Employees of startups and other private companies have long struggled with the tax treatment of equity-based compensation. In general, Sec. 83 has required individuals to recognize taxable income when stock they have received via an exercise of a stock option or a stock grant is substantially vested (i.e., is either transferable (other than to the transferor of the stock — normally, the employer) or no longer subject to a substantial risk of forfeiture). Except in the case of qualified stock plans, income tax withholding is due with respect to the receipt of substantially vested stock, and the source for payment of these taxes is sometimes the employee. The whole situation may be counterproductive to the employer's original intent to create an employee incentive.
In the past, the limited alternatives to ameliorate this situation have included Sec. 83(b) elections and the creation of plans featuring restricted stock units (RSUs). Sec. 83(b) elections have commonly been used to manage employees' tax liability, by permitting the employee to recognize taxable income on a restricted stock grant immediately upon receipt and without respect to substantial vesting. By bypassing the time frame for the stock to substantially vest, a Sec. 83(b) election may accelerate the recognition of taxable income but also the commencement of the employee's holding period. In the context of many startup situations, where there is an anticipation that the stock will significantly appreciate in value, the most prominent benefit of such an election is that it minimizes ordinary income and maximizes capital gain upon the eventual sale of the stock.
However, while Sec. 83(b) elections are useful in the context of traditional restricted stock awards (RSAs), they do not apply to stock options. Instead, to try to mitigate the unfavorable cash flow impact of exercises, employees of startup companies might be left to delay the exercise of their options for as long as possible, often to the detriment of their desire to take advantage of long-term capital gains rates.
Sec. 83(b) elections do not apply to RSUs. The regulations under Sec. 409A make deferral opportunities available beyond the date that the payment is earned, but the entire amount of the compensation at the end of the deferral period is taxed as ordinary income, thereby also frustrating the employee's opportunity to maximize long-term capital gains should the stock appreciate.
Qualified equity grants
The law known as the Tax Cuts and Jobs Act, P.L. 115-97, provides another alternative designed to help ease the burden on employees receiving stock due to the exercise of a stock option or an RSU settlement after Dec. 31, 2017, in the form of newly created Sec. 83(i), which applies to "qualified equity grants." Recipients of traditional RSAs are not eligible.
Electing recipients of qualified equity grants can defer the inclusion of taxable income for up to five years beyond the date substantial vesting occurs. While the election defers the date on which income is recognized, it does not affect the amount or character of income recognized: The ordinary income amount includible at the end of the income deferral period is the difference between the fair market value (FMV) and price paid for the stock at the time it was substantially vested, not when recognized at the end of the inclusion deferral period. This means that when the stock is ultimately sold, the resulting capital gain or loss will normally be the same amount as if no Sec. 83(i) election were in place. The inclusion deferral election permitted by a Sec. 83(i) election also naturally permits the deferral of income tax withholding (though not Federal Insurance Contributions Act (FICA) or Federal Unemployment Tax Act taxes), so the negative cash flow aspects are diminished.
Stock received pursuant to an incentive stock option plan or qualified employee stock purchase plan (ESPP) is eligible for an election under Sec. 83(i), although exercises will be treated as nonqualified stock options for FICA purposes.
While there is a maximum inclusion deferral period of five years following substantial vesting, four other occurrences could accelerate the termination of this period:
- The stock becomes transferable (including to the employer);
- The employee becomes an excluded employee;
- The stock becomes readily tradable on an established securities market; or
- The employee revokes the election.
A qualified equity grant exists when "qualified stock" is issued to a "qualified employee." To be qualified stock, it must be transferred in connection with the exercise of an option or settlement of an RSU, for the performance of services by an employee, and during a calendar year in which the corporation is an "eligible corporation." A qualified employee is defined as an individual who is not an "excluded employee," which is:
- A 1% owner during the calendar year or any of the preceding 10 calendar years;
- The CEO, CFO, or anyone acting in such a capacity, either currently or at any prior time;
- Individuals related to persons described above within the meaning of Sec. 318(a)(1); or
- One of the four highest-compensated officers (determined by reference to SEC shareholder disclosure rules), either currently or during any of the preceding 10 calendar years.
The "eligible corporation" rules restrict the use of Sec. 83(i) to private companies and limit its availability to those employed by companies with broad-based plans under which no less than 80% of all employees (not including "excluded" and part-time employees) have the same rights and privileges to receive qualified stock during the calendar year of the grant. While many startups have 80% workforce coverage, others may be hard-pressed to meet this coverage requirement and will need to evaluate the utility of expanding their plans to permit the election to be made. Further, the "same rights and privileges" requirement may require changes to existing plans to qualify. It currently references the ESPP rules under Sec. 423(b)(5) but with some relaxation to permit differences in shares awarded, as long as each employee covered has more than a de minimis amount.
An election to apply the deferral rules of Sec. 83(i) must be made no later than 30 days after the first date the employee's rights in the stock are transferable or are substantially vested, whichever occurs earlier. The required contents of such an election are similar to those listed for a Sec. 83(b) election.
Elections will be precluded where a Sec. 83(b) election has already been made with respect to the stock, where the stock becomes publicly traded, or in certain situations where the corporation has redeemed stock in a prior calendar year.
Employers with plans featuring qualified stock and that fail to observe employee notification requirements can incur relatively significant penalties, insofar as these penalties can accumulate with multiple failures. The notification must take place at the time that, or a reasonable period before, substantial vesting occurs with regard to the eligible stock. The notification requirements are:
- The employer must certify to the employee that the stock is qualified stock;
- The employer must notify the employee that the stock qualifies for deferral under this provision;
- At the end of the deferral period, the inclusion deferral amount is measured when the stock first becomes transferable or substantially vested, even if the stock declines in value;
- The stock will be subject to income tax withholding at the maximum individual tax rate at the end of the deferral period; and
- The employer must notify the employee of his or her responsibilities with respect to income tax withholding.
The penalty for failure to comply with these notification requirements is $100 for each failure, up to a maximum penalty of $50,000 per calendar year. Due to the effective date of this provision, employers could have been obliged to issue notifications as early as Jan. 1, 2018, and there is no indication plan eligibility is itself elective. In short, the notification requirement creates a compliance pitfall for corporations with eligible plans, particularly those that may not even be aware that they have an eligible plan.
Employers will also be required to report the deferred income amount in the employee Forms W-2, Wage and Tax Statement, in the year the inclusion deferral election is made and the year that election terminates. In addition, the employer will need to report the aggregate amount of income subject to the election at the end of each calendar year.
Timing of corporate deduction and deferral holding period
Similar to other situations involving Sec. 83 property, the employer deduction will mirror the employee's inclusion amount. Legislative guidance suggests that the deduction will be permitted in the tax year of the corporation that includes the end of the tax year of the individual when the inclusion deferral period ends, rather than in accordance with the employer's method of accounting.
As of this writing, neither the statute nor the legislative guidance addresses the holding period for deferral stock. While the matter is not specifically addressed under Sec. 83(i), it appears that an election would not disturb the commencement of the stock's holding period under Sec. 83(f) and would therefore start at the time substantial vesting occurs, rather than be delayed until the end of the inclusion deferral period. IRS confirmation on this point would be welcome.
Additional guidance ensuring the withholding requirements with respect to the deferral stock is also anticipated.
Benefits for startups, burdens for others?
Employers will need to reconsider their current plans and dispersion, and evaluate the utility of featuring an eligible arrangement. Many will conclude that a broad-based plan is an inefficient and costly way to incentivize their employees and that the administrative obligations of having an eligible plan will be burdensome. Others may be unwilling to defer the corporate deduction attributed to stock option exercises and vesting of RSUs. Startups are more likely to be able and willing to do so, but existing plans may need to be modified to meet the requirements of Sec. 83(i).
Nevertheless, with the decline in the number of public companies and lengthy gestation period for recent initial public offerings, qualified equity grants provide a useful alternative for employees of startups as well as other private companies. The elective deferral treatment alleviates some of the practical difficulties historically associated with the use of equity-based compensation.
Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Washington.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or email@example.com.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.