Part of Our Series on the Tax Cuts and Jobs Act of 2017
When an employee exercises a stock option or receives shares of stock from the settlement of a restricted stock unit (or “RSU”), generally the employee has income based on the value of the stock received. Income tax and Social Security and Medicare (“FICA”) taxes are due, and the employer must withhold and report these taxes.
Employees of publicly traded companies usually can sell shares in the public market to cover the cost of their taxes. However, there is typically no market for shares of privately held companies, such as start-ups. As a result, employees receiving shares of a private company through a stock option exercise or RSU settlement usually must come up with the cash to pay the IRS.
The Tax Cuts and Jobs Act of 2017 (the “Act”) adds a new section 83(i) to the Code that allows certain employees of private corporations that broadly grant stock options or RSUs to elect to defer income tax for up to five years. This is referred to as an “83(i) election”.
Section 83(i) was billed as a way to make it easier for employees of start-ups and other private companies to share in their employers’ success. However, as we explore in this post, the benefits of an 83(i) election may be limited. As discussed in more detail below, private employers face a number of questions about how they can — and whether they will want to — offer an equity program that is eligible under section 83(i).
Requirements for an 83(i) Election
An employee is eligible to make an 83(i) election if the following requirements are met:
- 80% requirement. In the year in which the stock option or RSU was granted, the employer granted to at least 80% of its full-time U.S. employees stock options, or RSUs, with the same rights and privileges. The 80% threshold is applied separately to options and RSUs, so (i) an employee may make an 83(i) election with respect to a stock option only if the employer granted options to 80% of its employees in the year that option was granted, and (ii) an employee may make an 83(i) election with respect to an RSU only if the employer granted RSUs to 80% of its employees in the year that RSU was granted. Until the issuance of Treasury regulations or other guidance, employers may rely on a reasonable good faith interpretation of this 80% requirement.
- Not an excluded employee. The employee is not an “excluded employee”—defined generally to mean the current and former CEOs and CFOs, certain current and former highly compensated employees, and employees who own more than 1% of the employer.
- No ability to cash-out. The employee is not able to sell the shares to (or receive cash in lieu of shares from) the employer.
- Repurchase limitation. The employer has not repurchased any of its shares in the prior calendar year, unless either (i) shares subject to an 83(i) election represented at least 25% of the value of the shares repurchased or (ii) all shares subject to an 83(i) election are repurchased. The language of the statute and the Act’s legislative history indicate that the relevant calendar year is the year prior to the year in which the employee makes the election. As described in the paragraph below, the timing for the election should be clarified in guidance.
An 83(i) election must be made within 30 days after the rights of the employee in the stock underlying an option or RSU are first either (1) transferable or (2) not subject to a substantial risk of forfeiture (i.e., vested). A sensible interpretation of this rule is that the 30-day period begins to run from the date the stock is received upon exercise of an option, or settlement of an RSU, as long as the stock is not subject to additional vesting conditions. (In the case of an “early exercise” of an unvested stock option, the employee receives stock that is subject to further vesting, and the 30-day period would begin on the later vesting date.)
However, some have questioned whether the 30-day period runs from the date of vesting of the option or RSU; particularly in the case of an option, this could be years before the exercise date. Employers will be looking for Treasury and the IRS to provide clarity on this timing question.
Effect of an 83(i) Election
If an employee makes an 83(i) election, income tax is deferred until the earliest of:
- The stock becoming publicly traded (for example, in connection with the employer’s IPO);
- The stock becoming transferable (for example, in connection with a sale of the employer), including transferable to the issuing employer;
- The employee becoming an “excluded employee”;
- The employee revoking the election (to the extent permitted by the IRS, though there is not yet guidance from the IRS on this); or
- Five years after the employee’s rights to the stock are first transferrable or not subject to a substantial risk of forfeiture.
The income recognized in the later year is equal to the amount that would have been included at the time of exercise or settlement, even if the value of the stock has since increased or decreased. When the employee recognizes income, the employer may take a corresponding deduction and must withhold income tax at the highest marginal income tax rate (currently 37%). The special income tax withholding rules for non-cash fringe benefits apply to income deferred under an 83(i) election.
Note that an 83(i) election does not apply to FICA taxes. As a result, even if an employee makes a proper 83(i) election, the employee and employer portion of FICA taxes will be due in the normal course — generally upon the exercise of a stock option (that is not an incentive stock option) and upon the vesting or settlement of an RSU.
Effect on ISOs and ESPPs
An employee may make an 83(i) election with respect to incentive stock options (“ISOs”) or options granted pursuant to an employee stock purchase plan, but this will result in a loss of the tax-favored treatment that normally applies to these types of awards.
Notice and Reporting.
Several notice and reporting requirements apply:
- An employer must provide a notice to employees explaining the availability of the 83(i) election at the time the income would be recognized by the employee absent the election, generally at exercise or settlement. There is a $100 penalty for each failure to provide the notice, with a maximum penalty of $50,000 per year. Until the issuance of Treasury regulations or other guidance, employers may satisfy the notice requirement based on a reasonable good faith interpretation.
- An employer must report in box 12 of an employee’s W-2 both (1) the amount being deferred pursuant to one or more 83(i) elections as of the end of the year (using code HH) and (2) the amount includible in gross income under section 83(i) for that year (using code GG).
- An employer must also report on its return the value of shares it repurchased for any year in which shares are covered by an 83(i) election.
The provisions of section 83(i) are generally effective for stock options exercised, or RSUs settled, in 2018 and later years. This means that an 83(i) election might be available for stock received pursuant to a stock option or RSU granted in an earlier year, if the exercise or settlement occurs in 2018 or a later year and the requirements of 83(i) are met.
Implications for Private Employers
For a number of reasons, the application and benefit of section 83(i) may be limited:
- 80% requirement is inconsistent with common practices. As noted above, an employee is eligible to make an 83(i) election with respect to an option only if in the year that option was granted the employer also granted options to at least 80% of its other employees. A typical start-up company might grant a stock option to each new hire and make occasional grants in connection with a promotion or other notable achievement, but usually will not make grants to all continuing employees on an annual basis. In fact, there is a significant incentive for stock option grants to be front-loaded, since options must have an exercise price of at least the fair market value of the shares on the grant date, and, in general (although not always), the share price of a successful start-up will increase over time. An employee joining a start-up in its early days will prefer a single option grant at hire, instead of grants spread throughout the employee’s tenure. RSUs, which are less common than stock options among private companies and do not require an exercise price pegged to the fair market value at grant, may be better suited to a program of annual grants, as contemplated by section 83(i).
- Employer repurchases may make election unavailable. 83(i) elections are not available if the employer has repurchased stock in the prior year unless the repurchase meets certain requirements. Private employers often reserve the right to repurchase shares, for example, upon an employee’s termination of employment. It remains to be seen whether guidance from Treasury and the IRS will provide that certain repurchases will not cause the 83(i) election to be unavailable.
- ISO rules already offer employees preferential tax treatment. The general rule that income and employment tax is due on exercise of an option does not apply to ISOs. No income tax is due on exercise, and generally employment tax is never due for an ISO. The exercise of an ISO is included for purposes of the alternative minimum tax (“AMT”), but only relatively high earners are subject to the AMT. Unlike the 83(i) rules, under the ISO rules tax is deferred until the employee sells the shares received upon exercise. In addition, depending on the circumstances, all or a portion of the income recognized on the sale of stock received under an ISO may be taxed at preferential long-term capital gains rates, which are more favorable to the employee than the ordinary income tax rates that apply under section 83(i). Dollar value limits apply to ISOs, and ISOs granted to employees who are more-than-10% shareholders are subject to additional restrictions, but, as noted above, highly compensated employees and others are not eligible to make 83(i) elections. For employees eligible for ISOs, these may be preferable to the tax treatment under section 83(i). Whether section 83(i) is available for any employees affected by the ISO limits or with AMT liability may depend on the particular facts.
- Potential disadvantages to section 83(i). Employers may see disadvantages with an equity program that is subject to section 83(i). For example:
- Absent an 83(i) election, the employer generally may take a deduction when the employee exercise an option (other than an ISO) or receives shares upon settlement of an RSU. As noted above, the employer’s deduction is delayed if an employee makes an 83(i) election.
- If employees hold shares subject to an 83(i) election and the employer undergoes an IPO, the 83(i) deferral ends and the employees will recognize income. However, under the terms of the IPO, employees may be subject to a lock-up so that they are unable to sell their shares immediately for cash to cover their taxes.
- Employers will want to consider how employees will react to other possible scenarios under section 83(i)—for example, if the deferred tax becomes due because the five year maximum deferral period ends before an IPO or sale, or the shares decrease in value after the 83(i) election is made, with the amount of income to be recognized having been fixed based on the higher value.
- Ambiguities and open questions. In some cases, the Act indicates that employers may rely on a good faith interpretation of the statute until guidance is issued. However, the language of the statute includes other ambiguities and raises a number of other questions.
Particularly given the notice, withholding, and reporting requirements, private employers should review their equity arrangements and consider whether 83(i) elections are available for any currently outstanding stock options or RSUs, and whether (and if so, how) they will offer stock options or RSUs that will be subject to section 83(i). As of the writing of this post, Treasury and the IRS have not indicated when they expect to issue initial guidance under section 83(i). Check back to InsideCompensation, as we will continue to keep you apprised on this and other important developments for employers under the Act.