It has been more than a year since the passage of the Tax Cuts and Jobs Act of 2017, and by now most employers who issue employee equity incentives are at the very least familiar with the new election to defer compensation allowed by Section 83(i) of the Internal Revenue Code of 1986, as amended. Now that the IRS issued additional guidance on the practical considerations of Section 83(i) in Notice 2018-97, it has become clearer that there are limited benefits to this election opportunity both for employees and employers. In fact, it is hard to imagine a situation where those limited benefits would outweigh the burdens to both employee and employer.
An employee who makes a Section 83(i) election with respect to stock received upon exercise of an option or settlement of a restricted stock unit (RSU) may defer the inclusion of the value of that stock in income until the earliest of the following events occurs:
Once the earliest event occurs, the employee would pay income tax only on the value of the deferred amount, and any subsequent appreciation of the stock's value would be taxed at capital gains rates. Small and newly established companies encouraging alignment of employees' financial goals with their own goals may find that offering the Section 83(i) election gives employees yet another incentive to take ownership in the business; however, certain key restrictions severely curb the election's utility.
In order to offer the Section 83(i) election, a series of specific events must align just right. First, a privately held corporation must grant stock options or RSUs with the same rights and privileges to receive stock to 80 percent of its employees, including employees of entities in the same controlled group as the employer, in the calendar year in which the Section 83(i) election is to apply. Many employers prefer to make equity grants at hire, but for this election opportunity to apply, the employers may find that they need to make grants more frequently, especially if they are expanding their workforce. Additionally, to meet the "same rights and privileges" requirement, employers must issue either options or RSUs to 80 percent of its employees; they cannot, for example, issue RSUs to 70 percent of their employees and options to 10 percent. Section 83(i) also excludes from the deferral opportunity the following executives and highly compensated employees from making an election thereunder: 1) anyone who is or was a 1 percent owner during the current or previous 10 calendar years; 2) anyone who is or was the chief executive officer or chief financial officer, or is the spouse, child, grandchild or parent of the chief executive officer or chief financial officer; and 3) anyone who is or was one of the four highest compensated officers of the corporation for any of the current or 10 previous tax years. Employers who offer equity incentives only to their officers or very small employers, most of whose employees are excluded, will not be able to offer this election. Finally, if an employer has repurchased stock in the previous calendar year, the employer will not be able to offer the election unless the repurchases were of 1) all stock for which a Section 83(i) election was made, or 2) stock for which a Section 83(i) election was made with respect to at least 25 percent of the grants. Employers who want to offer this election may find that they are unable to repurchase stock from terminated employees. These requirements dramatically reduce employers' flexibility in making equity grants.
There are already opportunities for tax preferred treatment for certain forms of equity awards. Employers who offer incentive stock options (ISOs) or who offer options through an employee stock purchase plan (ESPP) may generally be better off leaving these incentives unchanged. An employee who makes a qualifying disposition of an ISO pays tax on his or her profit at the much lower capital gains rate, but an employee who makes a Section 83(i) election pays both ordinary income tax on the spread at exercise and capital gains tax on future appreciation. Qualified ESPPs (though rare in a private company) and ISOs do not impose a withholding requirement on employers, but when an employee makes a Section 83(i) election, the employer must withhold income tax at the time of exercise. An ISO is not subject to Federal Insurance Contributions Act (FICA) or Federal Unemployment Tax Act (FUTA) taxes at exercise or upon a qualifying disposition of stock. Because the Section 83(i) election disqualifies an ISO, stock issued with respect to an ISO that otherwise would not have been subject to payroll taxes would now be subject to payroll taxes. Furthermore, Section 83(i) defers only the payment of ordinary income tax, so the employer would still be required to withhold, and the employee would still be required to pay, payroll tax at the normal timing (the time of exercise for a nonqualified stock option). The employer must also defer its deduction until the year the amount is included in the employee's income.
However, there is more. The burdens of Section 83(i) can be significant. At the end of the Section 83(i) deferral period, the employee owes income tax on the value of the stock at vesting or exercise and the employer must also withhold income tax at that time. Notice 2018-97 requires employers to hold stock with respect to which a Section 83(i) election was made in escrow until the employer meets its withholding requirement. To be clear, if the value of the stock decreases following vesting or exercise, the employee still pays income tax on the value of the stock at the time of vesting or exercise. The escrow, though providing some access to stock to pay the withholding, does not guarantee that there will be sufficient value to cover any applicable tax withholding obligations.
In addition, an employer is required to provide a notice of the availability of the Section 83(i) election to employees or face a fine of $100 for each failure, up to a maximum penalty of $50,000 per year. Fortunately, there is little risk that an employer would create the precise conditions needed for employees to make an 83(i) election without intending to do so. Indeed, on initial review of the multitude of requirements necessary for the Section 83(i) deferral election opportunity to apply, it would appear that it is inapplicable to most employers' equity arrangements and that an employer would need to make an affirmative effort to cause the rules to apply should the benefits of the Section 83(i) deferral opportunity be desirable. Until Notice 2018-97 was released, many practitioners were also concerned that those rare employers inadvertently, and perhaps miraculously, meeting the requirements of Section 83(i) would be required to offer the deferral "opportunity" of Section 83(i) and face onerous penalties if it failed to make the offer. However, Notice 2018-97 clarifies that an employer may intentionally avoid the application of Section 83(i) by, among other things, not establishing the required escrow arrangement. An employer may explicitly state in its equity plan that no election under Section 83(i) will be available, thereby informing employees at the outset of the equity arrangement.
Small employers should carefully consider the administrative burdens and potential benefits of offering a Section 83(i) election to its employees before implementing such an arrangement and consider taking action to affirmatively avoid the application, and obligations, of Section 83(i) by amending its equity plan.
If you have any questions regarding the impact of Section 83(i), please contact the authors or another member of Holland & Knight's Employee Benefits and Executive Compensation Group, including Partners Ari Alvarez, Kelly Bley, Gregory Brown, Christopher Buch, Bob Friedman, Kerry Halpern, Claudia Hinsch, John Martini and David Pardys.
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