United States: Substantial Risks of Forfeiture - Mintz Levin Deferred Compensation Advisory Series

The American Jobs Creation Act of 2004 (the "Act") rewrote the rules governing deferred compensation arrangements maintained for the benefit of employees and other service providers. The new rules, which are set out in §409A of the Internal Revenue Code (the "Code"), generally provide that, unless certain requirements are met, amounts deferred under a non-qualified deferred compensation plan will be includible in gross income in the year the amounts are no longer subject to a substantial risk of forfeiture and to the extent not previously included in gross income. Accordingly, what constitutes a "substantial risk of forfeiture" is a matter of critical importance.

The concept of "substantial risk of forfeiture" has been a part of the regulatory landscape for some time in connection with compensatory transfers of property under Code §83. Although Code §83 applies to all types of property, it is best known for its application to equity-based compensation (e.g., restricted stock). The "substantial risk of forfeiture" concept also has important application to certain non-qualified deferred compensation plans maintained by tax-exempt employers.

In the Act’s legislative history, Congress expressed concern over certain abuses of the rules relating to substantial risks of forfeiture, and it directed the regulators to narrow the concept for Code §409A purposes. In both Notice 2005-1 and a proposed regulation issued in September 2005 (the "proposed regulation"), the Internal Revenue Service and the U.S. Department of the Treasury followed Congress’ direction. This advisory explains substantial risks of forfeiture both under prior law and in the context of Code §409A.

According to Notice 2005-1 and the proposed regulation, a plan provides for the "deferral of compensation" only if, under the terms of the plan and the relevant facts and circumstances:

• the service provider (employee or independent contractor) has a "legally binding right" during a taxable year to compensation that has not been actually or constructively received and included in gross income, and

• pursuant to the terms of the plan, the compensation is payable to (or on behalf of) the service provider in a later year.

Importantly, a legally binding right to compensation can exist even where the right is subject to a substantial risk of forfeiture—i.e., it is not currently vested. (A benefit is said to be "vested" once it is absolute and not subject to a contingency.)

Example: A service provider is promised in year 1 a bonus equal to a set percentage of employer profits, to be paid out in year 3 if the service provider has remained in employment through year 3. The service provider in this instance has a legally binding right to the compensation in year 1 that is subject to a substantial risk of forfeiture—i.e., he or she must remain employed though the last day of year 3 in order to be paid.

If a deferred compensation plan violates the requirements of Code §409A, the service provider must currently include the deferred compensation in his or her income, and he or she is subjected to a 20% excise tax on such amount, plus interest and penalties from the date on which the deferred compensation is no longer subject to a substantial risk of forfeiture.

Congress adopted Code §83 as a part of the Tax Reform Act of 1969. Code §83 provides that a transfer of property to an employee in connection with the performance of services is taxed in an amount equal to the excess of—

• the fair market value of the property as of the date on which the property is either transferable or not subject to a substantial risk of forfeiture, over

• the amount that the employee pays for the property.

So long as property transferred in connection with the performance of services is non-transferable and subject to a substantial risk of forfeiture, taxation is deferred. The rights of a person to property are generally 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." The regulations issued under Code §83 elaborate:

"[W]hether a risk of forfeiture is substantial or not depends upon the facts and circumstances. A substantial risk of forfeiture exists where rights in property that are transferred are conditioned, directly or indirectly, upon the future performance (or refraining from performance) of substantial services by any person, or the occurrence of a condition related to a purpose of the transfer, and the possibility of forfeiture is substantial if such condition is not satisfied." (Emphasis added.)

Thus, under Code §83, a payment made to an employee in exchange for a non-compete covenant could be deemed to be subject to a substantial risk of forfeiture, provided that the restriction on the employee has sufficient substance when considered in light of the surrounding facts and circumstances.

Although the guidance under Code §409A is influenced by Code §83 principles, and, for the most part, what constitutes a substantial risk of forfeiture for Code §83 purposes may also constitute a substantial risk of forfeiture for Code §409A purposes, Notice 2005-1 and the proposed regulation make the following important distinctions:

• The addition of any substantial risk of forfeiture after the beginning of the service period to which the compensation relates, or any extension of a period during which compensation is subject to a substantial risk of forfeiture, is disregarded. This is so irrespective of whether the addition or extension is at the election of either the participant or the plan sponsor or by the mutual agreement of both. This means, for example, that rolling risk of forfeiture provisions that are common in certain plans maintained by tax-exempt employers may not operate to defer vesting for purposes of Code §409A.

• An amount is not subject to a substantial risk of forfeiture merely because the right to the amount is conditioned, directly or indirectly, upon the refraining from performance of services. Therefore, a covenant not to compete will not constitute a substantial risk of forfeiture for Code §409A purposes.

• If a service provider has the option to receive certain compensation currently or at some future date and the service provider elects to defer its receipt (an "elective salary deferral"), such compensation will not be considered to be subject to a substantial risk of forfeiture, unless the compensation that the service provider would receive at a future date, which is subject to a substantial risk of forfeiture, is materially greater than the amount the service provider would receive if he or she elected to receive the compensation currently. Accordingly, compensation subject to an elective salary deferral will vest immediately for Code §409A purposes unless the deferral is linked to the possible future payment of a materially larger amount of compensation.

As a result of these restrictions, the phrase "substantial risk of forfeiture" has different meanings depending on whether one is applying Code §83 or Code §409A. It is possible, therefore, for a plan provision to constitute a substantial risk of forfeiture for the purpose of one Code provision and not the other. By way of example, an extension of a vesting provision—i.e., a rolling risk of forfeiture—might be acceptable for Code §83 purposes but, in the event of a violation of Code §409A, would not operate to postpone the date on which tax penalties begin to accrue.

The "substantial risk of forfeiture" concept is particularly important in connection with the so-called "short-term deferral rule" (see Mintz Levin Deferred Compensation Advisory Series, Issue No. 5, for an explanation of the short-term deferral rule). The short-term deferral rule exempts from the reach of Code §409A amounts that are paid out within 2 ½ months after the end of the taxable year of the service provider, or the service recipient, in which amounts are no longer subject to a substantial risk of forfeiture. In granting this exemption, the regulators were persuaded that such short-term deferrals so closely resembled current compensation that there was little opportunity for abuse.

By narrowing the definition of what constitutes a substantial risk of forfeiture for Code §409A purposes, Congress and the regulators have put limits on the sorts of arrangements that qualify for exemption under the short-term deferral rule. Thus, for example, non-competition agreements and salary deferral non-qualified deferred compensation plans will not qualify for the short-term deferral exemption, and they must therefore conform to Code §409A’s requirements. In contrast, many long and short-term incentive programs will qualify as short-term deferrals so long as they are properly structured.

Given the draconian tax penalties applicable under Code §409A (interest from the time of the initial deferral year plus a 20% tax on the deferral amount), plan sponsors and their advisors will be looking for ways to avoid being subject to Code §409A if at all possible, thereby making the short-term deferral rule particularly attractive. Plan sponsors may be tempted to test the limits in defining a substantial risk of forfeiture so that they may apply the short-term deferral rule, but they do so at their peril. The IRS has signaled its intent to scrutinize deferred compensation arrangements far more aggressively than it has in the past, and, although Code §83 may serve as a guide, it may be some time before the contours of the new deferred compensation rules are clear.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.