“Would I ever leave this company? Look, I’m all about loyalty. In fact, I feel like part of what I’m being paid for here is my loyalty. But if there were somewhere else that valued loyalty more highly, I’m going wherever they value loyalty the most.” Dwight Schrute, The Office

Retaining Talent

A constant challenge in the world of the closely held business, and one that is likely to become even more daunting as Baby Boomers continue to pass their businesses along to younger family members[i] – many of whom may share the older generation’s appreciation for living well, but neither its drive nor its business acumen – is the retention of key employees who are able to operate the business profitably in spite of changes in ownership or leadership within the family and the business.


Over the years, employers have utilized many kinds of economic (as well as other) incentives to attract and keep good people. Regular salary increases, annual bonuses,[ii] all manner of nonqualified deferred compensation arrangements[iii] (both equity-based – like phantom equity or equity appreciation rights – and non-equity-based varieties), low-interest loans,[iv] split-dollar life insurance,[v] change-in-control arrangements,[vi] options to acquire equity,[vii] restricted equity,[viii] profits interests,[ix] and outright grants of equity.[x]

I am not a fan of issuing equity to employees,[xi] but I recognize there are circumstances in which the employer may have little choice as a practical matter.[xii] In that case, the employee[xiii] – who is ultimately hoping for long-term capital gain treatment on their ultimate sale of the equity – will initially be concerned with the income tax consequences of receiving compensation in the form of an equity interest in their employer.[xiv]

Substantial Risk of Forfeiture

In general, if an employer issues equity to an employee as compensation in exchange for their services, the employee must include the fair market value of such equity[xv] in their gross income unless the employee’s rights in such equity are not transferable and are subject to substantial risk of forfeiture; i.e., “restricted stock.”[xvi]

Stated differently, the fair market value of the equity will be includible in the employee’s gross income at the time their rights in the equity become transferable or are no longer subject to substantial risk of forfeiture (i.e., when they “vest”), whichever occurs first.[xvii] This amount, which may be greater than the fair market value of the equity at the time it was issued to the service provider, will be treated as compensation, which is taxable as ordinary income.[xviii] The employee’s holding period for the equity will begin with the inclusion of its value in their gross income;[xix] their basis for the equity will be equal to its then fair market value.

For purposes of this rule, an employee’s rights are “subject to substantial risk of forfeiture” if they are conditioned upon the employee’s future performance of substantial services, or upon the satisfaction of some condition that is related to a purpose of the transfer (such as a performance goal) if the possibility of forfeiture is substantial.[xx]

Sec. 83(b) Election

Alternatively, an employee whose rights to the equity are subject to a substantial risk of forfeiture may elect to include in their income for the year in which they receive the equity an amount equal to its then fair market value.[xxi] If an employee makes such an election, they will not be required to include the value of the equity in their income when the equity subsequently vests in the hands of the employee. In other words, the election cuts off the compensatory element associated with the equity.[xxii] What’s more, the electing employee’s holding period in the equity will begin with the year it was received; this affords the employee a greater opportunity to recognize any appreciation in the value of the equity as long-term capital gain.


For the year in which the employee is required to include in their gross income the value of the employer stock, the employer is allowed to claim a deduction for an amount equal to the amount included in the gross income of the employee.[xxiii]

S Corporation Shareholder?

In the case of an employer that is an S corporation, any stock in the corporation “that is issued in connection with the performance of services . . . and that is substantially nonvested” – i.e., is subject to substantial risk of forfeiture – “is not treated as outstanding stock of the corporation” for tax purposes.[xxiv] For that reason, profits or losses of the S corporation-employer will not flow through to an employee-shareholder of non-vested stock, and is not required to be included in the holder’s gross income.[xxv]

The U.S. Tax Court recently considered the application of these S corporation rules and, specifically, whether the shares held by an employee-shareholder of an S corporation were subject to a substantial risk of forfeiture.[xxvi]

A Tax Scheme is Born

In Year One, Taxpayer incorporated “S Corp.” Taxpayer and his two “partners” (the “Partners”) were named S Corp’s directors and officers. On the same day, Taxpayer and the Partners formed LLC as a wholly owned subsidiary of S Corp through which they promoted tax shelter transactions for a fee.[xxvii] No, you can’t make this up.

Taxpayer caused S Corp to form an Employee Stock Option Plan (“ESOP”) and a related trust for its employees and contributed 150 shares of common stock to the ESOP, causing it to become a 5 percent shareholder of S Corp; Taxpayer and the Partners held the remaining shares. The ESOP had four trustees: Taxpayer, the Partners, and another individual. The IRS recognized the ESOP as a qualified plan.

Taxpayer, as president of LLC, adopted the ESOP on behalf of LLC as a “participating employer.” There were nine participating employees in the ESOP, including Taxpayer and the Partners; the other participants were employed by LLC, not S Corp.

Employment and Restricted Stock Agreements

Simultaneously with the foregoing steps, each of Taxpayer and the Partners signed an employment agreement with S Corp pursuant to which they received shares of common stock of S Corp; the ownership of these shares was “governed” by restricted stock agreements that prohibited the three shareholders from transferring or otherwise disposing of any of their S Corp shares without first obtaining the written consent of all the shareholders of S Corp (including the ESOP). Each restricted stock agreement also provided that if the employee’s employment was terminated before a date certain, the employee was deemed to have forfeited his shares of S Corp stock.

The restricted stock agreement was effective until written consent to termination by the holders of all the outstanding shares of voting common stock. Upon receipt of written notice of consent to termination, S Corp had to promptly deliver copies of such written notice to all shareholders.[xxviii]

S Corp’s Tax Returns

S Corp filed Forms 1120S for each of Year One and Year Two on which S Corp reported the income and expenses of LLC as a single-member LLC that was disregarded for Federal income tax purposes,[xxix] including fees paid to LLC in connection with its tax shelter activities, and the salary expenses of the six LLC employees.

All S Corp’s income for Years One and Two was allocated to the ESOP, as reflected on the Schedules K-1 for the ESOP were attached to S Corp’s returns. Taxpayer did not report any income related to the LLC’s tax shelter transactions on his tax returns for Years One and Two because, he claimed, his S Corp stock was not substantially vested.[xxx]

The Jig is Up

Late in Year Two, the IRS announced that the above-referenced tax shelters were not bona fide economic arrangements and that penalties might be imposed on the promoters of these transactions.[xxxi]

Following this announcement, Taxpayer and the Partners began terminating LLC’s employees, ceased all new transactions, and wrapped up the deals that were already on the books.

At the start of the immediately succeeding year (Year Three), Taxpayer and the Partners released the forfeiture restrictions on their shares of S Corp stock.[xxxii] Significantly, they did not resign their positions as trustees of the ESOP before terminating their stock restrictions. They did not inform the ESOP participants of their action or allow the ESOP or anyone on behalf of the ESOP to consent to the removal of the restrictions.[xxxiii]

Taxpayer’s Returns

On his Year Three income tax return, Taxpayer reported income on Schedule E, Supplemental Income and Loss, passthrough income from S Corp relating to termination of the purported S Corp stock restrictions. Taxpayer also reported a Schedule E passthrough loss from S Corp relating to his pro rata share of S Corp’s loss claimed on its Year Three return.

The Issue is Joined

After examination, the IRS issued a notice of deficiency to Taxpayer. The IRS determined that, because the parties did not respect the restrictions on Taxpayer’s S Corp stock,[xxxiv] Taxpayer’s stock in S Corp was not subject to a substantial risk of forfeiture. Accordingly, the IRS explained, Taxpayer should have included his distributive share of S Corp’s income in his gross income for Years One and Two.[xxxv]

Taxpayer petitioned the Tax Court where the issue for decision was whether the IRS had erred in determining that Taxpayer’s stock in S Corp was not subject to a substantial risk of forfeiture.

Tax Court

The Court began its discussion by explaining that, for purposes of the S corporation rules, “stock that is issued in connection with the performance of services * * * and that is substantially nonvested * * * is not treated as outstanding stock of the corporation, and the holder of that stock is not treated as a shareholder solely by reason of holding the stock.”[xxxvi]

Whipsaw the Fisc

Taxpayer, the Court continued, did not report any pro rata share of passthrough income from S Corp for either Year One or Year Two on the basis of his position that his shares of S Corp stock were subject to a substantial risk of forfeiture and therefore were unvested.

The Court further explained that the income from an S corporation flows through to its shareholders, resulting in only one level of taxation. An S corporation shareholder generally determines their tax liability by taking into account a pro rata share of the S corporation’s income, losses, deductions, and credits.[xxxvii]

ESOPs and S corporations: Pre-2005

The Court then delved into the matter of ESOP ownership of an S corporation, and especially the impact of an ESOP’s favored tax status.

Qualified ESOPs and their related trusts, the Court stated, are generally exempt from income taxation.[xxxviii]  Effective January 1, 1998, Congress provided that ESOPs were permitted to be shareholders of S corporations.[xxxix] Unfortunately, these changes, when coupled with the S corporation rules for nonvested stock, facilitated a framework which – prior to the enactment of anti-abuse provisions in 2001 – allowed all of the outstanding shares of an S corporation to be owned by an ESOP, effectively allowing S corporation profits to escape federal income taxation during the taxable years in question.[xl]

According to the Court, the shareholders of some S corporations used the above framework to defer income: the shareholders held shares of stock that were “substantially nonvested”; because such stock was not considered to be “outstanding,”[xli] the S corporation could allocate 100% of its income, losses, deductions, and other tax items to a tax-exempt ESOP.

Section 83

As explained earlier, the value of property transferred to a service provider “in connection with performance of service” is taxable in the first year in which the recipient’s rights in the property are “transferable or are not subject to a substantial risk of forfeiture.”[xlii] Thus, a taxpayer can defer recognition of income until their rights in the restricted property become “substantially vested.”[xliii]

Shares of stock are subject to a substantial risk of forfeiture if the owner’s rights to their full enjoyment are conditioned upon the future performance of substantial services by any individual.[xliv] The regulations provide that “a substantial risk of forfeiture exists only if rights in property that are transferred are conditioned, directly or indirectly, upon the future performance (or refraining from performance[xlv]) of substantial services by any person.”[xlvi]

Substantial Risk of Forfeiture

The Court considered whether the shares of stock held by Taxpayer were subject to a substantial risk of forfeiture.

The Court stated that whether a substantial risk of forfeiture exists depends on the facts and circumstances, including whether the forfeiture of the employee’s shares will be enforced.

According to regulations[xlvii] issued by the IRS, there are five factors to consider when determining whether the possibility of forfeiture is substantial in the case of an employee who owns a “significant amount” of stock of the employer corporation:

  • the employee’s relationship to other stockholders and the extent of their control, potential control, and possible loss of control of the corporation,
  • the position of the employee in the corporation and the extent to which they are subordinate to other employees,
  • the employee’s relationship to the officers and directors of the corporation,
  • the person or persons who must approve the employee’s discharge, and
  • past actions of the employer in enforcing the provisions of the restrictions.

Thus, in order for Taxpayer to support the position that he was not required to include in gross income his stock’s pro rata share of S Corp’s income during Year One and Year Two, the facts and circumstances had to show that the stock held by Taxpayer was subject to a substantial risk of forfeiture during that period.

Relying upon the restricted stock agreement, Taxpayer argued that the S Corp stock issued to him was subject to a substantial risk of forfeiture and, therefore, did not vest until the employment-related restrictions were released in Year Three. The IRS countered that the S Corp stock was substantially vested when Taxpayer received it in the earlier year because the forfeiture conditions were unlikely to be enforced.[xlviii]

The Court observed that Taxpayer and the Partners owned “a significant amount of the total combined voting power or value of all classes of stock of the employer corporation”; 95 percent of S Corp’s common stock, as compared to the 5 percent owned by ESOP.

The Court also mentioned the close working relationship among Taxpayer and the Partners, which indicated a de facto power to control. Taxpayer and the Partners formed S Corp and promoted the tax shelters together. When the tax shelter work slowed to a halt, Taxpayer and the Partners collectively released their restrictions rather than enforce the restrictive agreement. In other words, “when the arrangement was no longer beneficial,” they terminated it. Taxpayer did not show that there was sufficient likelihood that the earnout restrictions would be enforced. Rather, his relationship to the officers and directors of S Corp (i.e., the Partners) and their actions “revealed an effort to collectively avoid enforcement of the restrictions.”[xlix]

Furthermore, removal or waiver of the forfeiture provision required the consent of the holders of 100 percent of S Corp’s shares, including the consent of ESOP, before lifting the stock forfeiture restrictions. Taxpayer never sought ESOP’s consent. These facts – together with Taxpayer’s failure to put forward any convincing evidence that he could possibly lose control over the S corporation – showed that Taxpayer and the Partners had complete control over S Corp.[l]

Therefore, the Court concluded that the stock forfeiture restrictions were never likely to be enforced. Accordingly, the S Corp stock was not subject to a substantial risk of forfeiture.


Of course, the decision discussed above involved an unusual set of facts and was rife with abuse. Its message about the enforcement of forfeiture restrictions, however, should resonate with any business that is considering the compensatory grant of equity in the business to a key employee, regardless of such employee’s being related to any of the other owners or not.

If the tax liability arising from such a grant is to be deferred based upon the presence of a substantial risk of forfeiture,[li] the employer must be prepared to enforce the employee’s forfeiture of its equity interest in the employer following the employee’s failure to satisfy the conditions set forth in the grant agreement.

This is a burden that should not be taken lightly and, so, the imposition of such conditions and risks of forfeiture should likewise not be undertaken lightly, especially where the employee’s continued happiness and presence is vital to the well-being of the business.

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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.

[i] See https://americansfortaxfairness.org/issue/dynasty-trusts-giant-tax-loopholes-supercharge-wealth-accumulation/ for an interesting but disturbing discussion of dynastic wealth.

[ii] Which may be performance-based.

[iii] Basically, an unsecured, unfunded promise to pay compensation at some time in the future. Don’t forget IRC Sec. 409A

[iv] See IRC 7872.

[v] Reg. Sec. 1.61-22.

[vi] But see the punitive golden parachute rules of IRC Sec. 280G and Sec, 4999

[vii] In some cases, statutory stock options may be available. IRC Sec. 421 et seq. For “nonqualified” stock options, see Reg. Sec. 1.83-7. In either case, the exercise price must equal the fair market value of the underlying equity at the date of grant.

[viii] IRC Sec. 83.

[ix] Profits interests are limited to tax partnerships. Rev. Proc. 93-27 and Rev. Proc. 2001-43.

[x] The equity may or may not have voting rights.

We will assume that the employee is not furnishing any consideration other than their services. In other words, we are not looking at a bargain issuance of stock.

[xi] After all, you suddenly have a minority owner to whom certain fiduciary duties are owed, with whom certain financial information will have to be shared, and to whom the law affords certain protections.

[xii] A well-drafted shareholders’ or partnership/operating agreement can go a long way toward addressing many concerns.

[xiii] Assuming they have recovered from the shock of having to guarantee business debt and other obligations (like a line of credit or a lease).

[xiv] In most instances, the equity will be issued by the employer. However, it is possible for a large shareholder to transfer some of their shares of employer stock to an employee of the corporation in connection with the employee’s services to the corporation. In that case, the shareholder will be treated as having made a capital contribution of the transferred shares to the corporation, and the corporation will be treated as having then issued the shares to the employee as compensation. See Reg. Sec. 1.83-6(d).

[xv] So-called “non-lapse” restrictions are considered in determining the fair market value of the equity. For example, a provision that restricts transfers while fixing the price for permitted transfers at book value (a “formula” price) may also fix (depress) the fair market value for purposes of these rules. Of course, the elimination of the restriction may itself be treated as a compensatory event measured by the resulting increase in value of the equity. See Reg. Sec. 1.83-5.

[xvi] An employer corporation does not recognize gain on the issuance of its own stock as compensation. IRC Sec. 1032.

[xvii] Vesting – i.e., the lapse of the risk of forfeiture – may occur at one time (“cliff vesting”; for example, after the completion of a specified number of years of service, or the achievement of a specified performance goal); or it may occur gradually over a number of years (for example, 20 percent per year over five years of service).

[xviii] The employer must not lose sight of its income tax and employment tax withholding obligations.

[xix] IRC Sec. 83(f); Reg. Sec. 1.83-4.

[xx] IRC Sec. 83(c); Reg. Sec. 1.83-3(c). For example, 7 years of continual service, or the satisfaction of predetermined performance goals (whether the individual’s or, for example, the division’s that they oversee) the attainment of which is not a foregone conclusion.

[xxi] This is the so-called “Section 83(b) election.” The election must be made not later than 30 days after the equity is issued. Reg. Sec. 1.83-2.

[xxii] An election would make sense where the employee was reasonably confident that the value of the equity was certain to increase before vesting, and that the equity would not be forfeited. An employee who has to forfeit their equity is not allowed a deduction in respect of the forfeiture. IRC Sec. 83(b)(1).

[xxiii] IRC Sec. 83(h).

[xxiv] Reg. Sec. 1.1361-1(b)(3).

[xxv] Under IRC Sec. 1366, every shareholder of an S corporation is required to take into account their pro rata share of the corporation’s income for a taxable year for purposes of determining their income tax liability for such year.

[xxvi] Larson v. Commissioner, T.C. Memo 2022-3 (Feb. 2, 2022).

[xxvii] The intended effect of the arrangement was for investors in the shelter to claim inflated bases in the distributed assets which in turn generated tax losses upon the sale of the distributed assets.

[xxviii] The ostensible purpose of these agreements was to incentivize retention of one of the partners, who had a history of frequently changing jobs. This partner requested that Taxpayer and the other partner also sign restricted stock agreements so as not to single him out.

[xxix] Reg. Sec. 301.7701-3.

[xxx] See the S corporation allocation rule described above with respect to unvested shares of stock.

[xxxi] Notice 2000-44.

[xxxii] Can you say, “conflict of interest”?

[xxxiii] Several ESOP participants were unaware that Taxpayer was an employee of S Corp rather than LLC. These employees were likewise unaware that S Corp owned LLC. Furthermore, these employees never received a copy of Taxpayer’s restricted stock agreement, were not advised of their rights as participants of the ESOP or were unaware that Taxpayer’s stock was subject to forfeiture.

The LLC employees were unaware that Taxpayer had released the stock forfeiture restrictions, and they did not vote to release those restrictions. Taxpayer did not cause the ESOP to retain outside counsel to protect its interest. Upon leaving LLC, employees received funds from their ESOP accounts via transfers to rollover individual retirement accounts.

[xxxiv] In the alternative, IRS disregarded the S Corp stock restrictions on the basis that the entire arrangement was entered into primarily to reduce taxes, was a sham, and must be disregarded for income tax purposes.

[xxxv] The IRS also determined that all or parts of Taxpayer’s underpayments of tax for these years were due to fraud.

[xxxvi] Reg. Sec. 1.1361-1(b)(3).

[xxxvii] IRC Sec. 1366.

[xxxviii] IRC Sec. 501(a).

[xxxix] Small Business Job Protection Act of 1996, Pub. L. No. 104-188.

[xl] To address concerns about ownership structures involving S corporations and ESOPs that could result in inappropriate tax deferral or even tax avoidance, Congress amended the Code prospectively in 2001 to require that income or loss that had previously been allocable to the ESOP be attributable to certain non-ESOP shareholders of a closely held corporation. See Economic Growth and Tax Relief Reconciliation Act of 2001, Pub. L. No. 107-16, Sec. 656.

[xli] Reg. Sec. 1.1361-1(b)(3).

[xlii] IRC Sec. 83.

[xliii]  Reg. Sec. 1.83- 1(a)(1).

[xliv] The requirement that an employee render future services as a precondition for obtaining full enjoyment of restricted property is often referred to as an “earnout” restriction.

[xlv] Basically, a non-compete.

[xlvi] Reg. Sec. 1.83-3(c)(1).

[xlvii] Reg. Sec. 1.83-3(c)(3).

[xlviii] In contrast, if the shareholder-employees had resigned as trustees of the ESOP and if the ESOP participants had been allowed to vote on the removal of the restrictions, it is possible the Court would have determined there was a substantial risk of forfeiture.

[xlix] See Reg. § 1.83- 3(c)(3).

[l] The Court found that Taxpayer’s casual treatment of his fiduciary duties with respect to ESOP was particularly telling. As a trustee, Taxpayer – who was also a CPA and attorney – was required to refrain from self-dealing in the plan’s assets and to “discharge [his] duties . . . with the care, skill, prudence, and diligence . . . that a prudent man acting in a like capacity . . . would use.” A trustee of an ERISA-qualified plan, such as the ESOP, had “a fiduciary duty to inform participants and beneficiaries of their rights under the plan as a result of general fiduciary standards of loyalty and care borrowed from the common law.”

Taxpayer did not resign as an ESOP trustee before voting on the stock forfeiture restrictions. He did not retain outside counsel to protect the ESOP’s interest when voting to lift the stock forfeiture provisions. The record did not show a pattern of open and fair dealing with regard to the ESOP participants. In short, the Court found that Taxpayer’s actions with regard to the ESOP participants made it evident that he and the Partners had complete control of S Corp.

[li] In the case of an S corporation, the “deferred” inclusion of the employee’s share of pass-through income also has to be considered.