The IRS issued Notice 2018-97 (Notice) on December 7, 2018, providing some much needed guidance on interpreting Internal Revenue Code (Code) section 83(i) for qualified equity grants. Section 83(i) was added to the Code as part of the 2017 Tax Cuts and Jobs Act effective at the beginning of this year and permits employees granted stock options or Restricted Stock Units (RSUs) under a “qualified equity grant” to elect to defer the income tax resulting from the receipt of stock from the exercise of an option or the settling of the RSU for up to five years. See New Section 83(i) Provides a New Tool for Allowing Employees to Participate in the Sale of their Private Corporation-Employer, and A More Detailed Look at Section 83(i) Plans. The Notice was issued as a result of stakeholders requesting guidance from the IRS on certain aspects of section 83(i). The Notice provides guidance on calculating the number of employees receiving grants in the year to determine if the 80% test is met; the employer’s obligation to withhold income tax on the deferred income; and how an employer can opt out of a grant being subject to section 83(i) if its provisions are otherwise met.
Annual 80% Test. Section 83(i) provides that if qualified stock is transferred to a qualified employee who makes an 83(i) election, then the income tax on such transfer can be deferred up to five years. Qualified stock is defined as stock received by a qualified employee from the exercise of a stock option or the settlement of an RSU that was granted when the corporation was an eligible corporation. An eligible corporation is one that issues grants of stock options or grants of RSUs to at least 80% of its qualified employees (80% Test).
The Notice clarifies that the 80% Test only counts grants made during the calendar year and does not count grants made in prior years on a cumulative basis. In applying the 80% Test, employers must take into account the total number of non-excluded full time employees employed during the calendar year. This means the 80% Test is only met if the grants are made to at least 80% of the highest number of such employees during the year.
Income Tax Withholding. The Notice also reiterates how the employer is responsible for income tax withholding when the deferred income becomes taxable as wages to the employee. Income tax is to be withheld at the maximum rate which is currently 37%. The employer must make a reasonable estimate of the value of the stock at that time. However, withholding can be a problem if the employee who made the election no longer works for the employer. To remedy this, the Notice provides that the 83(i) election must provide that the employee agrees that stock subject to an 83(i) election must be held in escrow until: 1) the corporation has recovered the income tax withholding amount form the employee; or 2) between the date of income inclusion and March 31 of the following year, the employer retains an amount of stock with a fair market value equal to the amount of income tax withholding.
Opting Out. As soon as section 83(i) became law, the question arose as to whether any qualified employee participating in a stock option plan or RSU plan of an employer could make a valid 83(i) election if the grant met the requirements of section 83(i). The Notice somewhat clarifies this by providing an employer can avoid a plan being subject to section 83(i) by simply declining to offer the required escrow arrangement described above. Further, the terms of the stock option or RSU may provide that no 83(i) election will be available with respect to stock received upon exercise or settlement.
Conclusion. The Treasury Department intends that the guidance under the Notice will be incorporated into regulations in the future and the Notice guidance will be effective as of December 7, 2018, the date of the Notice. Any other future guidance will apply prospectively. The Treasury Department and IRS are requesting comments through February 5, 2019.
While the clarifications under the Notice are helpful, they do add additional complexity to the administration of plans eligible for the 83(i) election. Employers have to count all eligible employees throughout the year of grant to determine whether the stock issued as a result of that grant qualifies for the election. Additionally, 83(i) elections now must contain the required escrow arrangement language. This may require existing election forms to be rewritten. Employers considering adopting a stock option or RSU plan might decide not to offer the 83(i) deferral due to such complexity. Still for start-up companies or smaller employers who want to give a significant number of employees “skin in the game”, a section 83(i) eligible plan could be quite useful.