Making the Sec. 83(i) election

In some cases, employer stock may be transferred to an employee in settlement of restricted stock units (RSUs). An RSU is an arrangement under which an employee has the right to receive at a specified future time an amount determined by reference to the value of one or more shares of employer stock. The receipt of employer stock in settlement of an RSU is subject to the same rules as other receipts of employer stock with respect to the timing and amount of income inclusion by the employee and the employer's deduction.

Sec. 83(i) provides an election that allows a qualified employee to defer the inclusion of income from the exercise of an RSU or option of the qualified stock of a nonpublicly traded corporation for up to five years from the date of vesting. The election can be made for stock options exercised and RSUs settled after Dec. 31, 2017, even if the stock options or RSUs were granted before 2018.

Note: A plan does not become subject to the nonqualified deferred compensation rules of Sec. 409A solely because of an employee's Sec. 83(i) election (Sec. 409A(d)(7)).

If a Sec. 83(i) election is made, then the tax year of inclusion is the employee's tax year that includes the earliest of:

1. The first date the qualified stock becomes transferable (including to the employer) (Sec. 83(i)(1)(B)(i));
2. The date the employee first becomes an excluded employee (defined below) (Sec. 83(i)(1)(B)(ii));
3. The first date on which any stock of the corporation that issued qualified stock becomes readily tradable on an established security market (Sec. 83(i)(1)(B)(iii));
4. The date that is five years after the first date the employee's rights in the stock are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier (Sec. 83(i)(1)(B)(iv)); or
5. The date on which the employee revokes (at the time and in the manner the IRS provides) the Sec. 83(i) election with respect to the stock (Sec. 83(i)(1)(B)(v)).

The qualified stock for which a Sec. 83(i) election is made is treated as wages received on the earliest date above for the tax year of inclusion, and the income tax withheld must be at the maximum income tax rate in effect for individuals under Sec. 1 (37% for calendar year 2021) (Sec. 3402(t)(1)). The tax owed is calculated when the employee makes the Sec. 83(i) election and is due at the end of the deferral period regardless of the stock value. If the stock value has declined, tax is not recomputed based on the lower amount.

Caution: If the FMV of the stock decreases within the deferral period, the FMV on the date the stock is received still must be included in the employee's income. This creates the risk of the employee paying income tax on an amount that is never received.

If a Sec. 83(i) election is made, the employer's deduction is deferred until the employer's tax year in which, or with which, ends the tax year of the employee when the amount is included in the employee's income.

Qualified employee defined

A qualified employee agrees in the Sec. 83(i) election to meet the requirements, determined by the IRS, that are necessary to ensure the employer corporation's income tax withholding requirements with respect to the qualified stock are met (Sec. 83(i)(3)(A)(ii)). The following individuals are excluded from being a qualified employee:

1. A 1% owner within the meaning of a top-heavy plan under the rules of Sec. 416(i)(1)(B)(ii) at any time during the calendar year, or who was a 1% owner at any time during the 10 preceding calendar years (Sec. 83(i)(3)(B)(i)).
2. The corporation's CEO, CFO, or an individual acting in that capacity currently or at any earlier time (Sec. 83(i)(3)(B)(ii)).
3. An individual with a relationship described in the Sec. 318(a)(1) family attribution rules to the corporation's CEO, CFO, or individual acting in that capacity (Sec. 83(i)(3)(B)(iii)).
4. The four highest-compensated officers of the corporation for the tax year or for any of the 10 preceding tax years, determined on the basis of the shareholder disclosure rules for compensation under the Securities Exchange Act of 1934 as if those rules applied to the corporation (Sec. 83(i)(3)(B)(iv)).

Qualified stock defined

Qualified stock eligible for the Sec. 83(i) election is any employer's stock that meets the following conditions (Sec. 83(i)(2)(A)):

1. A qualified employee receives the stock in connection with the exercise of an option or in settlement of an RSU; and
2. The corporation granted the option or RSU in connection with the performance of services as an employee during a calendar year in which the corporation was an eligible corporation.

Note: If the employee has the right to receive cash in lieu of stock or may sell the stock to the corporation when the stock is vested, the stock is not considered qualified stock (Sec. 83(i)(2)(B)).

A stock option eligible for a Sec. 83(i) election can be an incentive stock option (ISO), an employee stock purchase plan (ESPP), or a nonqualified stock option (NQSO). If the election is made, the option is treated as a disqualifying distribution and the provisions of Secs. 422 and 423 that would normally apply for ISOs or ESPP options do not apply when the options are exercised. Instead, the rules applicable to NQSOs under Sec. 83 apply.

Other than Sec. 83(i), no part of Sec. 83, including Sec. 83(b), applies to RSUs (Sec. 83(i)(7)).

Eligible corporation defined

For purposes of determining whether stock is qualified stock, a corporation is an eligible corporation if:

1. No stock of the corporation, or any predecessor of the corporation, is readily tradable on an established securities market, as determined under Sec. 83(i)(1)(B)(iii), during any preceding calendar year (Sec. 83(i)(2)(C)(i)(I)) up to the time a Sec. 83(i) election is made; and
2. The corporation has a written plan under which, in that calendar year, not less than 80% of all employees who provide services to the corporation in the United States or any U.S. possession are granted stock options, or are granted RSUs, with the same rights and privileges to receive qualified stock (Sec. 83(i)(2)(C)(i)(II)).

The determination of rights and privileges is made in a similar manner as under Sec. 423(b)(5) for ESPPs (Sec. 83(i)(2)(C)(ii)); however, employees will not fail to be treated as having the same rights and privileges to receive qualified stock solely because the number of shares available to all employees is not equal in amount, so long as more than a de minimis number of shares is available to each employee (Sec. 83(i)(2)(C)(ii)(II)). Rights and privileges with respect to the exercise of an option are not treated the same as rights and privileges with respect to the settlement of an RSU (Sec. 83(i)(2)(C)(ii)(III)).

The requirement that 80% of all applicable employees be granted stock options or RSUs with the same rights and privileges cannot be satisfied in a tax year by granting a combination of stock options and RSUs. Rather, all such employees must either be granted stock options or be granted RSUs for that year. For purposes of the 80% requirement, the term employee does not include any part-time employee, as described in Sec. 4980E(d)(4) (i.e., an employee who is customarily employed for fewer than 30 hours per week), or any excluded employee (defined above) (Sec. 83(i)(2)(C)(iii)). For calendar years beginning before Jan. 1, 2018, the 80% requirement is applied without regard to whether the rights and privileges with respect to the qualified stock are the same (Sec. 83(i)(2)(C)(iv)).

The corporation must determine if it is an eligible corporation each calendar year. The 80% requirement is met for the calendar year based on the stock options or RSUs granted during that calendar year. Any full-time employee who is not an excluded employee and who was employed by the corporation at any time during the calendar year is taken into account, even if that individual was not employed at the beginning or end of the calendar year (IRS Notice 2018-97).

Note: Stock options or RSUs can be granted to part-time employees, but they are not included in the full-time employee count to meet the 80% requirement.

The 80% requirement is based on the highest number of eligible employees counted at any time during the year. To ensure that stock options or RSUs are granted to meet the requirement, the employer must track the number of eligible employees throughout the year. This adds a layer of administrative complexity for the employer.

Caution: The IRS determined that the 80% requirement could not be met for a calendar year on a cumulative basis that takes into account stock options or RSUs granted in prior calendar years (Notice 2018-97). This is not considered a reasonable, good-faith interpretation of the requirement. Employers that may have used this method before guidance was issued cannot rely on the transition rule included in the law known as the Tax Cuts and Jobs Act, P.L. 115-97.

Corporations that are members of a controlled group of corporations under Sec. 414(b) are considered one corporation for Sec. 83(i) purposes (Sec. 83(i)(5)).

A Sec. 83(i) election must be made no later than 30 days after the first date the employee's rights in the qualified stock are transferable or are not subject to a substantial risk of forfeiture, whichever is earlier (Sec. 83(i)(4)(A)). A Sec. 83(i) election is made in a manner similar to a Sec. 83(b) election, which means that the employee must provide the employer with a copy of the election.

A Sec. 83(i) election cannot be made with respect to any qualified stock if (1) the qualified employee made a Sec. 83(b) election with respect to the same stock, or (2) any stock of the corporation that issued the qualified stock is readily tradable on an established securities market at any time before the election is made (Sec. 83(i)(4)(B)). A Sec. 83(i) election also cannot be made for qualified stock for which the employee has made a Sec. 83(b) election to report income in the year nonvested property is received (Sec. 83(i)(4)(B)(i)), so Sec. 83(i) does not apply to income with respect to nonvested stock that is includible as a result of a Sec. 83(b) election.

This case study has been adapted from PPC's Guide to Tax Planning for High Income Individuals, 22d edition (March 2021), by Anthony J. DeChellis and Patrick L. Young. Published by Thomson Reuters, Carrollton, Texas, 2021 (800-431-9025; tax.thomsonreuters.com).