Equity-based compensation can be a great way to reward and retain valued employees, especially for companies with limited cash on hand. And the Tax Cuts and Jobs Act (TCJA) makes it even more advantageous by offering a new tax-favored alternative to employees who receive these awards.
Under Internal Revenue Code Section 83(i), eligible employees can elect to defer for up to five years taxable income from exercising a stock option or receiving restricted stock. Here are the details.
There are various types of equity-based compensation awards. Popular examples include:
Restricted stock. The company grants restricted stock units (RSUs) when it awards an employee restricted stock. Company stock is transferred to the RSU recipient when certain conditions (such as continued service to the company or predetermined performance goals) are met.
The fair market value of restricted stock is generally taxable to the recipient employee when there's no longer a substantial risk of forfeiture with respect to the shares. The most common risk of forfeiture is a requirement for continued employment through a specified date for the RSUs to become vested.
Incentive stock options (ISOs). Employees who receive ISOs have the right (but not the obligation) to purchase shares at a predetermined (exercise) price by the exercise date.
Gains from shares acquired by exercising ISOs are generally taxable when the shares are sold. However, if the employee is subject to the alternative minimum tax (AMT), the so-called "bargain element" (the difference on the exercise date between fair market value of the option shares and the exercise price) counts as AMT income.
Nonqualified stock options (NQSOs). These are stock options that don't qualify for the more-favorable tax treatment given to ISOs. With NQSOs, the bargain element is taxable when the option is exercised. That amount is treated as additional salary income subject to both income taxes and federal employment taxes.
Postexercise appreciation is taxed as a capital gain when the shares are sold. So, the favorable rates for long-term gains apply if the shares are held for more than a year after the exercise date.
Now, under the TCJA, Sec. 83(i) allows qualified employees of eligible private companies to elect to defer taxable income from vested qualified stock grants for up to five years. But three specific requirements must be met for this alternative to be available.
1. Qualified stock. This election is available only for transfers of "qualified stock." That means stock received by a qualified employee from exercising an option, or in settlement of an RSU. The stock must be from the eligible corporation that employs the qualified employee, and the employee must have received the option or RSU for the performance of services.
Stock isn't considered "qualified stock" if the employee has the right to either sell it back to the employer or to receive cash in lieu of the stock immediately upon vesting.
There are a couple of pitfalls to watch out for. First, a Sec. 83(i) election can't be made if the corporation has — or has had — any stock that is or was readily tradable on an established securities market at any time before the election is made. Additionally, if the corporation repurchased any stock in the preceding calendar year, the Sec. 83(i) election isn't available unless at least 25% of the total dollar amount of the repurchased stock was stock for which the Sec. 83(i) election was in effect.
2. Qualified employee. This is generally any employee who makes the Sec. 83(i) election. However, certain individuals are not considered qualified employees, including:
3. Eligible corporation. This is a private corporation that has a written plan under which at least 80% of full-time employees are granted stock options or RSUs. The options or RSUs must confer the same rights and privileges to receive qualified stock. However, employees can receive varying amounts of options or RSUs as long as they get the same type of grant and more than a de minimis grant.
For purposes of the 80% rule, part-time employees (those who usually work less than 30 hours per week) and individuals who are excluded from the qualified employee definition (such as the CEO) aren't counted.
The 80% rule basically forces employers to grant stock options or RSUs to at least 80% of their full-time employees for the Sec. 83(i) election to be available to any employees. In many cases, that would be unacceptable except for the fact that the employer can still grant additional equity-based compensation (for example, more RSUs, ISOs or NQSOs) to a select group of employees as long as 80% of the employees receive more than de minimis stock grants. Unfortunately, we're still awaiting guidance from the IRS on what's considered a de minimis grant.
The Sec. 83(i) election must be made by the employee no later than 30 days after the earlier of:
While qualified employees have the choice of making the Sec. 83(i) election, the employer must meet the applicable qualification rules for the choice to be available. As of the date of this article's publication, the IRS hadn't yet issued guidance on making this election.
Assuming all the requirements have been met, an employee can make the Sec. 83(i) election to defer taxable income from qualified equity grants. The deferral period is five years from the vesting date. However, taxable income must be recognized earlier if any of the following occur:
The Sec. 83(i) election defers income only for income tax purposes. It doesn't defer income for Social Security, Medicare or FUTA tax purposes. The federal employment taxes will be due when the qualified stock becomes vested based on the fair value of the shares on the vesting date.
If your company is considering awarding equity-based compensation, it's a good time to put a written plan in place, thanks to the TCJA. Consult your tax advisor to make sure your plan meets all the requirements needed to make the Sec. 83(i) election available to employees.
To show how the new rule works, consider Joe, a qualified employee of XYZ Corp., which is a profitable privately held technology company. On December 1, 2018, XYZ adopts a written plan that grants RSUs to 90% of its full-time employees. Joe receives RSUs for 1,000 shares of XYZ stock that vest after four years.
On December 1, 2022, Joe's shares vest, and they're transferred to him. He isn't required to pay anything for the shares, which are worth $50,000 ($50 per share) on December 1, 2022. On December 15, 2022, Joe files a Section 83(i) election in accordance with yet-to-be released IRS guidelines.
By making the election, Joe defers recognition of $50,000 of taxable income (the fair market value of the RSU shares at the time they became vested) until 2027 for federal income tax purposes. However, federal employment taxes are due on the $50,000 in 2022 (the year vesting occurs). XYZ can withhold Joe's share of the employment taxes from his regular salary. Alternatively, Joe can write a check to the company to cover the taxes.
For federal income tax purposes, XYZ treats the $50,000 as taxable wages paid to Joe in 2027. That's true even if the shares are then worth $200,000 ($200 per share). The $150,000 of appreciation would be taxed at long-term capital gains rates when Joe sells his shares.
No federal employment taxes are due on the $50,000 of income reported to Joe in 2027, because those taxes were already paid in 2022.
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