Substantial Risk of Forfeiture Definition Comparison Chart (Posted on April 21, 2017 by )


Carol V. Calhoun, Counsel
Venable LLP
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Carol V. Calhoun

The chart that follows compares the circumstances in which a person’s rights to compensation are subject to a substantial risk of forfeiture (SRF) for purposes of income taxation under each of sections 83, 409A, 457, and 457A of the Internal Revenue Code (I.R.C.) and Social Security and Medicare (FICA) taxation under I.R.C. § 3121(v)(2). As a practitioner drafting or advising on compensation arrangements—especially arrangements involving non-qualified (or ineligible), unfunded deferred compensation (referred to herein as NQDC)—you must be able to correctly interpret these I.R.C. sections and distinguish the concepts of SRF expressed therein to ensure that an employer understands and achieves the tax goals for which its arrangements’ are designed.

Although the basic SRF definition under the relevant sections is substantially similar, Department of Treasury regulations and other guidance interpret them somewhat differently for the various purposes for which they are used. Recently proposed regulations under I.R.C. §§ 457A and 409A further clarify some of the distinctions. 81 Fed. Reg. 40,548 (June 22, 2016); I.R.C. § 409A, 81 Fed. Reg. 40,569 (June 22, 2016). The guidance pursuant to these proposed regulations are incorporated in this chart. For more information on SRF, see Substantial Risk of Forfeiture (referred to in this chart as the SRF Practice Note).

I.R.C. § 83 and 3121(v)(2) 409A 457(f) 457A

General Application of IRC Section, Tax Effect of a SRF, and General SRF Definition

General Application of the I.R.C. Section Section 83. Income taxation on transfers of compensatory property (such as the grant of restricted stock to an employee or independent contractor in connection with the performance of services). 26 C.F.R. § 1.83-3(c).

Section 3121(v)(2). Social Security and Medicare (FICA) taxation of (employees’) NQDC (incorporates section 83’s SRF rules). 26 C.F.R. § 31.3121(v)(2)-1(e)(3).

Income taxation of NQDC payable to “service recipients” (which include employees and independent contractors); limited exception where paid to independent contractor providing services to multiple unrelated service recipients. 26 C.F.R. § 1.409A-1(f)(2). Income taxation of NQDC (not paid under an eligible deferred compensation plan under I.R.C. § 457(b)), paid by tax-exempt organizations and state and local governments (with the limited exclusion of nonelective deferred compensation of non-employees from the definition of “deferred compensation”). I.R.C. § 457(e)(12); 26 C.F.R. § 1.457-2(e). Generally prohibits NQDC arrangements payable by nonqualified entities (i.e., tax haven organizations that do not benefit from a deduction for deferred compensation amounts). I.R.C. § 457A(b).
Tax Effect of a SRF Section 83. Transferee owes taxes on the FMV of the property (minus amount paid) for the year in which the property becomes (1) transferable, or (2) substantially vested (i.e., SRF has lapsed), unless the transferee has elected to be taxed at the time of the original transfer. I.R.C. § 83(a)(1), (b).

Section 3121(v)(2). NQDC amount subject to FICA taxes on the later of (1) when the services are performed, or (2) when there is no SRF of the rights to such amount.

NQDC is subject to income tax plus additional tax on lapse of SRF, unless rules are met (or an exception applies). I.R.C. §409A(a)(1)(A)(i).

Lapse of SRF also constitutes a permissible payment event under payment rules, and identifies the taxable year (or 2.5 month period following such year) in which compensation should be paid so as not to constitute deferred compensation (i.e., the short-term deferral rule)

NQDC is subject to income tax on lapse of the SRF. I.R.C. § 457(f)(1)(A).

Proposed regulations apply the same short-term deferral rule as under Section 409A. 81 Fed. Reg. 40,555.

NQDC is subject to income tax on lapse of the SRF, if the amount is determinable I.R.C. § 457A(a), (c)(1)(A).

Similar short-term deferral rule as under Section 409A, except that the period lasts for 12 months following the taxable year in which SRF lapses. I.R.S. Notice 2008-9, Q&A 4.

General SRF Definition SRF exists where there is:

  • A requirement to perform substantial services (a so-called service condition)
  • A requirement to refrain from performing services –or–
  • The occurrence of a condition related to a purpose of the transfer

26 C.F.R. § 1.83-3(c)(1).

SRF exists where there is:

  • A service condition –or–
  • The occurrence of a condition related to a purpose of the transfer

26 C.F.R. § 1.409A-1(d)(1).

Same general rule as under section 83.

See I.R.S. Notice 2007-62, 2007-2 C.B. 331; I.R.S. Priv. Ltr. Rul. 200321002, 2003 PLR LEXIS 201 (Feb. 11, 2003); I.R.S. Priv. Ltr. Rul. 199943008, 1999 PLR LEXIS 1173 (July 20, 1999); Prop. Treas. Reg. § 1.457-11(e)(1) (81 Fed. Reg. 40,567).

SRF only exists where there is a service condition.

I.R.C. § 457A(d)(1)(A); I.R.S. Notice 2009-8, 2009-4 I.R.B. 347, Q&A 3(a).

Do the following conditions support the existence of a SRF:

A service condition (as an employee)? Yes. 26 C.F.R. § 1.83-3(c)(1). Yes. I.R.C. § 409A(d)(4). Yes. I.R.C. § 457(f)(3)(B). Yes. I.R.C. § 457A(d)(1)(A).
A consulting requirement (i.e., a service condition as an independent contractor)? Yes, if the individual is expected to perform services that are substantial relevant to the payment. 26 C.F.R. § 1.83-3(c)(2). Likely yes. Same as Section 83. Prop. Treas. Reg. § 1.457-12(e)(3), Example 1 (81 Fed. Reg. 40,568) Likely yes.
Restrictions on the right to transfer the grant of property? Only in very limited circumstances (e.g., where the sale of property at a profit could subject a person to a lawsuit under section 16(b) of the Securities Exchange Act of 1934 until the end of the 16(b) period). 26 C.F.R. § 1.83-3(c)(1), (j), (k). N/A N/A N/A
Forfeiture upon termination for cause or criminal conduct, or clawbacks? Not under the regulations, but see Austin v. Commissioner, 141 T.C. No. 18 (Dec. 16, 2013), holding that such factors can give rise to a SRF if termination for cause is defined broadly. Probably the same as I.R.C. § 83. See SRF Practice Note. Probably the same as I.R.C. § 83. See SRF Practice Note. Probably the same as I.R.C. § 83. See SRF Practice Note.
Any other condition that is related to a purpose of the compensation (e.g., meeting earnings goals)? Yes. 26 C.F.R. § 1.83-3(c)(1). Yes. 26 C.F.R. § 1.409A-1(d)(1). Yes. Prop. Treas. Regs. §§ 1.457-12(e)(1)(i), (iv) (81 Fed. Reg. 40,548; 81 Fed. Reg. 40,567–68). No. I.R.C. § 457A(d)(1)(A).
A noncompete requirement? Presumed not to result in a SRF, but the presumption can be overcome. 26 C.F.R. § 1.83-3(c)(2). No. 26 C.F.R. § 1.409A-1(d)(1). Only if certain conditions are met Prop. Treas. Reg. § 1.457-12(e)(iv) (81 Fed. Reg. 40,568). No. I.R.C. § 457A(d)(1)(A).

Will any of the following circumstances negate the existence of an SRF:

An initial election to defer? No, provided the election takes place before the employee has constructive receipt. Martin v. Commissioner, 96 T.C. 814 (1991). No, if the present value of the NQDC is materially greater than the present value of the current compensation the recipient could have elected to receive. 26 C.F.R. § 1.409A-1(d)(1). Yes, unless the plan meets certain conditions. Prop. Treas. Reg. § 1.457-12(e)(2) (81 Fed. Reg. 40,568). No, if the present value of the NQDC is materially greater than the present value of the current compensation the recipient could have elected to receive. I.R.S. Notice 2009-8, 2009-1 C.B. 347, Q/A-3(a).
A second or subsequent deferral? No, provided the second deferral takes place before the employee has constructive receipt. Martin v. Commissioner, 96 T.C. 814 (1991). Such deferrals are subject to special rules, although those rules are not specifically tied to SRF. Prop. Treas. Reg. § 1.409A-2(b)(2) (81 Fed. Reg. 40,581). Yes, unless the plan meets the same conditions as would apply to an elective deferral. Prop. Treas. Reg. § 1.457-9(a) (81 Fed. Reg. 40,559). No authority, but presumably would have to comply with the conditions for an elective deferral. See SRF Practice Note.
Acceleration on termination of employment? Yes, unless it is limited to death, disability, or involuntary termination without cause. 79 Fed. Reg. 10,664 (Feb. 26, 2014). Yes, unless it is limited to death, disability, or involuntary termination without cause, and only if there is a substantial risk that the service provider will not be involuntarily separated from service without cause. 72 Fed. Reg. 19,250—51. Yes, unless it is limited to death, disability, or involuntary termination without cause. I.R.S. P.L.R. 200321002, 2003 PLR LEXIS 201 (Feb. 11, 2003); I.R.S. PLR 199943008, 1999 PLR LEXIS 1173 (Jul. 20, 1999). Yes, unless it is limited to death, disability, or involuntary termination without cause. I.R.S. Notice 2009-8, 2009-1 C.B. 347, Q/A 23.
Other circumstances? Yes. No SRF will exist if the employer is unlikely to enforce the restriction (e.g., in a case where an employee (especially an employee-shareholder) has such control over the employer that the forfeiture condition is likely to be waived.

See 26 C.F.R. § 1.83-3(c)(3).

Yes. Same as for section 83. 26 C.F.R. § 1.409A-1(d)(3)(i). Yes. Same as for section 83. 26 C.F.R. § 1.457-12 (e)(1)(v). Yes. Same as for section 83. I.R.S. Notice 2009-8, 2009-1 C.B. 347, Q/A-3(c).

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