Internal Revenue Code Section 83(i) was introduced as part as of the Tax Cuts and Jobs Act of 2017. Under Section 83(i), if certain requirements are satisfied, employees of private companies who receive nonstatutory stock options (NSOs) or restricted stock units (RSUs) may elect to defer federal income tax on the exercise of the NSOs or settlement of the RSUs for up to five (5) years (referred to as an 83(i) election).
The Internal Revenue Service (IRS) recently released IRS Notice 2018-97 to provide guidance to companies that wish to make the 83(i) election available to their employees. However, in weighing the cost of satisfying section 83(i)’s onerous requirements and the benefits of other tax-advantaged equity compensation alternatives, including incentive stock options (ISOs), companies may find little advantage in offering employees the opportunity to make an 83(i) election.
Section 83(i): The Basics
Section 83(i) provides that if an “eligible corporation” transfers “qualified stock” to a “qualified employee” who makes an election under Section 83(i) within 30 days of the exercise of the NSO or settlement of the RSU, the employee may defer federal income taxes on the value of the stock determined at the time of exercise or settlement until the earliest of:
An “eligible corporation” is a privately held company that has a written plan under which at least 80% of all employees who provide services to the company in the United States are granted NSOs or RSUs during a calendar year.
“Qualified stock” means stock in a company that is the employer of the qualified employee (or its parent), if such stock is received (i) in connection with the exercise of an NSO or settlement of an RSU, and (ii) the NSO or RSU was granted in connection with the performance of services as an employee during a calendar year that the company was an eligible corporation. Section 83(i) does not apply to incentive stock options because no federal income tax is due at the time an incentive stock option is exercised (with the possible exception of the alternative minimum tax).
A “qualified employee” is any employee who is not an “excluded employee” and who agrees to meet certain requirements established by the IRS to ensure that withholding taxes are collected. An “excluded employee” means any employee who:
Notably, a “qualified employee” must be an employee rather than a director or consultant.
Section 83(i)(6) provides that any company which transfers qualified stock to a qualified employee shall, at the time an amount attributable to such stock would first be includible in the gross income of such employee (or a reasonable time before), certify to the employee that the stock is qualified stock, and notify the employee that the employee may be eligible under Section 83(i) to defer income tax on the stock. Stated simply, the notice must be provided before the NSO is exercised or the RSU is settled. A penalty of $100 for each failure to provide a notice (up to a maximum of $50,000 per calendar year) may apply for tax years beginning after December 31, 2017. As the notice requirement attaches at the time of exercise or settlement, it could be triggered before the company knows whether the 80% requirement will be satisfied for a given year unless the award is subject to a one-year vesting cliff.
Employees who wish to make an 83(i) election must do so, using a similar election form as is used to make an 83(b) election, within 30 days of the exercise of an NSO or settlement of the RSU. No election may be made under Section 83(i) if the qualified employee has made an election under Section 83(b), or if the company had purchased any of its outstanding stock in the prior calendar year, with a limited exception for repurchases of Section 83(i) deferral stock.
The Notice clarifies several ambiguities, including: 1) application of the 80% requirement; 2) the company’s employment tax withholding obligations; and 3) procedures for opting out.
Recent IRS Guidance: The Details
1. 80% Requirement
As previously described, for any calendar year, a company is an “eligible corporation” if it grants to not less than 80% of all employees in the United States (or any possession of the United States) stock options or RSUs, with the same rights and privileges, pursuant to a written plan document. The Notice explains that in calculating whether the 80% requirement is satisfied, the company must take into account the total number of individuals employed at any time by the company during the year in question, regardless of whether the employees were employed by the company at the beginning or the end of the calendar year. In addition, the IRS explained that 80% of all employees must be granted options or RSUs (but not a combination thereof) during the given calendar year.
This guidance has several immediate implications:
2. Federal Income Tax Withholding
Only federal income taxes are deferred under an 83(i) election. FICA and FUTA taxes are unaffected and remain due at the time of exercise of the option or settlement of the RSUs for both the employee and employer.
The Notice explains that stock subject to an 83(i) election, or “deferral stock,” is included in income for purposes of federal income tax withholding on the last date of the deferral period. The deferral period ends on the earliest of the dates listed above under “Section 83(i): The Basics.” As a result, the employer must remit federal income tax withholding to the IRS for awards subject to an 83(i) election soon after the end of the deferral period. The Notice reiterates that the income from an option or RSU subject to an 83(i) election is subject to federal income tax withholding at the maximum marginal income tax rate (37% for 2019), without regard to withholding exemptions or other allowances claimed by the employee on his or her Form W-4. If the employer pays the withholding amounts using its own funds, the employer may recover the amount it paid from the employee until April 1 of the year following the calendar year in which such income was recognized. However, under the laws of some states, including California, the employer may be required to receive authorization before withholding any amounts from an employee’s compensation to pay the taxes.
To ensure that the company will be able to satisfy its statutory income tax withholding obligations at the end of the deferral period, the IRS is requiring that each 83(i) election include a mandatory share escrow arrangement. This arrangement would require employees who make an 83(i) election to keep any deferral stock in escrow with the employer until the withholding tax becomes due, or otherwise make arrangements to pay the withholding tax.
After the deferral period, the employer may deduct stock from the escrow account to pay the withholding tax and release any remaining deferral stock to the employee.
In theory, the escrow account provides protection for employers. However, because the IRS does not accept shares of privately held companies as payment for taxes, companies will still be required to spend cash to pay the withholding tax, effectively giving employees a right to redeem shares if cash cannot be collected from them otherwise. In addition, the company (and the employee) retain the risk of loss if the stock subject to the 83(i) election decreases in value.
3. Opt-Out Opportunity
Finally, the Notice confirms that a corporation may effectively opt out by not establishing a stock escrow arrangement as described above. This means that companies will not be required to comply with the Section 83(i) notice requirements if they had inadvertently met the conditions for Section 83(i) deferral eligibility and do not intend to make the election available.
The Notice provides needed clarity on several issues but adds few carrots to the 83(i) election scheme. Companies now have a better sense of what the 80% threshold test requires, but satisfaction of that test is still onerous.
In addition, the Notice establishes a potentially helpful escrow arrangement to secure the withholding tax obligation. However, the potential illiquidity and depreciation in value of the escrowed stock at the end of the deferral period compromises the potential usefulness of the escrow arrangement. Cash-strapped private entities, particularly early-stage startup companies, could likely end up paying for any withholding tax out of pocket.
While these terms and conditions make it unlikely that many private companies will seek to offer 83(i) elections for equity awards, companies should continue to monitor IRS guidance and consider employee recruitment and retention benefits associated with offering equity awards potentially subject to an 83(i) election.
For further information, including information about best practices, please contact the authors of this Alert.