The IRS has issued interim guidance on a recent tax law change that allows qualified employees of privately-held corporations to defer income tax for up to five years on the value of qualified stock options and restricted stock units granted to them by their employers.

The new section 83(i) of the Internal Revenue Code permits eligible private corporations to adopt qualified equity grant plans for issuing stock options or restricted stock units (RSUs) to eligible employees in exchange for the performance of services.

New guidance for this section is likely useful for a narrow portion of business-owning wealthy clients, according to Dana Fried, a Jericho, N.Y.-based managing director in the national tax office of CohnReznick LLP.

“Use of the guidance boils down to scenarios of start-ups that have to compete for talent and don’t have the cash,” he said. “You offer a pot of gold at the end of the rainbow, with the theory that there will someday be liquidity.”

The taxpayer has 30 days from the time the rights are transferable or are not subject to a substantial risk of forfeiture to make the election. “The employer has strict notification requirements regarding telling the employee about the section 83(i) stock,” added Bill Smith, Bethesda, Md.-based managing director for CBIZ MHM’s national tax office

There is one problem with giving such an eventual windfall to an employee: Tax rules can result in levies when the employee has only a piece of paper in hand. “An auditor or appraiser can assign value to those pieces of paper and the employee has nothing [in hand] but tax liability,” Fried said. “The employer also has the federal income tax obligation and the payroll tax obligation.”

Wealthy clients who own businesses can typically get the money for these obligations from the employee paycheck. One protection for employers is that the deferral stock will be held in escrow. When the income relating to the stock becomes taxable, the corporation may remove shares equal in value to the required income tax withholding; the remaining shares can then be released to the employee.

Still, what’s the likelihood of a liquidity event within five years? What happens if in those five years the stock goes down?

“It’s up to the client if they want to take on this risk of a higher tax bill,” said Lawrence Pon, an accountant at Pon & Associates in Redwood City, Calif. “I’ve seen clients take extraordinary risks with exercising stock options. One former client mortgaged their house and exercised all of their options in a well-known tech company that flopped on their IPO.”

And "not all states have conformed to this new provision, so the taxpayer can have different results for federal and state reporting,” added Michael Gray, a CPA in San Jose, Calif. Failure to provide proper notification to employees in such stock offerings also opens employers to hefty fines.

The stock option must be granted to at least 80 percent of the total number of employees who worked full-time in the business at any time of the year—and generally executives, highly compensated officers and those owning one percent or more of the corporation’s stock are excluded from the 80-percent rule and from being able to take the deferral election.

A company with 20 employees might ideally give stock options to three to five employees “and stock options aren’t normally the way to go except to senior management,” Fried said.