Tax - Substantial Risk of Forfeiture (SROF)​

Applicable Definitions of Substantial Risk of Forfeiture (SROF)

2017.04.24  Earn-out + ESOP Fiduciary Duty= SROF.  In Austin v. Commissioner, the Tax Court rejected arguments that two 47.5% shareholders were not taxable on their restricted stock awards at the time of grant because, quoting from the decision:

  • ... an earnout restriction “creates a ‘substantial risk or forfeiture’ if there is a sufficient likelihood that the restriction will actually be enforced.” Austin, 141 T.C. at 568. 
  • Removal or waiver of this forfeiture provision required the consent of the holders of 100% of the company’s shares. As a holder of a 47.5% interest facing the holder of another 47.5% interest, neither petitioner had power to control the company. Neither petitioner could act unilaterally to remove the forfeiture restriction affecting his stock. If either petitioner threatened to leave during the five-year earnout period, the other had a strong incentive to insist that the forfeiture restriction be enforced as written. 
  • Because approving removal of the forfeiture provision affecting either petitioner’s shares would have been directly contrary to the economic interest of the ESOP, it would have been a grotesque conflict of interest for petitioners to have acted as ESOP trustees for such a vote. We are confident that petitioners in such circumstances would have resigned as trustees, as they in fact did in 2003, rather than face the consequences of a self-dealing charge. 
  • ​In sum, we conclude that petitioners’ stock was subject to a substantial risk of forfeiture when issued to them in 1998 and remained subject to that risk until the restrictions lapsed on January 1, 2004. Neither petitioner held a controlling position in UMLIC S-Corp. If either failed to perform his duties or left the company before the earnout restriction ended, the other would have had every incentive to insist on enforcement of the forfeiture provision according to its terms. The ESOP had (if anything) even stronger economic incentives to do this. 

2014.JulyTax Court Examines SROF from Termination for Cause. See this Journal of Accountancy article.

2014.Jan.31  Final §83 SROF Rules Maintain Status Quo. In T.D. 9659, the IRS clarifies existing authority by confirming that --

  • a SROF may be established only through a service condition or a condition related to the purpose of the transfer; both the likelihood that a forfeiture event will occur and the likelihood that the forfeiture will be enforced must factor into whether a SROF exists; and 
  • a SROF will not arise from transfer restrictions imposed by law (such as penalties or disgorgement risks), unless the sales involve the short-swing profit rule under Section 16(b) of the '34 Act or reflect the pooling-of-interests accounting rule (no longer applicable). This is consistent with the position stated in Rev. Rul. 2005-48.

2013.Dec. 16  SROF Recognized despite being defined as "Cause" for Termination. Because the definition of "Cause" applicable to restricted stock included a failure to faithfully and diligently perform the usual and customary duties of the company president's employment, the Tax Court held that the risk of forfeiture could be a sufficiently substantial earn-out restriction to constitute a SROF. Austin v. Commissioner, 141 T.C. No. 18, holding that: 

  • "The text and evolution of section 1.83-3(c)(2) indicate that the term “discharged for cause,” as used therein, does not necessarily have the same scope that parties to a particular contract may have given this term in their negotiations. Rather, as used in the regulation, “discharged for cause” refers to termination for serious misconduct that is roughly comparable -- in its severity and in the unlikelihood of its occurrence -- to criminal misconduct." 

2012  SROF Standard Articulated in Proposed Regulations.   The IRS and Treasury Department have issued Prop. Treas. Reg. Section 1.83-3 to clarify what constitutes a "substantial risk of forfeiture" for purposes of Code Section 83.  In particular, the proposed regulations state that a substantial risk of forfeiture may consist only of a service condition or a condition related to the purpose of the transfer.  Additionally, the regulations make clear that the likelihood that the condition will occur must be considered when determining whether a substantial risk of forfeiture exists.  Finally, except in limited circumstances, transfer restrictions will not constitute a substantial risk of forfeiture.