Most people associate equity awards with public companies. Private companies, however, can also issue equity to their employees as part of an overall compensation package. While this type of compensation aligns the success of employees with that of their companies, there are drawbacks. Unlike public companies, whose stock is typically traded on public exchanges, private companies lack a ready market for their stock. Therefore, their employees who are compensated with non-qualified stock options (NSOs) or restricted stock units (RSUs) typically have to come up with the cash to pay taxes on income generated when they exercise their options or upon settlement of their units.

To give employees of private companies some relief, Congress enacted Section 83(i) of the Internal Revenue Code as part of its recent overhaul, the Tax Cuts and Jobs Act. In theory, this section presents an interesting opportunity. In practice, however, the mechanics and requirements of Section 83(i) suggest that it may have only limited utility—something pointed out by critics.

While there are limitations in this new provision, there still are a few circumstances in which it might be quite useful. But first, it’s important to have a basic understanding of what it does.

What Does It Do?

Section 83(i) provides a new deferral mechanism for taxable income that would otherwise be recognized when stock options are exercised or RSUs are settled. Generally, the fair market value of the stock received under NSOs or RSUs, less the amount paid for it, is included as ordinary income. Ideally, any money needed to pay the ensuing taxes could be raised by selling some or all of the stock. If, however, there is no way to sell the stock, then the holder could owe substantial taxes but have no cash on hand to pay for them.

Congress added Section 83(i) for just such a situation, as long as certain requirements are met by the company, the stock and the employees. If an “eligible corporation” transfers “qualified stock” to an employee (other than those excluded) then that employee can possibly defer income (and the associated taxes) for up to five years, according to specific conditions.

How Does It Work?

Subject to certain limitations, an employee can make a Section 83(i) election within 30 days of exercising an option or settling a restricted stock unit. That election defers the ordinary income that otherwise would be part of taxable income. A person’s employment tax, however (FICA, for example) is not deferrable and must be paid, generally through withholding. Upon the eventual sale of the stock, the difference between the sale price of the stock and its fair market value when acquired should be taxed as a long-term capital gain (or loss), as long as the employee holds the stock for more than a year.

For example, suppose a private company employee with restricted stock units receives 10,000 shares upon settlement, each of which is worth $10. Normally, if an employee paid nothing for the shares, he or she would be required to pay income and employment taxes on $100,000 of ordinary compensation income, even though the shares can’t be converted into cash yet.

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?

Section 83(i) generally can offer value to employees who receive illiquid stock through non-qualified stock options or restricted stock units, but, for myriad reasons, the election may have limited availability or use.

1. The company may have difficulty qualifying. There are strict requirements for this election, and one of them is that it is available only for private companies in which at least 80% of all employees (providing services in the United States) are granted either options or restricted stock units, with the same rights and privileges to receive qualified stock. Many companies may struggle to qualify under those rules.

2. There are limitations for the employees. The election is limited to employees who own less than 1% of the company, who have not been the CEO or CFO (or related to them), and who have not been one of the four highest compensated officers of the company. For this reason, the election has been effectively denied to those who probably could derive the most benefit from it.

3. The election does not defer employment taxes. The employer typically will be required to withhold employment taxes, which can be substantial.

4. The election does not always apply to state taxes. Not all states follow the federal income tax rules on the timing of income inclusion. For this reason, the deferral offered by Section 83(i) may in some cases be unavailable for state income tax purposes.

5. The election could run into problems if the company goes public. A typical IPO could present a problem for an electing employee. If the employee has made a Section 83(i) election, it seems likely that he or she will have to pay the deferred tax liability at the time of an IPO, when the stock becomes readily tradable. In some cases, however, the employee may not yet be able to sell the stock because of traditional lockup arrangements.

6. The stock might decline. If the stock declines in value after the employee makes the election, then he or she will still have to recognize ordinary income after the deferral period with reference to the value as of the election date. This risk, however, must be considered in the context of the alternatives: (a) delaying the receipt of the stock if possible; or (b) not making the election and recognizing income upon receipt of the stock, even given the possibility that the stock will decline in value before it can be sold.

7. Companies must observe notice requirements and risk penalties. There is a notice requirement for corporations that transfer qualified stock to a qualified employee, and there are penalties for not complying with them. Specifically, the corporation must notify the employee:

• That the stock is qualified stock;

• That the income inclusion is deferrable;

• That if the employee makes the election, the amount of income recognized at the end of the deferral period will be based on the value of the stock when it becomes transferrable or substantially vested, even if the value declines during the deferral period; and

• That income included at the end of the deferral will be subject to withholding, leading to a tax responsibility of the employee.

The burdens of complying with these rules, as well as the potential for penalties for failing to do so, could lead some companies to avoid qualifying as eligible corporations by, for example, altering their option and restricted stock unit programs to restrict the percentage of employees who can participate.

Conclusion

While the new Section 83(i) has already been dismissed by many, it may still prove useful under the right circumstances. Thoughtful employees, employers and advisors must weigh all of the complex requirements and considerations in order to gauge its potential use and impact.       

Michael J. Nathanson, JD, LLM, is chairman, chief executive officer and president of The Colony Group. Sean Kelly, CPA, is a senior tax manager at The Colony Group. Joshua Nathanson and Matthew McKeown were summer wealth management interns at The Colony Group.