On Friday, Dec. 7, the IRS issued Notice 2018-97 (the “Notice”), which clarifies three issues in the application of section 83(i). Section 83(i) was added by the Act commonly referred to as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, in an attempt to alleviate the tax burden on the issuance of stock options and restricted stock units (RSUs) to employees of private companies.
General tax rules trigger inclusion of ordinary income to the grantee at the time a holder exercises a stock option or settles an RSU. In the private company context, however, there is frequently no market to readily sell the associated shares. Thus, employees are left with a sometimes significant ordinary income tax liability without a corresponding liquidity event (a sale of the shares) to finance that liability.
Section 83(i) attempts to ameliorate this issue by providing a means of voluntarily deferring the employee’s tax liability until up to five years from the date of the tax event under general rules. The grant must be made to at least 80 percent of employees in the corporation in a calendar year, must confer the same “rights and privileges” upon each grantee, and must be issued by a privately-held corporation. The grants do not need to award the same number of shares to each employee, provided the differences in the number of shares awarded to employees are “de minimis”, a term which has not yet been defined. Exercise must have occurred after Dec. 31, 2017. For further information, see these frequently asked questions.
The stock subject to the deferral election is subject to income tax withholding in the year section 83(i) applies,and the Notice (thankfully) clarifies, in part, the mechanics of that withholding.
The Notice provides guidance on three topics:
- The 80 percent threshold. It was initially unclear how to calculate whether 80 percent of US-based employees in a given calendar year received a grant. The Notice clarifies that the 80 percent test is applied by dividing the total number of employees who received a qualified grant in a given calendar year over the total number of US employees who worked at the company at any time during that calendar year (excluding, in both cases, certain part-time employees). The IRS clarified that there was no requirement to be employed at the beginning or end of the applicable calendar year to be counted. Further (and importantly), the IRS clarified that the determination applies only to grants made in a single calendar year; i.e., grants under the same plan in multiple years are not aggregated and applied cumulatively to test whether the 80 percent requirement is met.
- Manner of income tax withholding; escrow account. The IRS clarified various matters and provided a useful summary of applicable income tax withholding rules, including new section 3401(i). Stock subject to a section 83(i) election constitutes wages under section 3401(i) and it is treated as received in the taxable year that includes the date at which taxation applies under the section 83(i) deferral rule. When the wages are treated as paid under section 3401(i), the employer must make a reasonable estimate of the value of the stock and make deposits of the amount of income tax withholding based on that estimate. The wages are subject to withholding at the maximum rate of tax, determined without regard to the employee’s Form W-4. The employer can then true-up the tax withholding by Jan. 31 of the following taxable year. If an underpayment has occurred, the employer can attempt to recover the amount from the employee by April 1 of that following year. Employers are generally liable for underpayments, unless a special exclusion applies. Employers must place the shares subject to the deferral election in an escrow account; the escrow account allows employers to collect on any underwithholding during the deferral period by April 1 of the tax year following the time at which section 83(i) applies. If the employer does not establish an escrow account, the section 83(i) election is unavailable to the employee.
- Ineligible equity-based compensation. The Notice clarifies that employers can prevent employees from making an election under section 83(i) on certain grants that would otherwise be eligible for the election, resolving some of the uncertainty regarding whether section 83(i) was elective for employers or whether penalties would apply for not supplying notices for grants otherwise meeting section 83(i) requirements. The Notice clarifies that the corporation effectively “holds the cards” when it comes to creating the conditions sufficient for a section 83(i) election. Among other mechanisms, the employer can decline to create the escrow account, or simply provide language in the grant itself that the stock or RSU underlying the plan is not subject to section 83(i).
The guidance provided in the Notice applies to taxable years ending on or after Dec. 7, 2018. The Notice anticipates subsequent formal guidance in the form of proposed regulations.