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Tax News
Proposed Section 83 Regulations Adopt the Lock-up Agreement Reasoning of Rev. Rul. 2005-48
May 31, 2012
Administrative Actions
Several days ago Treasury issued Prop. Reg. §§1.83-3(c) and (j) (REG-141075-09). In these proposed regulations the IRS adopted the reasoning of Rev. Rul. 2005-48 as to the interplay between lock-up agreements and Section 83 of the Code. The ruling and the proposed regulations basically stand for the proposition that a lock-up agreement alone does not cause the compensatory shares to be substantially nonvested, and thus, it does not prevent the taxation of the shares under Section 83 at the time of receipt. These principles are illustrated by Ex. 6 of Prop. Reg. § 1.83-3(j).

How can these rules apply in the investment fund context? Well, sometimes successful investment advisors and managers go public, whether it will be here in the US or in offshore locales such as the UK and Hong Kong. The individual fund managers could have options that have significantly appreciated in value as of the time of the IPO. The option documents would often provide that the options become exercisable at the time of an IPO. At that time, the manager exercises the options and receives the shares, but as part of the underwriter’s IPO conditions, those shares are often subject to a lock-up agreement whereby the manager is prohibited from selling them for a certain period. The investment fund and its managers must figure out whether the shares are taxable/deductible at the time of receipt or at some later date. The proposed regulations would require an inclusion at the time of receipt despite the lock-up period. So, in other words, the manager could be stuck with phantom income. It has the shares, it includes them in income, but yet, it cannot sell them to pay the related tax bill.

That said, the above outcome may not necessarily be the most typical outcome in these scenarios. Both Rev. Rul. 2005-48 and the proposed regulations are predicated on the fact that there are no service related restrictions as part of the lock-up agreement. However, some funds would impose restrictions well beyond any transferability restrictions. Funds could view the IPO as an opportunity to lock their top managers for a longer period of time. After all, the fund’s star managers are its most precious assets. As part of the lock-up agreement and related documents the fund would also impose a forfeiture restriction conditioned on future employment. In that instance, there could be a substantial risk of forfeiture and the manager may have a choice, via an 83(b) election, whether to include the shares in income now or later when the conditions expire. Thus, instead of taking the proposed regulations literally, it is helpful to approach each lock-up individually and analyze the specific documents and conditions. The outcomes could differ depending on the specific circumstances.
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Tags: lock up, lock up agreement, manager options, manager shares, prop. reg. 1.83-3, section 83