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.

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.