JD, LLM, Managing Director - National Tax Services
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Tax Cuts and Jobs Act - New IRC Section 83(i) Offers Tax Deferral Opportunities When Private Company Equity Compensation is Granted
Enacted as part of the Tax Cuts and Jobs Act of 2017, new IRC Section 83(i), Qualified Equity Grants, appears to have been enacted in contemplation of concerns of employees of privately-held corporations who are granted stock options or stock-settled restricted stock units.
Equity compensation arrangements for employees of privately-held corporations have been subject to the inherent challenge encompassed by the lack of a public market for the shares, and the general inability of the recipient employee to monetize the compensation absent some type of liquidity event.
To the extent that equity, such as shares of the employer’s stock is granted in consideration for the performance of services, once the shares are “substantially vested” (are transferable or not/no longer subject to a substantial risk of forfeiture), the grantee is taxable on the fair market value of those shares (less the amount paid for the shares, if any). Where a nonqualified stock option for a private company’s shares is exercised, perhaps due to its low exercise price and the approach of the option’s expiration date, the option holder is taxable on the difference between the fair market value of the shares for which the option is exercised on the exercise date over the exercise price for such shares. Further, where a stock-settled restricted stock unit (RSU) becomes vested and, under the terms of the arrangement, the shares are distributed to the employee, the employee is taxable on the fair market value of the distributed shares.
The above presents a conundrum for the employee, who, because of the taxable event, generally must provide his employer with the funds necessary for it to meet its federal (and perhaps state) income tax withholding requirements, as well as the employee’s federal Social Security tax (subject to an annual earnings ceiling) and Medicare tax (no earnings ceiling) obligations. When no liquidity event is on the horizon, the employee may be forced to invade his own savings, borrow from a relative, bank or other third-party lender, or as is often the case, ask the employer for a loan, as necessary to obtain the funds needed to meet the above obligations, essentially in return for non-marketable pieces of paper.
A very popular means for addressing this cash-flow concern is where the employee, upon becoming taxable, “sells” back to the employer the number of shares having a fair market value equal to the amount needed, with the employer funding the necessary amounts in return for those shares. The use of this approach may serve to significantly undercut the very incentive which the equity compensation was designed to provide in the first place.
The above concern may be further exacerbated in the case of a start-up corporation which needs talented employees, but has little cash to offer as compensation. Historically, these start-ups have relied heavily on equity compensation to attract needed talent, because management does not have the cash available to offer the netting arrangement.
Inclusion Deferral Elections Under New IRC Section 83(i):
Under new Section 83(i), the taxable event triggered by the exercise of a private corporation stock option or the settlement of a stock-settled private corporation RSU, the new provision is not applicable to the equity compensation of an LLC which is taxed as a partnership, may be deferred for a limited time for certain employees participating in qualifying broad-based equity compensation plans. Perhaps most noteworthy, and as described below in greater detail, the Section 83(i) deferral opportunity is not available for certain shareholder employees, the CEO, the CFO, and certain highly compensated officers
Specifically, Section 83(i) permits a “qualified employee” of an “eligible corporation” to make a limited “inclusion deferral election” for income tax purposes (these elections that have no effect on FICA wages), in connection with the exercise of stock options and/or settlement of stock-settled RSUs, which are exercised for/settled in shares of “qualified stock” in 2018 or thereafter. These elections also will serve to defer the employer’s related compensation income tax deduction. A Section 83(i) inclusion deferral election must be made no later than 30 days after the first date the rights of the employee in the stock first become “substantially vested,” i.e., are transferable or are not subject to a substantial risk of forfeiture, whichever is earlier, and must be filed with the Internal Revenue Service. An inclusion deferral election under Section 83(i) will not create deferred compensation for purposes of IRC Section 409A (Inclusion in Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation Plans).
A qualified employee may not make an inclusion deferral election for a year if, in the preceding calendar year, the corporation purchased any of its outstanding stock unless at least 25 percent of the total dollar amount of the stock so purchased was stock with respect to which an inclusion deferral election is/was in place (“deferral stock”), and the determination of which individuals from whom deferral stock is purchased is made on a reasonable basis. An individual’s deferral stock with respect to which an inclusion deferral election has been in effect for the longest period must be purchased first. A corporation that has deferral stock outstanding as of the beginning of any calendar year and that purchases any of its outstanding stock during the calendar year must report on its income tax return for the tax year in which the calendar year ends, the total amount of the outstanding stock purchased during the calendar year. An inclusion deferral election may not be made with respect to shares for which the employee previously made an IRC Section 83(b) election. An inclusion deferral election may be made with respect to a stock option which is an IRC Section 422 “Incentive Stock Option,” or was granted under an IRC Section 423 Employee Stock Purchase Plan. However, where such is the case, the election will convert the option into a nonqualified stock option.
The deferral under an inclusion deferral election will cease upon the occurrence of the earliest of the date as of which:- The qualified stock becomes transferable, including to the employer corporation.
- The employee is no longer a qualified employee (this can be triggered by the employee’s separation of service form the employer corporation).
- Any stock of the employer corporation (or of its controlled member) becomes readily tradeable on an established securities market.
- Is 5 years after the employee’s right to the shares became “substantially vested” (transferable or not subject to a substantial risk of forfeiture) - generally, 5 years from the date of the exercise of a vested option or the settlement of a stock-settled RSU.
- The employee’s revocation of his inclusion deferral election.
Section 83(i) Defined Terms:
Eligible corporation: a corporation having no stock, including stock of its predecessor or of any member of its Section 414(b) controlled group (with certain exceptions, generally based upon 80% or greater ownership) is readily tradable on an established securities market at any time, and maintains a written equity compensation plan that provides for stock option or stock-settled RSU grants (for any year, either but not a combination) to at least 80 percent of the employer’s full-time (customarily fewer than 30 hours) employees who provide services in the United States or any U.S. possession, with the same rights and privileges to receive qualified stock. All such employees need not receive the same share amounts; however, de minimis share grants will not qualify for this purpose.
Qualified employee: an employee of an eligible corporation who is not an “excluded employee” and who agrees as part of the inclusion deferral election to meet requirements to be determined by the Secretary of the Treasury to ensure compliance with the income tax withholding requirements applicable to the employer corporation.
Excluded employee: a 1 percent owner (owns more than 1 percent of the outstanding stock of the eligible corporation or stock possessing more than 1 percent of the total combined voting power of all stock of the eligible corporation) during the current or any of the preceding 10 calendar years, at any time is or was the eligible corporation’s CEO (or an individual acting in such capacity) or CFO (or an individual acting in such capacity), or the spouse, child, grandchild or parent of the current or past CEO or CFO, or one of the 4 highest compensated officers for the current or any of the preceding 10 tax years.
Qualified stock: stock received upon the exercise of a stock option or upon settlement of an RSU. This does not include any stock that the employee may sell to the corporation (or otherwise receive cash from the employer in lieu of stock) at the time the employee’s rights to the stock first becomes transferable or not subject to a substantial risk of forfeiture.
Employee Notice Requirement and Employer Penalty for Failure to Comply
The corporation that transfers qualified stock to a qualified employee must provide a notice to the qualified employee at the time (or a reasonable time before) the employee’s right to the qualified stock first becomes substantially vested (and income attributable to the stock would first be includible absent the inclusion deferral election).
The employee notice must (1) certify to the employee that the stock is qualified stock, and (2) notify the employee that the employee may, if eligible, elect to defer income inclusion with respect to the stock, and that if the employee makes an inclusion deferral election, the amount of income required to be included at the end of the deferral period will be based on the value of the stock at the time the employee’s right to the stock first becomes substantially vested (even if that value has declined during the deferral period), and will be subject to income tax withholding at that time (the notice must also include the employee’s responsibilities with respect to required withholding).
Failure to provide the employee notice may result in a penalty of $100 for each failure, with a maximum penalty of $50,000 for all failures occurring during any calendar year.
What Does CohnReznick Think?
Widespread use of the Section 83(i) deferral election opportunity is not likely due to the 80 percent coverage requirement and its inapplicability to certain shareholders, current and past members of senior management and their families, and highly-compensated officers. The illiquidity of the private company stock that would be received, combined with the fact that the deferral would be limited to income tax, such that upon exercise or settlement, even where the inclusion deferral election is made, the employee would need the funds to meet his FICA tax liability, will likely serve to further limit the impact of this provision.
Certain small earlier-stage companies that cannot afford to pay significant cash compensation and which accordingly rely upon stock options and/or stock-settled RSUs to attract and compensate many of their employees at various levels, may have a greater interest in establishing the plans needed for purposes of providing the deferral election opportunity. For the right corporation and its employees, such an arrangement may be an important tool for utilizing equity compensation as an employee incentive. Ultimately, the effectiveness of the use of a Section 83(i) arrangement may turn upon whether the maximum 5-year deferral period will be sufficient to permit the occurrence of a monetizing liquidity event before the employee’s deferred tax liability must be met in connection with the stock option or RSU.
Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute legal or professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice specific to, among other things, your individual facts, circumstances and jurisdiction. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its partners, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.