Under current law, the fair market value of property transferred to an employee in connection with the performance of services, less any amount paid for the property, is included in the employee’s gross income when the property is no longer subject to a substantial risk of forfeiture. With respect to stock options, the amount of the income inclusion equals the fair market value of the shares on the date of exercise over their exercise price (i.e., the spread). For restricted stock units (“RSUs”), the amount included in the employee’s gross income equals the fair market value of the shares received on settlement.
If the shares subject to the option or RSU are those of a publicly traded corporation, the employee can usually sell the number of shares necessary to pay his or her related tax liability. In contrast, if the shares are those of a private company, the employee must come up with the cash necessary to pay the tax, unless the employer agrees to repurchase the number of shares necessary to cover the employee’s related tax liability.
Section 13603 of The Tax Cut and Jobs Act (“TCJA”) added new Section 83(i) to the Internal Revenue Code. The new law attempts to address this potential liquidity problem and thereby enhance the attractiveness of private company equity compensation arrangements. For the reasons noted below, it is not clear at this time whether employers and employees should rely upon the new law to address liquidity issues.
New Section 83(i) allows a “qualified employee” of a “qualified corporation” to elect to defer the taxation of gain realized on the exercise of a stock option or settlement of an RSU for up to five years if certain conditions are satisfied.
A "qualified employee" is any individual:
A corporation is a "qualified corporation" if:
An employee will not fail the "same rights and privileges" test solely because the number of shares available to all employees is not the same, so long as the number of shares available to each employee is more than a de minimis amount.
"Qualified stock" is that of the employer if:
An electing employee calculates his or her gain at the time the option is exercised or the RSU settled, but does not include the gain in gross income until the earliest of:
The election is made no later than 30 days after the employee’s right to the stock is substantially vested or is transferable, whichever occurs first.
An employer is required to notify an employee that he or she is eligible to make the election at the earlier of the time the employee’s right to the stock is substantially vested or the stock is transferable. The notice must include, among other things, the employer’s certification that the stock received by the employee is qualified stock. An employer who fails to provide proper notice is subject to a $100 fine per failure that is capped at $50,000.
While additional IRS guidance will be required before the new law can be fully assessed, a few observations are warranted:
From the employee’s perspective, the new law does not shield an employee from the risks inherent in the corporation’s business. While the value of the stock received may decline significantly, the amount of gain to be recognized by the employee at the end of the deferral period remains constant, and there is no assurance that a liquidity event will occur that will allow an electing employee to monetize the value in his or her stock.
If the employee’s ordinary income increases over the deferral period, the income recognized at the end of the deferral period may be subject to tax at a higher rate than it would have been in the election year. An election also prevents the favorable incentive stock option rules from applying to stock that would have otherwise been subject to those rules.
From the corporation’s perspective, it may be necessary to grant options or RSUs to employees who would not otherwise receive such grants, in order to satisfy the 80% coverage threshold and meet the definition of a qualified corporation.
Alternatively, a corporation may unwittingly satisfy the requirements necessary for an employee to make the election and fail to provide notice to the employee that he or she may make the election, and thereby subject itself to penalties.
In addition, if an employee elects to defer the payment of tax on his or her gain, the employer’s related compensation deduction is deferred until the tax year in which the employee includes the gain in his or her gross income.
Mark M. Hrenya possesses a breadth and depth of experience in tax law that spans several decades. He assists U.S. companies with domestic and foreign issues and also handles tax matters within the U.S. for foreign businesses. Hrenya Senatore LLP also provides employment law counsel for domestic and international clients. For additional information, please refer to the firm's attorneys and practice areas pages or contact Hrenya Senatore.