Nonlapse restrictions.

The IRS has ruled that a provision in an employer's restricted stock plan that causes the restriction to lapse on the occurrence of a public offering or change in control does not prohibit the restriction from functioning as a nonlapse restriction, provided the event's occurrence is highly speculative.

In Letter Ruling 9308022, Employer established a supplemental executive retirement plan. Under the plan, Employer's board of directors could grant share awards to officers and key employees (participants). There were two types of share awards: current share awards and deferred share awards.

Current share awards granted participants shares of common stock. Though the participants were not required to pay for these awards, they had to enter into an agreement restricting the shares, i.e., the shares would not be transferable and the participant would sell the common shares to Employer for book value if the participant terminated employment. If there was a public offering or change in Employer's control, the restrictions no longer applied. However, if there was a change of control, the participant would be required to vote with the majority of the common shares.

A deferred share award was an agreement that entitled a participant either to receive or buy shares of common stock at a future date. If a participant had to buy the common shares, the price was set at book value. The right to receive or buy the shares was contingent on continued employment. Prior to the date the participant received or bought the shares, the participant had no voting or other ownership rights in the common shares. The shares, when granted, were subject to the same restrictions as the common shares granted as current share awards.

In general, Sec. 83(a) provides that if property is transferred to a service provider, the excess of (1) the property's fair market value (FMV) (determined without regard to any restriction other than a restriction which by its terms will never lapse) over (2) any amount paid for the property, will be included in the service provider's gross income in the first tax year in which the rights of the service provider are transferable or are not subject to a substantial risk of forfeiture. According to Sec. 83(d)(1), for property subject to a restriction that by its terms will never lapse, and that allows the transferee to sell the property only at a price determined under a formula, the price determined is deemed to be the property's FMV (unless otherwise established by the IRS).

Regs. Sec. 1.83-3(h) provides that a restriction that by its terms never lapses is a permanent limitation on the transferability of property that (1) will require the transferee of the property to sell (or offer to sell) it at a price determined under a formula and (2) continues to apply to and be enforced against the transferee or any subsequent holder (other than the transferor). Sec. 83(d)(2) sets out the tax consequences to the service provider and service recipient that will be encountered if a nonlapse restriction is canceled by the service recipient.

The Service concluded that because, under Sec. 83(d)(2), under normal business practice, nonlapse restrictions can in the future be canceled by the service recipient, the fact that a restriction lapses on the occurrence of an event provided for in a plan did not prohibit it from functioning as a nonlapse restriction, as long as the event's occurrence was highly speculative.

The IRS went on to rule that the plan did not violate the single-class-of-stock requirement of Sec. 1361(b)(1)(D).