Startup, technology and life sciences companies often utilize stock compensation incentives to drive competitive compensation and fuel employees motivation. The Tax Cuts and Jobs Act introduced Internal Revenue Code Section 83(i), which allows for a deferral of income attributable to stock options or Restricted Stock Units (RSU) received in connection with the performance of services for up to five years.
This tax deferral is permitted as an election for certain qualified stock transferred to qualified employees and the corporation administering the equity compensation plan must grant at least 80% of the employees stock options or RSUs. The election must be made within 30 days of the date of qualified equity grants to defer income taxes on qualified stock. This generally means the election must be made within 30 days from the exercise date (in the case of a vested option) or the settlement date (in the case of an RSU).
If a valid election is timely filed, any tax liabilities to the employee will be deferred until the earliest of:
Once one of these events above has occurred, the amount of taxable income will be based upon the fair market value of the stock on the date when the options/RSUs are vested (i.e. the date the election was made). This can potentially lead to significant tax deferral if the value of the stock appreciates over time. It also may allow for an employee to defer the tax bill until a liquidity event produces the cash to pay it.
Stock qualifies for an 83(i) election if the stock is received by an exercise of a nonqualified stock option or in settlement of an RSU. The employee must have received the options or Restricted Stock Units in connection with the performance of services during employment by an eligible corporation.
Generally, Section 83(i) defines qualifying employees as all employees except for excluded employees defined below:
A taxpayer holding stock options or RSUs with high chances of appreciation may benefit from making an election under Section 83(i). To demonstrate the advantages of this election let’s analyze the example below:
Assume a taxpayer has been granted Restricted Stock Units for 5,000 shares of employer stock that vest after two years of service to the Company. On day 1, year three assumes all RSUs have vested and transferred to the employee and the value of the stock is $10,000. If the taxpayer makes an election under Section 83(i), the $10,000 of stock that has been transferred to the employee is tax-deferred, and no cash is paid out of pocket for income taxes. The employee may have a deferral period of up to 5 years assuming the stock does not become transferable earlier. If the election is not in place, the employee must pay a tax of up to 37% on the value received on day 1, year 3, regardless of the stock being a non-liquid asset.
Assume further the stock appreciates during the 5 year deferral period to a value of $50,000. With an 83(i) election in place, the employee will pay ordinary income tax rates on $10,000 of income (the fair value as of the date of the election) and capital gain tax rates on the appreciation amount of $40,000. Capital gains rates are a maximum rate of 23.8% rather than ordinary income tax rates of up to 37%.
It is important to note that if an election is made and the stock depreciates in value the taxpayer may end up with a tax liability in excess of the fair value of the stock once includable income. Further, the deferral is limited to income taxes only, on the date of the election the employee will still be held liable for social security and medicare taxes.
If you have any questions on qualified equity grants, please reach out to your Withum Tax Advisor or fill out the form below and we’ll reach out to you shortly.