Suppose instead that the employee makes a Section 83(i) election, allowing a deferral of the $100,000 of income. Suppose further that three years later the employee sells the shares for $25 each. Now, the employee will include the $100,000 as ordinary income and the $150,000 as capital gain ($250,000-$100,000). Unlike three years ago, however, there will be plenty of cash to pay the taxes. However, if the value of the shares declined to $8 per share over the three-year period and then they were sold, the same $100,000 of ordinary income would be picked up and the employee would realize a long-term capital loss of $20,000.

When Can The Election Be Useful?

While there are limitations, some of which are described below, let’s first take a look at the circumstances in which the election may be quite valuable.

1. When the company is nearing a liquidity event. Many companies are increasingly seeking to adopt a more egalitarian approach to granting equity awards, making it easier for them to qualify as eligible corporations, as discussed below. A holder of non-qualified stock options or restricted stock units in such a company (who, again, is not an excluded employee) and who has confidence in the stock as well as a belief that it will become transferrable within a reasonable period of time can benefit from a Section 83(i) election.

2. When the company is smaller. A similar dynamic can exist in a company with fewer employees—such as a start-up company—where a greater percentage of employees are likely to receive equity awards, thereby making it easier for the company to qualify as an eligible corporation.

3. When non-qualified stock options are expiring. For expiring NSOs in a private company, a Section 83(i) election can offer a qualified employee the opportunity to exercise vested options before they expire without immediately having to pay the associated income taxes.

4. When the restricted stock units are time-vesting. For time-vesting RSUs that will be settled with stock, a Section 83(i) election can be valuable to an employee because it defers his or her obligation to pay income taxes upon vesting. A deferral also reduces the employee’s current taxable income, which could unlock deductions and credits under the Tax Cuts and Jobs Act that were previously phased out. For instance, the child tax credit has been increased to $2,000 for each qualifying child, and the phase-out does not begin until modified adjusted gross income reaches $400,000. Elsewhere, the 20% qualified business income deduction may become available, whereas before it might have been limited by the $315,000-$415,000 taxable income phase-in/phase-out.

5. When there are small amounts of taxable income. In cases where there will be only small amounts of taxable income recognized under a non-qualified stock option, it may make sense to exercise the option, make a Section 83(i) election, and convert future appreciation into capital gain. In this case, the risk of the stock declining in value and/or not becoming liquid may be worth taking.

6. When there are incentive stock options. By making a Section 83(i) election with qualified stock options such as ISOs, the election appears to eliminate the tax-favored status of the option, generally making the election unattractive. In some cases, however, it may be worth considering making the election as a way of eliminating potential exposure to the alternative minimum tax (if applicable, given the higher exemptions), especially when the holder is likely to make a disqualifying disposition in subsequent years.

What Are The Limiting Considerations?