On Dec. 7, the IRS issued Notice 2018-97 to provide initial guidance on new Sec. 83(i), which was added to the Code by the law known as the Tax Cuts and Jobs Act, P.L. 115-97. New Sec. 83(i) permits eligible private company employees to elect to defer for up to five years the recognition of income from private company stock acquired by exercising a stock option or settling a restricted stock unit (RSU), provided the employee received the stock as part of a qualified equity grant. The income-deferral election applies to stock received due to options exercised or RSUs settled after Dec. 31, 2017.
Stock for which an employee can make the election (qualified stock) is defined as any stock in a corporation that is the employer of a qualified employee, if the stock is received (1) in connection with the exercise of a stock option or in settlement of an RSU, and (2) the stock option or RSU was granted in connection with the performance of services as an employee and during a calendar year that the employer corporation was an eligible corporation. The requirements for the employer to be an eligible corporation include that the employer must issue the grant according to a written plan under which, in that calendar year, not less than 80% of all U.S.-based employees who provide services to that corporation receive grants of stock options or RSUs.
According to the notice, stakeholders have asked whether the 80% requirement above applies on a cumulative basis so that employers can take into account stock options issued in previous years. The IRS believes that the statutory language requires that employers must meet the 80% requirement on a calendar-year basis, and whether the corporation has satisfied the 80% requirement is based solely on the stock options or the RSUs granted in that calendar year to employees who provide services to the corporation in the United States (or any possession of the United States). The IRS found that the interpretation that options issued in previous years can be counted on a cumulative basis with options granted in the current calendar year is contrary to the statutory language and not a reasonable good-faith interpretation of the 80% requirement.
As for the income tax withholding requirements of stock options or RSUs in the year they are includible in the employee's income, the notice provides that the employer should withhold at the maximum rate of tax in effect under Sec. 1. Withholding is determined without regard to the employee's Form W-4, Employee's Withholding Allowance Certificate, meaning there is no reduction for any withholding allowances. By Jan. 31 of the following year, the employer must determine the actual value of the deferral stock on the date it is includible in the employee's income and report that amount and the withholding on Form W-2, Wage and Tax Statement, and Form 941, Employer's Quarterly Federal Tax Return. If the employer pays the income tax withholding for the deferral stock from its own funds, it may recover that withholding from the employee until April 1 of the year following the calendar year in which the wages were paid.
To ensure that the withholding requirements are met, in order to be a qualified employee for purposes of the election, an employee making a Sec. 83(i) election with respect to qualified stock must agree in the election that all deferral stock will be held in an escrow arrangement until certain conditions are met.
Finally, the IRS provided that employers may opt out of permitting employees to elect deferred tax treatment by either declining to provide an escrow arrangement for deferral stock or otherwise creating conditions that will not allow an employee to make the Sec. 83(i) election. If the corporation intends to do this, the terms of a stock option or RSU may provide that no election under Sec. 83(i) will be available for stock received upon the exercise of the stock option or the settlement of the RSU. This would inform employees that no Sec. 83(i) election may be made for stock received upon exercise of the option or settlement of the RSU even if the stock is qualified stock.