What is Substatial Risk of Forfeiture

A person's rights in property are subject to a substantial risk of forfeiture if: (1) his full enjoyment of the property is conditioned upon the future performance (or refraining from performance) of substantial services by any individual, or the occurrence of a condition related to a purpose of the transfer; and (2) the possibility of forfeiture if the condition is not satisfied is substantial. IRC §83(c)(1); Treas. Reg. §1.83-3(c)(1). Whether a risk of forfeiture is substantial depends upon the facts and circumstances. Treas. Reg. §1.83-3(c)(1).

Because the inquiry is so fact-based, there is little definitive guidance as to the sorts of services that will be considered substantial. However, the regularity of performance and the time spent in performing the required services tend to indicate whether they are substantial. Treas. Reg. §1.83-3(c)(2). Furthermore, it is not clear how far into the future an arrangement must require substantial services in order to require adequate "future performance." See, generally, Treas. Reg. §1.83-3(c)(4). Nonetheless, the regulations' examples describe arrangements requiring employees to work for periods as short as one and two years as imposing substantial risks of forfeiture. See Treas. Reg. §1.83-3(c)(4), Ex. 1 and Ex. 3.

For examples of service requirements that have constituted a substantial risk of forfeiture in the context of IRC §457(f) plans (Q 125), see generally Let. Ruls. 9642046, 9642038, 9628020, 9628011, 9627007, 9623027, 9549009, 9444028, 9215019, 9030025.

Some things are clear. Requiring that property be returned if the employee is discharged for cause or for committing a crime will not create a substantial risk of forfeiture. Treas. Reg. §1.83-3(c)(2). The IRS has indicated that benefits would be taxable once a participant has met age and service requirements under an IRC §457 plan (see Q 123), although the benefits remained forfeitable if participants were fired for cause, and noted that forfeiture upon termination for cause was not sufficient to constitute a substantial risk of forfeiture under Treas. Reg. §1.83-3(c)(2). TAM 199902032. See also Burnetta v. Comm., 68 TC 387 (1977) (crime-decided before adoption of regulation), acq., 1978-2 CB 1.

A covenant not to compete will not ordinarily result in a substantial risk of forfeiture, unless the particular facts and circumstances indicate otherwise. Treas. Reg. §1.83-3(c)(2); see also Let. Ruls. 9548015, 9548014.

Similarly, the requirement that a retiring employee render consulting services upon the request of his former employer does not result in a substantial risk of forfeiture, unless the employee is, in fact, expected to perform substantial consulting services. Treas. Reg. §1.83-3(c)(2). See also Richardson v. Comm., 64 TC 621 (1975) (decided before regulation).

Imposing a sufficient condition on the full enjoyment of the property is not in itself enough to create a substantial risk of forfeiture; the possibility of forfeiture if the condition is not satisfied must be substantial. This possibility may be substantial even if there are circumstances under which failure to satisfy the condition will not result in forfeiture of the property. For example, the possibility of forfeiture is substantial where an employee would generally lose his deferred compensation upon termination of employment before completing the required services, but would not forfeit those benefits if his early termination were due to death or permanent disability. See Rev. Rul. 75-448, 1975-2 CB 55. The possibility that a forfeiture might not be enforced in the event of normal or early retirement before the satisfaction of the condition might not undermine the substantial risk of forfeiture. See Let. Rul. 9431021; but compare Let. Rul. 9215019 (where employer could accelerate vesting of employee's benefits under an IRC §457 plan anytime on or after three years of service under the plan, employee's benefits would not appear to be subject to a substantial risk of forfeiture after three years; existence of such risk is a question of fact).

Special scrutiny will be applied in determining whether the risk of forfeiture is substantial concerning a property transfer from a corporation to a controlling shareholder-employee. In such situations, a restriction that would otherwise be considered to impose a substantial risk of forfeiture will be considered to impose such a risk only if the chance that the corporation will enforce the restriction is substantial. See Treas. Reg. §1.83-3(c)(3). Compare Ludden v. Comm., 68 TC 826 (1977) (possibility of forfeiture did not amount to a substantial risk of forfeiture because there was too little chance that the shareholder-employees would cause themselves to be fired), affirmed on other grounds, 620 F.2d 700, 45 AFTR 2d 80-1068 (Ninth Circuit 1980).

It is not clear whether one can effectively extend a substantial risk of forfeiture. One letter ruling has concluded that as long as the future services required of the employee were and would continue to be substantial, an agreement between the employer and the employee postponing the vesting date of restricted stock would not in itself trigger taxation of the stock. Let. Rul. 9431021. However, the ruling has generated controversy, particularly with respect to efforts to extend its reasoning to ineligible IRC §457(f) plans (see Q 125). ASRS, §64, ¶430.2(b).