With the introduction of Section 83 (i) to the tax code as part of the Tax Cuts and Jobs Act, private companies and startups can now recognize more flexible employee incentive plans involving qualified equity grants.
Historically, startups and private companies attract and retain top talent by offering equity-based compensation. The primary forms of this compensation are either incentive stock options or restricted stock units (RSU). Both of these vehicles present challenges from a tax standpoint, often requiring the employee to pay taxes prior to receiving any cash benefit from the award.
Stock options trigger taxes when the options are exercised leading most employees to delay exercise. Additionally, a significant portion of the gain related to stock options resulted in taxes paid at ordinary income rates rather than capital gain rates.
Restricted stock units trigger taxes when they are vested, also resulting in taxes paid at ordinary rates. While an 83(b) election could help reduce taxes from the appreciation of the award during the vesting period, it does result in accelerating the date of payment.
Unfortunately, both situations are counterproductive to the initial incentive employers are trying to create.
How Can Sec. 83(i) Help?
Sec. 83(i) works to alleviate the immediate tax burden of RSUs by allowing the deferral of taxable income for up to five years beyond the vesting date. Based on a typical vesting period of four years, this would defer tax for up to nine years. Equally valuable is that the ordinary income portion of the stock award is locked in at the date of award allowing subsequent appreciation to be taxed at capital gain rates.
This broad plan for handling qualified equity grants restores more of the incentive to employees. Upon issuance of the qualified stock, employees have 30 days to file a Sec. 83(i) election with the IRS.
Sec. 83(i) only applies to qualified stock received due to options exercised or RSUs settled after Dec. 31, 2017. Employees must receive the stock as part of a qualified equity grant.
Who are Qualified Employees?
Qualified employees are those meeting a specific range of criteria as advised by the IRS, which encompasses any employee who is not:
- A 1% owner during the calendar year or any of the preceding 10 calendar years;
- The CEO, CFO or anyone acting in such a capacity, either currently or at any prior time;
- Individuals related to persons described above within the meaning of Sec. 318(a)(1); or
- One of the four highest-compensated officers currently or during any of the preceding 10 calendar years.
Potential Drawbacks and Negatives
The drawbacks to Sec. 83(i) generally center on the idea of a broad-based plan that might be considered inefficient and costly in the wrong situation. For example, companies can only offer this option if it’s extended to at least 80% of its full-time U.S. employees, which it may not want to offer.
Due to the definition of “qualified employee,” employees set to receive vested equity under a Sec. 83(i) designation may result in immediate taxation if that employee becomes one of the four highest paid individuals within the company or obtains the title of CEO or CFO.
Another drawback involves employees acquiring more than 1% of the total company stock from other sources (such as the company going public). This triggers a nullification for qualified employees, resulting in immediate taxation or the inability to declare a Sec. 83(i) execution.
The Bottom Line
Sec. 83(i) creates a much more favorable avenue for employees set to receive qualified equity grants by giving them up to five years deferral on taxation. This affords them enough time to cash in on their options and minimize the cash flow issues that come from paying taxes on paper profits. It also maintains the original incentive concept of offering equity.
For private companies and startups seeking to attract, maintain and reward talent, Sec. 83(i) may prove to be a more flexible approach to offering equity. If you offer restricted stock units, consult your technology CPAs about whether or not qualified equity grants are feasible for your company.
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