The IRS has issued guidance for a new election to defer taxable income from exercising or vesting of an employee stock option or vesting of restricted stock units (RSUs). The election is part of the Tax Cuts and Jobs Act of 2017, enacted December 22, 2017.
The new law for the election is at Internal Revenue Code Section 83(i). The IRS guidance is Notice 2018-97, issued December 7, 2018. The Notice is 19 pages long.
Congress was trying to provide some relief to employees who have stock-based compensation when the stock isn’t publicly traded or eligible for redemption. The stock can’t be sold to get the cash to pay taxes.
Under the new law, the income of a taxpayer from exercising an employee stock option or from the vesting of an RSU who makes the election for qualified stock won’t be taxable until the earliest of:
(1) The first date the stock is transferable, including transferable to the employer;
(2) The date the employee first becomes an excluded employee;
(3) The first date on which any stock of the issuing corporation becomes readily tradable on an established securities market;
(4) The date that is five years after the first date the rights of the employee in such stock are transferable or not subject to a substantial risk of forfeiture, whichever occurs earlier; or
(5) The date on which the employee revokes the election (at such time and in such manner as the Secretary of the Treasury (IRS) provides.)
The requirements to qualify for the election are so onerous that I don’t expect many companies to meet them. In a calendar year, not less than 80% of all employees who provide services to the corporation in the United States or any possession of the United States must be granted stock options or granted RSUs, with the same rights and privileges to receive qualified stock. Stock options and RSUs usually are not used in such a nondiscriminatory way.
The notice makes it clear that this test applies each year, and grants of options and RSUs in previous years aren’t counted for the test. Also, the test applies for all employees of the company during the calendar year, regardless of when hired or terminated.
I’m not going to explain in detail who is an “excluded employee” It’s basically an individual who already owns at least 1% of the company stock or is a key officer of the corporation.
This is a separate election from a Section 83(b) election to treat nonvested stock received as if it was vested, accelerating income from the exercise of a nonqualified stock option. If a Section 83(b) election is made relating to the exercise of a nonqualified stock option, the transaction isn’t eligible for a tax deferral election under Section 83(i).
If a Section 83(i) election is made for an incentive stock option or a purchase using an employee stock purchase plan, the benefits of those sections no longer apply and the transaction is treated as the exercise of a nonqualified stock option.
The income amount is based on Internal Revenue Code Section 83(a), which is the excess of the fair market value on the later of the date of exercise or the vesting date. That date also determines when the Section 83(i) election must be made. The election must be sent to the IRS address for the taxpayer’s federal income tax return no later than 30 days after the later of the date of exercise or the vesting date.
The IRS did not provide an example of a Section 83(i) election in the Notice. It just says the election “shall be made in a manner similar to the manner in which an election is made under Section 83(b).” There are important differences. If you would like to have an example of the election that I drafted, write to me at email@example.com.
Any time a corporation transfers qualified stock to a qualified employee, it is required to notify the employee that the employee may be eligible under Section 83(i) to defer income on the stock. The notice should be provided at the time an amount attributable to the stock would first be includible in the gross income of the employee, or a reasonable time before. The notice states:
(1) The amount of income to be reported at the end of the deferral period will be based on the value of the stock at the time the rights of the employee first become transferable or not subject to a risk of forfeiture, even if the value of the stock declines before it becomes taxable;
(2) The income recognized at the end of the deferral period will be subject to federal income tax withholding at the highest federal income tax rate, with no reduction for personal exemption credits or estimated tax deductions;
(3) The responsibilities of the employee with respect to the withholding.
If an employer fails to provide the notice, it will be subject to a $100 penalty, up to a maximum of $50,000 per calendar year.
Although the federal income tax is deferred when the election is made, the amount that would otherwise have been taxable is currently subject to federal employment taxes, like social security, medicare and federal unemployment taxes. (This could still be a hardship for employees who receive no cash and can’t sell the stock.)
Under authority provided to the IRS in the new tax law, the Section 83(i) election by the taxpayer must include an agreement that the deferral stock will be held in an escrow arrangement. When the income relating to the stock becomes taxable, the corporation may remove shares equal in value to the required income tax withholding. The shares may be removed up to March 31 of the year following the year the income is taxable. The remaining shares can then be released to the employee. The employee can alternatively pay the tax with cash, in which case all of the shares would be released to the employee.
A corporation can preclude its employees from making a Section 83(i) election by declining to establish an escrow arrangement to hold their shares until the federal income tax is paid.
If a corporation intends that employees shouldn’t make Section 83(i) elections for stock received by exercising a stock option or RSU, the terms of the stock option or RSU may provide that no election under Section 83(i) will be available with respect to stock received under the option or RSU.
This new election is a baby step. I hope Congress provides more helpful relief to employees who receive stock options and RSUs of stock that isn’t publicly traded with more simplified rules in the future.