Under Sec. 83(a), an employee who receives shares of employer stock from exercising a nonqualified option or the settlement of a restricted stock unit (RSU) generally includes in gross income the value of the shares received (less any amount paid). The time of inclusion is the first tax year in which the employee's rights in the stock are transferable or are not subject to a substantial risk of forfeiture. Public company employees, if they choose, can fund the payment of the tax due on the income inclusion by selling a portion of the shares received. However, in the case of a privately held company, for many employees, the income inclusion rules of Sec. 83(a) present a problem in that they are paying tax on the receipt of stock for which there is not typically a ready market in which to sell the shares.
New tax law creates a private company solution — maybe
As part of the most comprehensive tax reform package enacted in 30 years (see the act formerly titled the Tax Cuts and Jobs Act, P.L. 115-97), Congress added new Sec. 83(i), providing eligible private company employees the opportunity to elect to defer for up to five years the recognition of income from private company stock acquired due to the exercise of a stock option or the settlement of an RSU, provided the employee received the stock as part of a qualified equity grant. The income-deferral election applies with respect to stock received due to options exercised or RSUs settled after Dec. 31, 2017.
Income tax deferral opportunity
If a qualified employee makes a Sec. 83(i) election, income taxes are due upon the earliest of the following dates:
- When the stock becomes transferable, including to the employer;
- When the employee first becomes an excluded employee;
- When the stock becomes readily tradable;
- Five years after the first date the rights of the employee in such stock are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier; or
- The date the employee revokes his or her election.
Value recognized and withholding rate required
The amount eventually included in income is the amount the employee would have realized at the time the shares would have become transferable or not subject to a substantial risk of forfeiture, even if the value of the shares has declined. As to income tax withholding, the employer is required to withhold tax at the maximum rate of tax in effect for the year of inclusion.
No FICA deferral
For Federal Insurance Contributions Act (FICA) tax purposes, the traditional inclusion in FICA wages on exercise of a nonqualified option or vesting of an RSU applies. This means employers will have to arrange to withhold or collect the employee's share of FICA at the time of the exercise or settlement before income tax inclusion.
Qualified equity grant requirements
A grant must meet certain requirements to be a qualified equity grant:
1. The grant must be one issued by a corporation the stock of which is not readily tradable on an established securities market (i.e., a private company), and it must be issued to an eligible employee as compensation for services;
2. The corporation must issue the grant pursuant to a written plan under which, in such calendar year, not less than 80% of all U.S.-based employees who provide services to such corporation receive grants of stock options or RSUs;
3. The grants must provide all eligible employees the same rights and privileges to receive qualified stock; and
4. The employee must not have the right to sell such stock to, or otherwise receive cash in lieu of stock from, the corporation at the time that the rights of the employee in such stock first become transferable or not subject to a substantial risk of forfeiture.
Excluded employees (discussed below) or any part-time employees are not taken into account when determining whether the plan meets the 80% threshold. For this purpose, part-time employees are any employees customarily employed for less than 30 hours per week.
Same rights and privileges
A plan makes the determination of whether the rights and privileges related to these equity grants meet the same-rights-and-privileges requirement by reference to the standards for an employee stock purchase plan (ESPP) under Sec. 423(b)(5). However, a plan shall not fail to provide the same rights and privileges solely because the number of shares available to all employees is not equal in amount, so long as the number of shares available to each employee is more than a de minimis amount. Further, Sec. 83(i)(2)(C)(ii) provides that a plan cannot treat the rights and privileges with respect to the exercise of an option as the same as rights and privileges with respect to the settlement of an RSU. This means that a corporation could not award some employees RSUs while granting options to another group of employees.
Qualified employees and excluded employees
All employees other than "excluded employees" are qualified employees. An excluded employee is any employee who (1) is or was at any time in the current or 10 preceding calendar years a 1% owner of the corporation, or (2) is or has been at any prior time the CEO or CFO of the corporation, or an individual related to the CEO or CFO under the Sec. 318(a)(1) family attribution rules. Additionally, any person who is one of the four highest-compensated officers of such corporation for the tax year (or in any of the 10 preceding tax years) as determined under SEC shareholder disclosure rules (as if they applied) is also an excluded employee.
Controlled group
For purposes of a qualified equity grant, all persons treated as a single employer under Sec. 414(b) (i.e., members of a controlled group of corporations) are treated as a single corporation.
Election procedures
A qualified employee must make the election with respect to qualified stock no later than 30 days after the first date the rights of the employee in such stock are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier. The qualified employee must make the election in a manner similar to the manner in which an employee makes an election to include an unvested stock award into income under Sec. 83(b). Current IRS guidance on a Sec. 83(b) election is published in Rev. Proc. 2012-29. Until the IRS issues guidance for making a Sec. 83(i) election, taxpayers may consider reviewing Rev. Proc. 2012-29 for guidance as to how to elect Sec. 83(i) treatment.
Procedural matters
An employer that offers qualified equity grants must comply with a number of notice, withholding, and information-reporting requirements. For example, the employee notice provisions require the employer to notify the employee that the stock received is eligible for the deferral election, and that, if the employee makes the election, the amount of income the employee will eventually report relates to the fair market value at the time the shares first became transferrable or not subject to a substantial risk of forfeiture — even if the value of the shares declines. Failure to meet the notice requirement will subject an employer to a penalty of $100 for each failure, with a maximum of $50,000 in any calendar year, under Sec. 6652(p).
Coordination with other Code sections
Section 13603 of P.L. 115-97 also amended Secs. 409A, 422, and 423 to provide that an employee's deferral election does not cause the arrangement to be a deferred compensation plan subject to Sec. 409A's election, time, payment, or other rules. Further, if an employee makes an election with respect to an option under an incentive stock option plan (Sec. 422) or an ESPP (Sec. 423), it is then treated as a nonqualified stock option.
Good-faith transition rules
Until Treasury issues regulations or the IRS issues subregulatory guidance, reasonable, good-faith compliance with the requirement to include at least 80% of all employees in a qualified equity grant plan, as well as with the employee notice requirements, should be sufficient.
Will employers issue qualified equity grants?
With the complexity of the rules and the requirement to include 80% of full-time employees in a plan that does not benefit the corporation's senior executives, it seems likely that few employers will proceed down this path. The exception could be employers that:
- Have a reasonable expectation of having a liquidity event (e.g., an initial public offering (IPO) or a sale of the corporation) within five years of the date the options would be exercisable or the RSUs would vest and settle; and
- Want to share some of the potential gain on an IPO or sale of the corporation with substantially all full-time employees.
However, when there is no plan for an IPO or sale of the corporation, the qualified equity grant does little for non-senior management employees who receive stock and, either immediately upon exercise or settlement or if they make the deferral election five years later, must pay tax on shares for which there is no market for resale. At best, the election allows some time to plan for the cash need and offers some benefit of the time value of money.
EditorNotes
Mo Bell-Jacobs is a manager, Washington National Tax, for RSM US LLP.
For additional information about this item, contact the author at Bill.OMalley@rsmus.com.
Unless otherwise noted, contributors are members of or associated with RSM US LLP.
