Legend had it at my law school that one day, a lost student walked into a torts class and asked the professor if this class was wills, trusts, and estates. The torts professor replied, “We haven’t gotten that far yet.” A dry sense of humor on the professor’s part? Perhaps. His point, however, was that the law can be a seamless web, with one area of law often having an impact on another. This point often is true with respect to the tax and securities laws.

We blogged previously that the IRS and Treasury issued final regulations under Code Section 83 to “clarify” the definition of “substantial risk of forfeiture” with respect to restricted stock (and other property) grants. One of the clarifications was that transfer restrictions, in and of themselves, do not constitute a substantial risk of forfeiture. For taxation to be deferred on restricted stock grants, the stock must be both non-transferrable and subject to a substantial risk of forfeiture. An example might help illustrate this point. Suppose that a company grants its CEO restricted stock that vests on the fifth anniversary of the date of grant, provided that the CEO has been continuously employed through that date. Also suppose that the CEO satisfies this vesting condition, but on the vesting date, the company’s insider trading policy prohibits the CEO from selling the shares for several months. The CEO would be taxed on the value of the shares on the vesting date, despite the fact that the CEO is unable to sell the shares.

The Code Section 83 regulations, both before and after the clarification, contain an important exception to the non-transferability rule. This exception arises mostly with stock option grants, rather than restricted stock grants, even though restricted stock grants are more often impacted by Code Section 83. That exception is the subject of this blog.

Section 16 liability

The exception relates to Section 16(b) of the Securities Exchange Act of 1934 (“Section 16(b)”), which provides that any profit realized by an insider on a “short-swing” transaction must be disgorged to the company upon demand by the company or a stockholder acting on the company’s behalf. A “short-swing” transaction is a non-exempt purchase and sale, or sale and purchase, of the company’s equity securities within a period of less than six months. When a public company grants a stock option that is not made under an applicable Section 16(b) exemption, the grant is considered a non-exempt “purchase.” The shares underlying the option generally are subject to Section 16(b)’s restrictions for six months from the date of grant. Any sale of shares within six months of the grant date could be matched with this non-exempt “purchase” and violate Section 16(b).

Substantial risk of forfeiture related to Section 16 liability

Basic notions of fairness would suggest that if a sale of shares would subject somebody to potential SEC penalties, taxation on those shares should be delayed until the risk of liability lapses. The Code Section 83 regulations have always recognized this point. They also continue to provide that if an insider may not sell shares of stock previously acquired in a non-exempt transaction within the past six months because of potential liability under Section 16(b), the shares are subject to a substantial risk of forfeiture. The risk of forfeiture does not lapse, and ,thus, the grantee will not realize taxable income until six months after the date in which he or she acquired the shares.

Clarification of the substantial risk of forfeiture guidance

One question from the prior regulations was whether a subsequent non-exempt purchase could further extend this substantial risk of forfeiture. A new example in the final regulations explains that the IRS and Treasury do not respect this strategy. The example states that any options granted in a non-exempt manner will be considered subject to a substantial risk of forfeiture only for the first six months after the date of grant. For example, suppose a company grants its CEO stock options, in a non-exempt manner, on April 1, 2014, that are fully and immediately vested. The CEO will not be able to sell the underlying shares until Oct. 1, 2014, because of potential Section 16(b) liability. As such, despite the fact that the options are fully vested in April, they will be subject to a substantial risk of forfeiture until Oct. 1, 2014. What if the CEO acquired additional shares in September in a non-exempt purchase? Could that further defer the substantial risk of forfeiture (and thus the taxable event) until 2015? The clarification in the regulations says no, it will not. The risk of forfeiture relating to Section 16(b) liability still lapses on Oct. 1, 2014.

What this clarification really means is that the risk of disgorging any profits under Section 16(b) generally will not have any impact on the substantial risk of forfeiture analysis. That is because most equity awards have a vesting period (either service or performance-based) of longer than six months. In the prior example, suppose the options granted in a non-exempt manner were not fully and immediately vested, but instead, vested in one third increments on each anniversary after the date of grant, through the third anniversary date. In that case, the options would be taxed when the CEO exercised the options. The only vesting date that would apply would be the time-based vesting requirements in the option agreement because regardless of how many additional non-exempt purchases of stock the executive made, the risk of forfeiture relating to Section 16(b) liability would apply only for 6 months after the date of grant.


Essentially, the IRS is eliminating any opportunity to abuse the Section 16(b) exception. It serves as yet another reminder that transfer restrictions, by themselves, cannot delay taxation. That is the case despite the fact that many efforts to comply with the securities laws often feel similar to a vesting condition on awards. As such, employers should make sure that their equity award grants contain a valid substantial risk of forfeiture in order to give their executives the opportunity to defer taxable income.

Special thanks to Jack Gravelle for his contributions to this article.