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Included in the Tax Cuts and Jobs Act of 2017 was Section 83(i) of the Internal Revenue Code of 1986, which was designed to ease the tax burden on rank and file employees of certain privately held companies of the receipt of restricted stock Units (“RSUs) or stock options. The IRS subsequently issued Notice 2018-97 providing guidance on the practical and administrative effects of offering employees the option to defer compensation under Section 83(i). The guidance makes clear that there are both limited benefits and administrative burdens to the election opportunity. Before offering a Section 83(i) election, employers should carefully consider the implications and burdens. In addition, if a company has already built flexibility intended by Section 83(i) into their equity incentive plans, the company should consider reassessing those amendments in light of the recent guidance.

OVERVIEW OF SECTION 83(i) AND POTENTIAL BENEFITS

Section 83(i) provides in general that eligible employee that receives stock upon exercise of a stock option or settlement of an RSU can make an Section 83(i) election to defer the inclusion of the value of that stock income until the earliest of the following:

  • Five years following the exercise of the option or vesting in the RSU;
  • The employer’s stock is publicly traded;
  • The stock becomes transferable;
  • The employee becomes an excluded employee; or
  • The employee revokes his election.

As soon as the earliest of these events occurs, the employee would pay income tax only on the value of the deferred amount. Additionally, any subsequent increase in the stock’s value would be taxed at capital gains rates.

Private companies that often rely on equity incentives to attract talent, such start-ups and technology companies may find that the Section 83(i) election would further incentivize such employees or potential employees; however, the restrictions and administrative burdens associated with such elections may outweigh the benefits.

SUMMARY OF CERTAIN OF RESTRICTIONS AND BURDENS

In order to offer a Section 83(i) election, a privately held company must grant stock options or RSUs with the same rights to 80% of its employees within the calendar year in which the election is to apply. As such, a continuing obligation exists to make equity grants that may not match the plans of certain companies, particularly those that only offer grants upon hiring.

Section 83(i) excludes certain employees from the deferral opportunity – including employees who are or were a 1% owner during the current or previous ten years; anyone who is or was the CEO or CFO of the company; and anyone who is or was one of the four highest compensated officers in the past ten years. Companies that only offer equity incentives to management and officers, or that have limited employees generally, may not be able to benefit from Section 83(i).

In addition, restrictions on stock repurchases in the context of the Section 83(i) may limit a companies ability to repurchase stock, which is a common feature with equity grants, particularly with respect to terminated employees.

At the end of the Section 83(i) deferral period, the employee that received the stock must pay income tax on the value of the stock at vesting or exercise. The Company, as the employer, has withholding requirements with respect to such income inclusion. Notice 2018-97 requires employers to hold stock in escrow until the company meets its withholding requirement. Beyond the administrative of escrowing the stock, the escrow itself does not guarantee that there will be sufficient value in the stock to cover any tax withholding obligations since the tax is based on the value at receipt or vesting of the stock not the value upon release from escrow.

Employers are further required to provide a notice of the availability of the Section 83(i) election. Those who fail to do so will face a fine of $100 for each failure, up to a maximum of $50,000 per year.

If you have specific questions about Section 83(i) or how it applies to your business, please contact Bradley Wooldridge or your Manning Fulton relationship attorney.

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