Startup Company Stock Options and IRC Section 83(i) – Useful or Useless?
Congress added Internal Revenue Code Sec. 83(i) as part of the Tax Cuts and Jobs Act of 2017 (TCJA) as an incentive for startup and early-stage private companies to provide broad-based ownership of company stock to their employees. The provision allows qualified employees of eligible companies to elect to defer the income tax (but not the FICA and FUTA) on the gain from the exercise of a stock option or settlement of a restricted stock unit (RSU) for up to five years after the exercise of the option or RSU. Congress’ intent was to help relieve employees from having to come up with the cash to exercise their options due to the lack of liquidity in private and startup company stock resulting from the inability to sell shares in the public market and the unlikelihood that the company, which is typically trying to conserve cash, would buy back sufficient shares from the employee to cover the exercise price. The IRS, in Notice 2018-97, provided some initial guidance for operating an option plan under section 83(i). A discussion of section 83(i) based on current guidance follows below.
IRC Sec. 83(i) Requirements
IRC Sec. 83(i) allows a “qualified employee” of an “eligible corporation” who receives “qualified stock” through the exercise of a stock option or settlement of a RSU to elect to defer the income tax on the gain for up to five years if certain conditions are met. The conditions to be met are described below.
A qualified employee is any employee who is not an “excluded employee” (see below) and has agreed to the income tax withholding requirements under Notice 2018-97 to ensure that federal income tax will be properly withheld and remitted. Further, a qualified employee must make an election under IRC Sec. 83(i) within 30 days of exercising the option or settling the RSU to defer the income tax on the gain.
An excluded employee is any of the following:
- An individual who becomes owner of more than 1 percent of the company during the calendar year;
- An individual who becomes owner of more than 1 percent of the company at any time during the preceding 10 calendar years;
- The current or former chief executive or chief financial officer or an individual acting in either capacity;
- A family member of an individual described above under the family attribution rules of IRC Sec. 318(a)(1);
- One of the four highest-compensated officers of the company during the taxable year; or
- One of the four-highest-compensated officers of the company for any of the 10 preceding taxable years.
A company is an “eligible corporation” for a calendar year if no stock of the employer corporation or any predecessor is readily tradeable on an established securities market during any preceding calendar year (i.e., a private company). Further, the company must have a written equity incentive plan under which at least 80 percent of all employees who provide services to the company in the U.S. are granted stock options or RSUs with the same rights and privileges (not yet defined by IRS) to receive qualified stock. For purposes of the 80-percent requirement, the employer must consider all the employees employed at any time during the calendar year excluding excluded employees and part-time employees (those working less than 30 hours per week). Also for this purpose, the “employer” is all members of a controlled group of corporations under IRC Sec. 414(b). Finally, the 80-percent requirement is separate for stock options and RSUs. In other words, if options are granted, they must be granted to at least 80 percent of all employees and the same is true for RSUs. Thus, a combination of option grants and RSU grants cannot be used to meet the 80-percent requirement. A grant to a qualified employee must be more than de minimis, but it is not required that employees receive identical grants.
A company’s stock is “qualified stock” with respect to a qualified employee if the stock in the corporation that is the employer of such employee is received a) in connection with the exercise of an option or in settlement of an RSU, and b) such option or RSU was granted by the company in connection with the performance of services as the employee during a calendar year in which the company was an eligible corporation. The term “qualified stock” does not include any stock if the employee can sell the stock to, or otherwise receive replacement cash from, the company at the time that the rights of the employee in the stock first become transferable or not subject to a substantial risk of forfeiture.
As noted above, a qualified employee must make an election to defer the federal income taxes on the gain from the exercise of a stock option or the settlement of an RSU within 30 days of the exercise or settlement date. An election will generally be made in the same manner as an IRC Sec. 83(b) election. As noted above, the election to defer the gain for federal income tax purposes does not affect the timing of the recognition of the income from the gain for purposes of FICA and FUTA withholding requirements.
The company is required to notify the qualified employee that he or she is eligible to make the election to defer the gain at the time the employee’s right to the stock is substantially vested or is transferable. Additionally, the employee must be notified that:
- If the employee makes the election to defer the gain, the amount of income taxable at the end of the deferral period (see below) will be based on the value of the stock at the time the option is exercised or the RSU is settled regardless of whether the value of the stock has declined since that date.
- The amount of the gain to be included in income at the end of the deferral period will be subject to income tax withholding.
Failure to notify the employee as outlined above subjects the company to a potential penalty of $100 for each failure with a maximum penalty of $50,000 for all such failures for any calendar year.
Once the qualified employee makes the election to defer the gain on exercise of an option or settlement of an RSU, their federal income tax is deferred until the earliest of the following dates when:
- The stock held by the employee becomes transferable, which includes transferable back to the company;
- The employee becomes an “excluded employee;”
- The stock becomes tradeable on an established securities market;
- Five years after the exercise of the option or settlement of the RSU; or
- The employee revokes the election.
It should be noted that the company’s deduction is also deferred until the company’s tax year in which the income from the gain is included in the employee’s income.
Withholding Requirements Under Notice 2018-97
The notice provides the following requirements for withholding federal income taxes on the gain deferred under an IRC Sec. 83(i) election:
- The deferred gain that was determined at the date of exercise of the option or settlement of the RSU is treated as paid on the earliest of the five dates listed above.
- The company is required to withhold tax at the then maximum current tax rate (currently 37 percent) without regard to any withholding allowances under an employee’s Form W-4.
- The company must determine the fair market value of the stock on the payment date by Jan. 31 of the year following payment and report on the employee’s Form W-2 that amount and the withholding on the greater of a) the gain as of the date of exercise or settlement in bullet 1 above or b) the spread between the fair market value at the payment date and the price paid to exercise the option or settle the RSU on the employee’s Form W-2.
- If the company pays the income tax withholding from its own assets, it has until April 1 of the calendar year following the payment date to recover the withholding amount from the employee.
Required Escrow Arrangement
Under the notice, IRS requires that an employee who makes an IRC Sec. 83(i) election agree to have the shares received at exercise or settlement held in an escrow account until the time the company receives from the employee and remits the income tax withholding on the gain realized. Under this arrangement, the company may, at any time between the payment date and March 31 of the calendar year following the payment date, retain sufficient shares of stock to cover its withholding obligation to the extent it has not otherwise been received from the employee by other means (e.g., a check to the company). In determining the fair market value of the shares the company needs to retain to cover its withholding obligation, the regulations under IRC Sec. 409A are to be applied as of the date the shares are retained by the company, which is different than the fair market value of the shares used to calculate the amount of income as of the exercise date of the option or the settlement of the RSU. Once the withholding obligation of the company is satisfied, the remaining shares held by the company, if any, must be delivered to the employee as soon as reasonably practicable thereafter.
It is important to note that if the employee does not agree to the escrow arrangement required under the notice, the employee will not be considered a qualified employee and may not make an IRC Sec. 83(i) election to defer the gain on the stock under an option or a RSU settlement.
Under the Notice, the IRS allowed companies concerned about the complexity of IRC Sec. 83(i) to opt out of providing the ability to defer the gain on the stock option exercise or RSU settlement. Specifically, if the company fails to establish an escrow arrangement for income tax withholding, it can preclude its employees from making an election under IRC Sec. 83(i) regardless of whether the company would otherwise be considered an eligible company under IRC Sec. 83(i). The company can notify the employees that the stock is not eligible for an IRC Sec. 83(i) election due to the company not having established an escrow arrangement.
Useful or Useless?
Given the complexity of IRC Sec. 83(i), both the company and the employee need to consider the potential pitfalls before proceeding with deferring the gain on stock from option exercises or RSU settlements. Below are potential issues for the company and the employee to consider.
- The IRC Sec. 83(i) election is not available to senior management.
- The company needs to grant options or RSUs to at least 80 percent of all the employees providing services to it in the U.S. during the calendar year. Accordingly, the company will not know until the end of the calendar year if it meets this requirement to be an eligible corporation under the 80-percent test.
- As a result of the 80-percent rule, companies will need to make annual awards to employees rather than making new awards after the initial new hire grants, which are typically larger grants, are fully vested. Thus, the company may need to make smaller grants each year, which could impact the ability to attract and/or retain employees.
- Even with the escrow arrangement, the company will be forced to use its own cash to pay its withholding obligations unless the employee pays the company directly rather than having shares withheld. Since preserving cash is critical for most start-ups, this could present a major obstacle to offering employees the ability to make IRC Sec. 83(i) elections. Further, if the value of the shares held in the escrow account declines substantially, it is possible that even by retaining all the shares subject to the deferral, the company would not fully meet its withholding obligation and, therefore, could bear the risk for the value of the withholding.
- For companies that believe they have a time horizon of five years or less before an initial public offering of shares or a sale of the company, offering employees the opportunity to defer the tax on the gain until there is liquidity could be very positively received and a good way to allow a large majority of the U.S. employees to share in the gain from a sale or IPO.
- IRC Sec. 83(i) does not protect the employee from the risks of the company’s business (nor was it intended to) in that the value of the stock received on the exercise of an option of the settlement of an RSU may decline significantly during the deferral period while the amount of gain subject to tax at the end of the deferral period remains the same.
- There is no assurance that even with a deferral period of up to five years there will be a liquidity event allowing the employee to monetize the value of the stock they are holding.
- If the employee makes an IRC Sec. 83(i) election on a grant of incentive stock options (ISOs) to defer the gain from the exercise, the stock will no longer eligible for the favorable tax treatment available to ISOs.
In order to comply with IRC Sec. 83(i), a company will need to monitor both its own eligibility to offer employees an IRC Sec. 83(i) deferral as an eligible corporation and the eligibility of the employees receiving grants of stock options or RSU to be considered qualified employees for purposes of IRC Sec. 83(i). They will also have to make sure they comply with the employee notification requirements. While the concept of deferring the gain from the exercise of an option of the settlement of an RSU is very attractive conceptually, most start-up are so focused on running and growing their business that the added layer of complexity under IRC Sec. 83(i) may be too much of a burden to make it worth the company’s time and related costs.
Peter Alwardt is a tax partner specializing in employee benefits, tax and ERISA issues for domestic and international clients. He is a member of the American Institute of CPAs and the New York State Society of CPAs.