separation from service without cause due to disability or death was sufficient as a stand-alone condition for the lapse of the SRF.
Second, it does not appear that Treasury or the IRS intended to establish an inconsistent definition of an SRF under Sections 409A and 457(f) applicable to ineligible plans. In the opposite, IRS Notice 2007-62, 2007-32 I.R.B. 311 states that Treasury and the IRS intend to issue rules concerning the definition of an SRF for purposes of Section 457(f) that would be similar to the definition under Section 409A.
Third, the Preamble distinguishes Section 409A plans, which by application include Section 457(f) arrangements, in setting forth the premise that, absent a transfer of property, an involuntary separation from service without cause cannot establish an SRF. Also, with respect to the Applicability Date, the Preamble provides that the final regulations “apply to property transferred on or after January 1, 2013.” But the Preamble omits an explicit statement of the rule that would apply to ineligible plans, which do not involve a property transfer. Thus, it appears that the IRS was not ready to confirm the treatment of an involuntary separation from service without cause as a permissible SRF condition for ineligible plan deferrals.
Conclusion. Accordingly, Treasury and the IRS should clarify that such treatment is consistent with the rule under Treas. Reg. section 1.409A-1(d)(1) permitting an involuntary separation from service without cause as an SRF factor for ineligible plan compensation awarded to executives of tax-exempt organizations and subject to Section 409A. For-profit employers would benefit from IRS guidance confirming whether or not an involuntary separation from service without cause could be a valid SRF in at least limited circumstances in light of existing IRS guidance permitting the SRF. More broadly, future guidance should provide specific methods for determining the mandatory level of likelihood of the occurrence of a service condition or of a condition related to the purpose of the transfer that may qualify as an SRF. Treasury and the IRS also may clarify that the standard for measuring the likelihood of occurrence of an involuntary separation from service without cause that would trigger failure of a service condition as an SRF is the same as the criteria for evaluating the necessary likelihood of occurrence of a permitted service condition for purposes of determining whether the possibility of forfeiture of an award is substantial.
In the meantime, both for-profit and tax-exempt employers awarding deferred compensation subject to the SRF rules under Section 83 are advised to revisit their arrangements existing as of January 1, 2013, as there is an absence of a grandfathering provision and the final regulations appear to apply retroactively to the covered compensation arrangements.