How to Utilize or to Avoid Section 83(i) Deferral of Tax Payment on Equity Compensation
How to Utilize or to Avoid Section 83(i) Deferral of Tax Payment on Equity Compensation
On December 7, 2018, the IRS issued guidance on the application of Internal Revenue Code (Code) Section 83(i) via Notice 2018-97 (Notice), which addresses three major concerns of corporate employers:
- The application of the requirement in Section 83(i)(2)(C)(i)(II) that grants be made to not less than 80 percent of all employees who provide services to the corporation in the United States.
- The application of federal income tax withholding to the deferred income related to the qualified stock.
- The ability of an employer to opt out of permitting employees to elect the deferred tax treatment even if the requirements under Section 83(i) are otherwise met.
Application of the 80 Percent Requirement
In order for an individual to defer under Section 83(i) the payment of federal income taxes generated by certain stock options or RSUs, the awards must be granted by an “eligible corporation” (i.e., a corporation whose stock is not readily tradable on an established securities market during any previous year), pursuant to a written plan that provides awards, with the same rights and privileges, to not less than 80 percent of all employees who provide services within the United States (or any possession of the United States).
Stakeholders were unclear as to whether the 80-percent requirement could be satisfied on a cumulative basis by taking stock options and RSUs granted in prior calendar years into account or only by taking the awards during each calendar year into account. The Notice makes it clear that the determination as an eligible corporation must be made on a calendar year basis, and whether the corporation has satisfied the 80-percent requirement is based solely on the stock options or the RSUs granted in that calendar year. Furthermore, the guidance indicates that applying the rule on a cumulative basis is contrary to the statutory language and is not a reasonable good-faith interpretation of the 80-percent requirement. Accordingly, any determination on that basis for 2018 will not satisfy the transition rule for good-faith compliance with the new rules.
In calculating whether the 80-percent requirement is satisfied, the corporation must take into account the total number of individuals employed and rendering services in the U.S., or any U.S. possession, at any time during such year as well as the total number of employees receiving grants during such year (in each case, without regard to excluded employees, i.e., 1 percent owners; the chief executive officer and chief financial officer, or individuals acting in such capacity; specified family members of such owners and officers; and the four highest compensated officers of the corporation), or part-time employees described in Section 4980E(d)(4)).
Income Tax Withholding and Employment Taxes
The TCJA amended the income tax withholding provisions in the Code to conform to the income taxation of deferral stock. Accordingly, the employer will not withhold federal income taxes on qualified stock subject to an 83(i) deferral election until the date the deferral period ends.
The amount determined under Section 83(a) with respect to such stock will be included in income on the first to occur of:
- The first date such qualified stock becomes transferable (including, solely for
- purposes of this clause, transferable to the employer).
- The date the employee first becomes an “excluded employee.”
- The first date on which any stock of the issuing corporation becomes readily tradable on an established securities market (i.e., an Initial Public Offering).
- The date that is five years after the first date the rights of the employee in such stock are transferable or not subject to a substantial risk of forfeiture, whichever occurs earlier.
- The date on which the employee revokes the election (at such time and in such manner as the Secretary of the Treasury provides).
Although it's not clear, the first bullet above may raise concerns for employers who include in stock option grants a right of first refusal or right to repurchase shares upon the occurrence of a specified event. Whether IRS will ignore the employer's right of first refusal or right to repurchase the stock so that an 83(i) election can be made remains unanswered. In the meantime, taxpayers should apply a good faith interpretation of the law and proceed with caution.
In summary, deferral stock constitutes wages under Section 3401(i) and is treated as received on the earliest date described above in an amount equal to the amount included in income under Section 83 for the taxable year that includes such date.
When the wages are treated as paid under Section 3401(i), the employer must make a reasonable estimate of the value of the stock and make deposits of the amount of income tax withholding liability based on that estimate. The wages included under Section 3401(i) are subject to withholding at the maximum rate of tax in effect under Section 1, and withholding is determined without regard to the employee’s Form W-4 (i.e., there is no reduction for any withholding allowances). By January 31 of the following year, the employer must determine the actual value of the deferral stock on the date it is includible in the employee’s income and report that amount and the withholding on Form W-2 and Form 941. In cases where the employer pays the income tax withholding for the deferral stock from its own funds, such amount may be recovered from the employee until April 1 of the year following the calendar year in which the amounts were treated as wages.
An employer that fails to deduct and withhold federal income tax under Section 3402 is liable for the payment of the tax whether or not the employer collects it from the employee, unless Section 3402(d) applies. Section 3402(d) provides that if the employer fails to deduct and withhold the correct amount of income tax withholding, and thereafter the income tax against which the tax under Section 3402 may be credited is paid, the tax imposed under Section 3402(a) shall not be collected from the employer. Section 3402(d) does not relieve the employer from liability for any penalties in respect of the failure to deduct and withhold.
The TCJA made no amendments to FICA and FUTA taxation with respect to deferral stock. Thus, the taxable amount should be treated as wages subject to FICA and FUTA in the year that taxation would occur absent the deferral election.
In order to adequately ensure the statutory income tax withholding requirements of the corporation will be met, the Secretary pursuant to its authority provided under Section 83(i)(3)(A)(ii), requires a Section 83(i) election to include an agreement that all deferral stock will be held in an escrow arrangement, the terms of which are consistent with the following requirements:
- The deferral stock must be deposited into escrow before the end of the calendar year during which the Section 83(i) election is made and must remain in escrow until removed in accordance with clause (ii) (see below), or until the corporation has otherwise recovered from the employee an amount equal to the corresponding income tax withholding obligation under Section 3401(i) for the taxable year determined in accordance with Section 83(i)(1)(B).
- At any time between the date of income inclusion under Section 83(i)(1)(B) and March 31 of the following calendar year, the corporation may remove from escrow and retain the number of shares of deferral stock with a fair market value (FMV) equal to the income tax withholding obligation that has not been recovered from the employee by other means. The FMV of the shares must be determined pursuant to the rules in Treasury Regulation § 1.409A-1(b)(5)(iv). The FMV used for purposes of this calculation is the FMV of the shares at the time the corporation retains shares held in escrow to satisfy the income tax withholding obligation.
- Any remaining shares held in escrow after the corporation’s income tax withholding obligation has been met, whether by retention of shares in accordance with clause (ii) (see above) or otherwise, must be delivered to the employee as soon as reasonably practicable thereafter.
In most cases, the corporation will not outlay cash in advance of collection from the employee. However, if the value of the stock dramatically declines while held in escrow, it is possible that the FMV of the assets in escrow will be insufficient to satisfy the income tax withholding on the taxable wage amount that is determined on the FMV of the shares at the time the 83(i) election was made.
Corporate Designation of Stock as Not Eligible for Section 83(i) Election
If a corporation rewards its employees with equity compensation, but does not want the administrative burdens associated with preserving the employees’ income tax deferral, it can preclude its employees from making Section 83(i) elections by declining to establish the required escrow arrangement. Therefore, corporations need not be concerned that a stock option or RSU program has inadvertently created the requirements to honor employee deferral elections or to comply with the notice requirement of Section 83(i)(6).
A corporation that does not intend to allow employee deferral elections may include in the terms of its stock option or RSU plan a provision clearly stating that no election under Section 83(i) will be available with respect to stock received upon the exercise of the stock option or settlement of the RSU even if the stock is Qualified Stock.