As part of the 2017 Tax Cuts and Jobs Act, Congress amended the tax code to add new Section 83(i), which allows employees of private companies to elect to defer the recognition of income on the receipt or vesting of stock, if the stock was received in connection with the performance of services and the employees received the stock as a result of the exercise of a stock option or the settlement of a restricted stock unit (RSU).
The availability of deferral treatment under Section 83(i) is conditioned on the existence of a written plan under which not less than 80 percent of a company’s employees are granted stock options or restricted stock units having the same rights and privileges to receive the stock. Other requirements are applicable, including a limitation on the ability of “excluded employees” to make the election. Excluded employees include (as determined under time periods specified in Section 83(i)) 1 percent owners, certain officers, and specified family members of certain officers.
If a person makes a Section 83(i) election, they will be taxable with respect to the stock that is the subject of the election on the first to occur of:
1. The date that the stock becomes transferable;
2. The date that the person becomes an excluded employee;
3. The date on which any stock of the issuing company becomes traded on an established securities market;
4. The date on which the person revokes the election (in accordance with Internal Revenue Service rules); or
5. The date that is five years after the first date that the rights of the person in the stock are transferable or not subject to a substantial risk of forfeiture.
Importantly, the amount included in income under Section 83(i) is the value of the stock at the time that the electing employee’s rights in the stock become transferable or not subject to a substantial risk of forfeiture. This would mean that an employee who makes a Section 83(i) election, and becomes taxable on the stock covered by the election five years after the employee’s rights in the stock vest, will be taxed on the value of the stock on the date of vesting, even if the value of the stock during that five-year period declines, and presumably even if the issuing company goes out of business, and the stock becomes worthless (unless the IRS creates a right to revoke the election under such circumstances).
The IRS recently issued Notice 2018-97, which provides guidance regarding a number of the operational requirements applicable to Section 83(i).
A large portion of the Notice 2018-97 guidance addresses the withholding of income taxes with respect to Section 83(i) elections.
The Notice references the statutory requirement that the income tax withholding rate is the maximum income tax marginal rate (37 percent in 2018). This rate will be applied without regard to withholding allowances elected on a Form W-4. According to the Notice, income tax withholding wages are treated as paid with respect to Section 83(i) deferral stock on the date that the stock become taxable under Section 83(i). On that date, the employer must make a reasonable estimate of the taxable value of the deferral stock and make timely deposits of income withholding taxes based upon that value. The actual taxable value of the deferral stock must be reported on the employee’s Form W-2, which is due January 31 of the following year. The employer has up until April 1 of the following year to recover from the employee any income withholding taxes paid by the employer.
One interesting, and somewhat unusual, aspect of the Notice is that it requires an employee who would like to make a Section 83(i) election must agree that all of the shares of stock covered by the election will be held in an escrow arrangement. The Notices provides that the company may remove from escrow shares having a then current fair market value equal to the income withholding taxes that the employee has not paid through some other means.
The Notice states that the escrow arrangement, in addition to ensuring that “the statutory income tax withholding requirements of the corporation will be met,” is intended to be “less burdensome than alternatives that would require a cash outlay by the corporation or the employee before the due date for the relevant withholding, and thus allow less flexibility with respect to resource allocation.”
The escrow arrangement raises a variety of potential practical considerations.
- For example, although the escrow arrangement is helpful to an employee, by avoiding the need to reduce wages or come up with the cash to pay income withholding taxes, it does not alleviate the potential burden on a cash-strapped company of having to make a tax deposit to the IRS.
- The Notice does not say so, but presumably the escrow arrangement will have to maintained by a third party, with the employer paying the costs of maintaining the escrow.
- As mentioned above, the removal of shares from escrow to pay income withholding taxes will not occur unless, and to the extent, the employee who owes the taxes otherwise fails to pay the company the amount of such taxes. For a variety of reasons, an employee may prefer reducing wages or making a cash payment to cover income withholding taxes to avoid giving up escrowed shares. In order for this choice to work smoothly, the company will need to put in place appropriate communication and administrative procedures to coordinate the choice with the escrow arrangement.
It bears mentioning that Section 83(i) does not change the timing of other payroll taxes, including FICA and FUTA taxes and state income withholding taxes, which may be applicable to option exercises and RSU settlements earlier than the time that federal income withholding taxes are imposed with respect to stock covered by a Section 83(i) deferral election.
Dan Morgan is partner at Blank Rome LLP in Washington in the employee benefits and executive compensation practice. He has spent his career representing a wide range of public and private companies and nonprofit organizations, as well as senior executives of those companies and organizations.