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;