There are many hoops to jump through to enjoy the benefits of Section 83(i), but under the right circumstances they may be worth it.

Last February I blogged about new Section 83(i) of the Internal Revenue Code that was added by the 2017 tax reform legislation and provides for up to a five-year deferral of the income tax consequences to an employee when exercising a Non-Statutory Stock Option or settling a Restricted Stock Unit in stock.  See New Section 83(i) Provides a New Tool for Allowing Employees to Participate in the Sale of their Private Corporation-Employer. That article was a brief overview of the new law. For a more detailed discussion click on my article published in the Summer issue of the Journal of Pension Benefits, titled Ay, Ay, Ay, How Do You Comply with Section 83(i) – To Obtain Tax Deferrals on Qualified Equity Grants.  As discussed in the article there are many hoops to jump through to enjoy the benefits of Section 83(i), but under the right circumstances they may be worth it.

Employers often tell me how they want to provide their employees who have helped them build their business an opportunity to benefit from a future sale of the business.  In the past, I have then discussed with them the pros and cons of such techniques as restricted stock, phantom stock, and stock appreciation rights, including the application of ERISA, tax law including Internal Revenue Code Section 409A, securities law, and shareholder rights under corporate law.  Afterward, the employer often decides that they don’t want all employees becoming actual shareholders in the company with the statutory rights that go with it, and opt for a phantom arrangement that provides for them to receive cash only as if they were a shareholder or due to a change in control.

Now, thanks to tax reform under the Tax Cuts & Jobs Act, there is a tool that can help with the tax burden of employees receiving compensatory stock by giving them up to five (5) years to pay the tax on the receipt of the stock.  If a qualified employee receives qualified stock from a qualified corporation as a result of exercising a non-statutory stock option (NSO) or settling a Restricted Stock Unit (RSU), the qualified employee can file an “83(i) election” to defer the tax for five (5) years unless a disqualifying event occurs in the interim.

An NSO is any stock option granted by a qualified employer that is not an incentive stock option (or statutory stock option) or provided under an Employee Stock Purchase Plan that qualifies for special tax treatment under Code Section 422.  An RSU is the right to receive stock in the future.

Generally, without an 83(i) election, employees are subject to income tax on the difference between the fair market value of the stock on the date of exercise of the option less the exercise price, if any.  Likewise, employees are subject to income tax from receiving stock on the settling of an RSU on the fair market value of the stock on settlement less any amount the employee paid for the RSU.  A Section 83(i) election allows the qualified employee to defer the tax for five (5) years.

Qualified Employee – A qualified employee is a U.S. based employee that regularly works more than thirty (30) hours per week that is not:  already an owner of at least 1% of the stock of the corporation; an employee that is or has ever been the CEO or CFO; a spouse, child, grandchild or parent of a 1% owner, CEO or CFO; or among the four (4) highest paid officers of the corporation.

Qualified Stock – Qualified stock is stock in the employer corporation received by a qualified employee in connection with the exercise of an NSO or settlement of an RSU in exchange for services to the employer during a year when the employer was an eligible corporation.

Eligible Corporation – An eligible corporation is one that during the calendar year in which the NSO or RSU was granted:  No stock of the corporation is readily tradeable on an established securities market during any preceding calendar year and the corporation has a written plan under which at least 80% of all U.S. based full-time qualified employees are granted NSOs or RSUs with the same rights and privileges to receive more than a de minimis amount of qualified stock.

Upon receipt of the stock, the qualified employee has thirty (30) days to make the 83(i) election by filing it with the IRS and giving a copy to the employer.  If made, the tax that would have been incurred will not be taxed until five (5) years from the year it would have been taxable without the election unless one of the following intervening events occurs earlier:

  1. The first date stock of the employer becomes publicly traded;
  2. The date the employee ceases to be a qualified employee;
  3. The date the qualified stock becomes transferable including to the employer;
  4. The date the employee revokes the 83(i) election.

The intent of Section 83(i) is to help with the “phantom income” problem that employees of private corporations have when being compensated with stock.  Without the Section 83(i) election, the employee is taxed on the exercise of an NSO on the difference between the fair market value of stock on exercise and the exercise price.  The income is considered wages subject to income tax withholding and employment taxes.  Likewise, upon receiving stock from the settling of the RSU the employee is taxed on the fair market value of the stock on the date of settlement.  Both situations cause phantom income because while the employee has taxable income, he/she has not received any cash to pay the additional tax or withholding which must come from other income.  Additionally, unlike employees of public corporations, the employee of a private corporation cannot just sell some of the stock received on the open market to get cash to pay the tax.

A Qualified Equity Grant Plan under Section 83(i) could be just the tool for a small private corporation that expects to be acquired in the next couple of years, to allow its full-time employees to share in the acquisition transaction.  For example, the qualified corporation could grant RSUs to all full-time employees in Year 1, with a fair market value of $2.00/share to be settled in Year 2.  In Year 2, the employees could make the 83(i) election deferring tax for five (5) years. However, in Year 4, all the employer’s stock is acquired by a buyer (including the employees’ stock which is transferrable upon a sale) for $5.00/share.  The employees now have money to pay the tax on the ordinary income of $2.00/share from receipt of the stock, plus the capital gain on the $3.00/share of appreciation based on the purchase of their stock by the buyer.  Thus, the employees have participated in the sale at capital gain rates and have cash to pay the tax on what would have been phantom income in year 2, if not for the Section 83(i) election.

If you think you may be interested in establishing a Qualified Equity Grant Plan or other compensatory equity or bonus plan, please contact me.