A much-touted change in employee compensation was instituted by the Tax Cuts and Jobs Act of 2017, but whether it will be a much-used election remains to be seen. An employee who receives a nonqualified stock option or restricted stock unit (RSU) is generally taxed on the value of the underlying stock (less amounts paid) in the year the option is exercised or the RSU is settled. This presents a liquidity challenge for the recipients of private company equity awards, as those grantees generally cannot sell shares to fund their income tax obligations. As a result, private company optionees will often wait until a company sale or IPO to exercise their options, and therefore will miss opportunities to qualify for long-term capital gain treatment.
New Section 83(i)
The Act added section 83(i) to the Internal Revenue Code to provide private company equity award grantees with the opportunity to defer the income tax otherwise payable upon exercise or settlement of their stock awards while still establishing a tax basis in the underlying shares. Many employers may find the requirements of section 83(i) to be onerous, and, as a result, it may not become widely used. But an overview of the new rule is helpful in sorting through the potential benefits of its application.
Section 83(i) permits an employee to defer income tax otherwise payable upon exercise of a stock option or settlement of an RSU until the date:
the stock becomes transferable, including back to the employer (for example, in connection with a sale of the employer);
the employee becomes an "excluded employee" (generally, a senior executive or 1 percent owner);
the stock becomes publicly traded;
five years after the first date the rights of the employee in such stock are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier; or
the date the employee revokes his or her section 83(i) election.
To be timely, a section 83(i) election must be made within 30 days of when the stock option is exercised or the RSU is settled. Section 83(i) does not defer FICA or FUTA taxes due upon option exercise or RSU settlement and may not defer state taxes, depending on the laws of the applicable state. A section 83(i) election will defer the employer’s tax deduction with respect to the stock award to which the election relates.
For a section 83(i) election to be available with respect to a stock award, (1) the award must have been issued by a privately held company pursuant to a written plan, (2) the company must have granted stock options or RSUs in the same year to 80 percent of all the U.S. employees of its controlled group, and (3) those other awards must have the same rights and privileges. One-percent owners, CEOs, CFOs and their family members, as well as the company’s four highest-paid executives in the year of the grant and the 10 preceding years, are not eligible to make section 83(i) elections and are not counted in determining whether the 80 percent coverage rule is satisfied.
Companies issuing section 83(i)-compliant equity grants must also comply with a number of notice, withholding and reporting requirements, and, if these administrative requirements are not satisfied, the company will be subject to financial penalties. For this reason, we are beginning to see private companies expressly state in their equity award documents that section 83(i) elections may not be made with respect to those awards.
While new section 83(i) was issued to provide a benefit to certain employees of private companies, significant hurdles must be overcome to receive these intended benefits. Some of the most notable requirements that will likely limit its election by taxpayers include the unavailability of section 83(i) for senior executives, the requirement to grant the equity grants to 80 percent of all controlled group employees, and the financial penalties for administrative noncompliance. In limited cases, section 83(i) may appeal to employers that already have a practice of making broad-based equity awards and that intend to conduct an IPO in the foreseeable future. Otherwise, we do not expect to see significant utilization of this deferral opportunity.