On Dec. 22, 2017, President Trump signed H.R. 1, commonly referred to as the Tax Cuts and Jobs Act (TCJA), making sweeping changes to the Internal Revenue Code, including implications for how many companies structure compensation and benefit plans. One particular effect of TCJA on employee compensation is the addition of section 83(i), which introduces the concept of qualified equity grants for private companies.
This new deferral opportunity brings many questions about how it works and what it could mean for certain private companies.
Q. What did section 83(i) add?
A. Section 83(i) permits qualified employees to elect to defer the income from amounts attributable to a qualified equity grant of an eligible employer for up to five years for income tax purposes.
Q. Prior to section 83(i), how were equity grants issued to employees treated for income tax purposes?
A. In general, section 83(a) covers the payment of property for the performance of services. Various types of equity commonly fall under this provision, including the transfer of employer stock, stock options, and grants of restricted stock units (RSU).
Under the general rules, an employee who receives shares of employer stock upon exercising a nonqualified option or the settlement of an RSU includes in gross income the value of the shares received (less any amount paid). The time of inclusion is the first taxable year in which the employee’s rights in the stock are transferable or are not subject to a substantial risk of forfeiture. (Alternatively, if applicable, an employee may report the property’s income in the year the stock is granted rather than wait until vesting at a later date (when the value may be higher) by making an election under section 83(b). However, section 83(b) is rarely applicable to stock options and RSUs.)
A substantial risk of forfeiture exists when the employee’s right to the property is conditioned upon the future performance of substantial services or upon the occurrence of a given event, such as time or performance-based vesting schedules for stock-based compensation arrangements.
When it is time to report income, an employee of a public company may choose to fund the tax due on the income inclusion by selling a portion of the shares received. However, in the case of an employee of a privately held company, the income inclusion rules of section 83(a) result in the employee paying tax on the receipt of stock for which there is not typically a ready market to sell the shares.
Q. What are the general requirements to be a qualified equity grant?
A. There are a number of requirements for a grant to be a qualified equity grant:
- The grant must be issued by an eligible corporation to a qualified employee as compensation for services
- The corporation must issue the grant pursuant to a written plan under which, in such calendar year, not less than 80 percent of all United States based employees who provide services to such corporation receive grants of stock options or RSUs.
- The grant must provide all qualified employees the same rights and privileges to receive qualified stock
- The qualified 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 the rights of the employee in such stock first become transferable or not subject to a substantial risk of forfeiture
Q. What is an eligible corporation?
A. A corporation is an eligible corporation with respect to a calendar year if no stock of the employer corporation (or any predecessor) is readily tradable on an established securities market during any preceding calendar year (i.e. a private company).
Note that the term corporation integrates controlled group rules so certain relationships with publicly traded companies would also preclude an entity from being eligible to issue qualified equity grants.
Q. Who is a qualified employee?
A. In general, all employees of an eligible corporation, other than excluded employees, are qualified employees. An excluded employee is any employee who meets one or more of the following criteria:
- An individual who is or has been a 1 percent owner at any time during the 10 prior calendar years
- The CEO or chief financial officer (or an individual acting in either capacity)
- A family member of an individual described in the above two criteria
- One of the highest four compensated officers for any of the 10 prior taxable years as determined under the Securities Exchange Commission shareholder disclosure rules (as if they applied)
Q. How does a plan meet the 80 percent threshold?
A. In determining whether the plan meets the 80 percent threshold, you do not take into account any excluded employees or any part-time employees. For this purpose, part-time employees are any employees customarily employed for fewer than 30 hours per week. The IRS provided additional insight into the 80 percent threshold in Notice 2018-97.
Q. What is qualified stock for the purpose of qualified equity grants?
A. Qualified stock is stock received in connection with the exercise of a stock option or settlement of an RSU that was granted by an employer, during the calendar year in which it was an eligible corporation, in connection with the performance of services.
An RSU is a promise to pay cash or stock at a future date with no transfer to the employee until the RSU vests. An RSU settled in stock is subject to section 83 only when the stock is actually transferred.
Other types of equity (e.g. restricted stock) are not qualified stock for purposes of section 83(i).
Q. What does it mean for a qualified equity grant to provide the “same rights and privileges” under the plan?
A. A plan makes the determination of whether the rights and privileges related to these equity grants meet the same rights and privileges requirements by reference to the standards for an Employee Stock Purchase Plan (ESPP). In general, the requirements are that provisions such as the method of payment and determination of purchase price apply in the same manner.
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, the new law provides that a plan cannot consider 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.
Q. Assuming all of the requirements are met, what is the benefit of providing qualified equity grants?
A. If a qualified employee makes a section 83(i) election, income taxes are due at 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 on an established securities market
- 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
- The date the employee revokes his or her election
In other words, the election allows an employee to defer the timing of the income tax liability from a qualified equity grant. Employees should note that while this timing difference may be beneficial, the value ultimately included in taxable income is based upon the fair market value at the time of vesting over the amount the employee pays for the shares.
Q. What is the process of making an election to defer income tax on qualified equity grants?
A. 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 section 83(b). Employees who have made a section 83(b) election with respect to any stock options are not eligible to make elections under section 83(i).
Additionally, the deferral election is generally not available if the corporation has bought back any outstanding stock in the preceding calendar year, unless at least 25 percent of the total dollar amount the company bought back is stock and the process in determining which employee to repurchase stock from is made on a reasonable basis. Also, stock subject to the longest deferral election under section 83(i) must be purchased first.
Q. What is the value of qualified equity stock recognized?
A. The amount included in income is the value the employee would have realized at the time the shares became transferable or not subject to a substantial risk of forfeiture, even if the value of the shares has declined.
Example:
Employee A provides services to Company XYZ. Company XYZ grants Employee A RSUs in year one when the stock value is $200 per share, but the RSUs are nontransferable by Employee A, and Employee A must continue to work for Company XYZ until year three to receive payment. In year three, when Employee A’s RSUs “vest” (i.e., are no longer subject to a substantial risk of forfeiture), the stock is worth $400 per share. In year eight, Employee A still holds the stock when it has a value of $150 per share.
Under section 83(a), Employee A would recognize $400 per share of taxable ordinary income in year three when the stock is transferred to him or her.
If Employee A made a section 83(i) election in year three, Employee A must still recognize $400 per share in year eight (assuming none of the other events triggering recognition have occurred), although the stock value has declined.
Q. What is the required income tax withholding rate?
A. The employer is required to withhold income tax at the maximum income tax rate in effect for the year of inclusion. For additional rules on withholding for section 83(i) purposes, see Notice 2018-97.
Q. How does this new law affect payroll taxes?
A. The section 83(i) deferral opportunity applies for income tax purposes but not for FICA (Social Security and Medicare) tax purposes. For FICA 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. Employers may choose to do this by requiring the employees to pay in the amount to the employer, by withholding it from other payment due to the employee or some other method.
Q. If an employee makes an inclusion deferral election, how should the employer’s deduction be treated?
A. Normally, if there is a transfer of property, compensation would be recognized upon vesting (assuming no section 83(b) election was made); and the employer is entitled to a corresponding deduction under section 83(h) unless disallowed by sections 162(m) or 280G.
If an employee elects under section 83(i) to defer the income from a qualified equity grant, the employer’s deduction is also deferred until the employer’s taxable year in which or with which ends the taxable year of the employee for which the amount is included in the employee’s income.
Essentially, an employer deduction may be taken the year in which the value of the grant is included in the employee’s income.
Q. What other procedural matters should employers consider prior to issuing qualified equity grants?
A. An employer that offers qualified equity grants will have to 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 section 6652(p). (Note that the IRS clarified in Notice 2018-97 that employers who do not wish to provide section 83(i) treatment to employees do not have to establish the procedures necessary to receive such treatment and the employer will not be penalized.)
Q. What type of employers should consider issuing qualified equity grants?
A. The section 83(i) rules are complex and the requirement to include 80 percent of full-time employees in the plan is a big consideration. Employers who may want to consider using qualified equity grants are those who:
- 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.
Certain startups may also want to consider whether qualified equity grants are a way to attract talent needed to get the entity up to full speed when 80 percent remains a relatively low number because there are not many employees yet.
When there is no plan for an IPO or sale of the corporation, the qualified equity grant does little for nonsenior 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. Nevertheless, the election allows some time to plan for the cash need and has some time value of money benefit.
The addition of section 83(i) establishes a way for privately held corporations to offer broad-based tax-qualified equity compensation to their employees, with the opportunity to make an election to delay taxation beyond otherwise applicable timing. If you are considering offering qualified equity grants, you should discuss the opportunity with your tax advisor to ensure all of the requirements could be met and to analyze the value the opportunity may provide your employees.
