January 30, 2019
What the New Section 83(i) Guidance Means for Your Company
Posted by Scott Schwartz
In December 2018, the Internal Revenue Service (IRS) issued new guidance under Notice 2018-97 to clarify some of the provisions of Code Section 83(i). Based on companies’ current practices, we believe that the new guidance will make more companies “ineligible corporations,” which may be a relief more than anything else.
Passed as part of the Tax Cuts and Jobs Act, Section 83(i) allows “qualified employees” of privately held “eligible corporations” to defer paying federal income tax for up to five years upon the exercise of stock options and/or settlement of restricted stock units (RSUs).
A qualified employee:
- is not an “excluded employee”
- agrees to certain requirements that ensure that proper withholding of federal income taxes will be met in connection with a Section 83(i) election
Eligible corporations are those that issue equity compensation with “equal rights and privileges” to at least 80% of full-time employees who provide services in the United States in a given calendar year. While the 80% rule was clarified (see more below), the provision around equal rights and privileges is still very much up to interpretation, and the IRS did not provide any further guidance in its notice. The ambiguity around 83(i) has made it very difficult for companies to adopt or to educate employees why adoption is not possible.
New Guidance on Section 83(i)
The 80% Requirement
The notice clarifies the determination based upon whether an employer satisfies the 80% requirement and whether it must be made on a calendar-year basis. It clarifies that only stock options or RSUs, respectively, granted during a “single calendar year” count toward the 80% minimum. In other words, the tests for options and RSUs are distinct: 80% must have received options or 80% must have received RSUs. Further, this disregards any prior year awards that may be vesting in the current year as it is specific to newly granted awards.
Under current granting practices, it would make it difficult for most companies to meet this 80% rule. We typically see employees receiving a “refresh” grant every two to four years, but not every year. A company could change its granting practice, to grant less up front, and spread it over multiple years, but the positives of 83(i) might be outweighed by the rising exercise price over the years or even a perception of being less competitive in recruiting.
A company must also consider, when calculating the requirement, the total number of employees employed at any time during the year as well as individuals receiving grants, whether they were employees at the beginning or end of the calendar year. This calculation may be cumbersome. Since we all typically hire based on our expected growth, and project growth throughout the year, you may not actually be able to calculate this number until the end of the year. Thus, determining if you are an eligible corporation likely will have to wait until the end of the year.
Income Tax Withholding Requirements
The notice provides clarification on withholding federal income taxes relating to deferral stock received:
- The determination must be made at the highest marginal income tax rate.
- The deferral must be applied at the required flat rate regardless of employees’ Form W-4 allowances or any agreement between the employee and employer to withhold more or less.
- By January 31 of the year following the payment date (five years or one of the other defined trigger dates), the employer must determine the actual value of the stock deferred and report that amount to the employee’s Form W2.
- FICA and FUTA taxes are still due at the time of exercise or settlement; 83(i) applies only to federal income taxes.
Opting Out of Section 83(i)
Many corporations are concerned about the complexity of the Code and are now able to opt out. The new notice states a mandatory escrow of deferral stock, and as a result, if employers do not establish an escrow arrangement, it can preclude employees from making a Section 83(i) election.
This does not mean ― as we have seen with clients ― that employees won’t make 83(i) elections on their own, and inform the company after the fact of such elections. For this reason, it is important to educate your internal stock administration and legal teams, and even your employees themselves.
If you would like more information on 83(i) and how it may impact your company, how you should reply to employee inquiries, or how to proactively educate your internal teams about 83(i), please do not hesitate to reach out.
Scott is a partner in our CFO Advisory Services practice who helps companies handle a wide array of business valuation needs, equity compensation challenges and technical accounting issues. He provides equity consulting and stock option administration services, as well as company transactions, award modifications and initial public offerings.