Updated 2/8/19: The IRS has issued guidance that elaborates on the requirement that a corporation must have a written plan that includes at least 80% of all employees (detailed below). The guidance provides that the satisfaction of this 80% requirement is determined on a calendar-year basis. Additionally, the notice also requires that employers make an estimate of the value of the stock treated as wages paid and make timely income tax withholding deposits on that estimate. Employees must agree that the deferral stock be deposited into escrow to ensure the withholding requirements are met. For additional info, see Notice 2018-97 and News Release IR 2018-246.
What’s the problem?
An employee who receives equity-based compensation may have to pay tax when they receive or exercise the stock or option, but the terms of the grant (such as a vesting period) may not allow them to exercise the option and/or sell the shares until a later date, leaving the employee with a tax bill and no way to liquidate their options to pull together the cash to pay the taxes due.
What’s the solution?
The 83(i) Election gives qualified employees of eligible companies the ability to defer income from vested qualified stock grants for up to five years. However, strict criteria, which we’ll review below, must be met before a Section 83(i) Election can be made (we’ll also define what it means to be a qualified employee, an eligible company, and a grant of qualified stock).
A Quick Recap…
Before we get into the meat of the new election, let’s quickly review some of the most common forms of stock-based compensation:
- What It Is – Grants of shares of stock in a company to employees, as part of their compensation package, that is not transferrable (i.e. it can’t be sold) by the employee until certain conditions, such as a certain number of years of employment, have been met.
- Tax Implications – It is taxable to the employee in the year in which it is no longer subject to substantial risk of forfeiture (i.e. when the conditions of vesting are met). Exception – If an 83(b) election is made by the employee, the receipt of the restricted stock will be taxable at the time of receipt. If you want to brush up on 83(b) elections, check out my article What is an 83(b) Election & Why Do My Entrepreneur Friends Keep Bringing It Up?
Restricted Stock Units (RSUs)
- What They Are – While a similar concept to restricted stock, RSUs are not stock. An RSU is a promise made by an employer to deliver a certain number of shares of stock in the company to an employee, as part of their compensation package, once certain conditions, such as a certain number of years of employment, have been met.
- Tax Implications – It is taxable to the employee in the year in which it vests and the shares are delivered to the employee. Because no shares are actually delivered to the employee until the RSU is vested, RSUs are not eligible for an 83(b) election.
Incentive Stock Options (ISOs)
- What They Are – Stock options granted to employees of a company as a part of their compensation package. The options are generally granted at the stock’s current market value, and the employee is expecting that by the time the options vest, the stock price will have risen and they will be able to exercise them and buy the stock at a discount, which could then be sold at a profit
- Note – RSUs and ISOs are different! Options are not shares of a company’s stock. An option is a contract that gives the holder the right to buy (or sell) shares of the company’s stock at a pre-determined price specified in the contract.
- Tax Implications – ISOs are generally taxable to the recipient when the underlying shares are sold (if various criteria, such as how long you hold the stock for, are met). To break it down, if your company grants you ISOs, it’s not taxable. If, after they vest, you exercise the ISO and now own shares of the company’s stock, it’s not taxable. Then, if you decide to sell the shares of stock at a profit, the gain on the sale is taxable at capital gains rates instead of at the higher ordinary income rates. Note – there are several layers of criteria that must be met for the disposition of stock to be considered “qualified” as well as potential AMT implications, but these topics are beyond the scope of this article. If you have any questions, let us know so we can help address your specific situation!
Nonqualified Stock Options (NQSOs)
- What They Are – Stock options granted to employees of a company as part of their compensation that fail to meet one or more of the criteria required for an option to qualify as an ISO.
- Tax Implications – When the employee exercises the option (i.e. buys the stock at the predetermined purchase price), they are taxed at ordinary income rates on the spread between the strike price (the predetermined purchase price) and the current market value.
How does Section 83(i) help, and how does it work?
If an employee makes the election, he or she may defer income from qualified equity grants for up to five years from the vesting date.
The amount includible in the employee’s income is determined when the 83(i) election is made, and equals:
- For a Stock Option – The excess of the Fair Market Value (FMV) of the stock at the time of exercise over the exercise price. For example, if the stock is exercised when the exercise price is $5 and the FMV is $9, the income is $9 – $5 = $4
- For an RSU – The FMV of the stock at the time of exercise (or vesting) less any amount that the employee pays for the stock. For example, if the RSU is valued at $2,000 at the vesting date and the employee pays $500 to obtain the stock when it vests, the income is $2,000 – $500 = $1,500.
The income is calculated as detailed above and is then included in the employee’s taxable income in a later year. The income can generally be deferred for 5 years. However, the income must be recognized earlier if any of the following occur:
- The stock becomes transferable (including transferring it back to the employer)
- The employee is no longer a qualified employee
- The stock becomes readily tradable on an established securities market
- The employee revokes the Section 83(i) election
Caution!! This election is not without risk! As with an 83(b) election, the employee runs the risk that instead of appreciating after the election is made, the stock can decrease in value. Given that the income is determined when the election is made, it is possible that the tax liability (based on this income determination) can actually be greater than the value of the stock when the income is included in the employee’s taxable income and the tax liability comes due!
I’ve made it this far! What qualifications must be met in order for Section 83(i) to apply?
The employee must be a qualified employee. A qualified employee is any employee who decides to make a Section 83(i) election, except for:
- An individual who owns (or has owned during the past 10 years) more than 1% of the outstanding stock or voting power of the corporation (a.k.a. a “1% owner”). Note – ownership can be direct or constructive (which aggregates the ownership of groups of people with certain relationships, such as siblings or parents and children)
- Anyone who has ever been the company’s CEO or CFO (or is a family member of one of these individuals)
- The four highest compensated officers for the current year or any of the prior 10 years
The employer must be an eligible corporation. An eligible corporation is a company that meets the following criteria:
- Is privately owned
- Has a written plan under which at least 80% of full-time employees are granted stock options or RSUs with the same rights and privileges to receive qualified stock
- Note – Employees may receive varying amounts of options or RSUs as long as they get the same type of reward and more than a de minimis amount (unfortunately, the IRS has not yet defined what they mean by de minimis for the purposes of this election)
The transferred stock must be qualified stock – Qualified stock must meet the following criteria:
- It must be received in connection with the exercise of an option or in settlement of an RSU to a qualified employee by an eligible corporation. An eligible stock option can be an ISO, an Employer Stock Purchase Plan (ESPP) or an NQSO
- The corporation in question must be the employer of the qualified employee (i.e. the employee must work for the company whose stock options they are selling)
- The employee must have received the option or RSU in connection with the performance of services for the employer
- The employee must not have the ability to sell it back to the employer or receive cash in lieu of stock immediately upon vesting. If you think about it, this rule makes sense. If this rule wasn’t in place, you could affectively pay an employee in cash by giving them stock and then immediately swapping it for cash or buying the shares back from them (for cash), and this election isn’t intended to be used for cash payments
How and when is the election actually made?
- The election must be made within 30 days of the stock or options vesting (i.e. being transferable or not subject to substantial risk of forfeiture)
- Similar to making an 83(b) election, a copy of the election must be provided to the employer
- As of now, the IRS hasn’t issued additional guidance on making an 83(i) election
How does the employer handle all of this?
The employer can take a deduction for the amount of the income reported to the employee in box 1 of Form W-2 for the tax year in which the employee recognizes the income.
For FICA and FUTA purposes, the income is not deferred. Employers can withhold the FICA on this portion of the employee’s wages from other wages, have the employee remit the amount of the withholding to the employer from his or her own funds, or pay the FICA for the employee (which results in additional compensation to the employee).
Additionally, the employer has notice and reporting requirements. When an employer transfers qualified stock to a qualified employee, it must provide notice to the employee at the time of the transfer tells the employee that:
- The stock is qualified
- They may elect to defer income by making a Section 83(i) election
- The income is determined at the time of the election, even if the stock decreases in value
- The income will be subject to federal income tax withholding at the maximum rate in effect for individuals (37% for 2018)
- The employee must agree to ensure the withholding requirements are met
- Note – Failing to provide this notice is subject to a $100 penalty for each failure (up to $50,000 in a calendar year) unless the failure is due to reasonable cause
The employer must also report the following on each employee’s Form W-2:
- The amount includible in the employee’s gross income for both the year of deferral and the year the income is required to be included in the employee’s taxable income
- The aggregate amount of income that’s being deferred under Section 83(i) elections as of the close of the calendar year
What does this all mean?
The tl;dr here is that this looks like it will be beneficial for employees of private companies since it will give them a 5-year deferral on certain income. However, we’re still waiting for substantial guidance from the IRS to determine some of the specifics that can have a material impact on how the final version of this election works. If you think this may apply to you, let us know! We can help make sure you’re optimizing your tax situation!