7547 / Can gain on certain stock options and restricted stock units be deferred under the 2017 tax reform legislation?
Generally, IRC Section 83(a) requires that, when a taxpayer receives property in exchange for services, the value of the property is taxable when it becomes transferrable or when it is vested (basically, when it is no longer subject to a substantial risk of forfeiture). As a result, when an employee receives an equity grant, appreciation on the stock can be taxed at ordinary income tax rates during the time between granting and vesting. Section 83(b) allows taxpayers to make an irrevocable election to pay income taxes on the unvested stock at its fair market value on the date of transfer (so that subsequent appreciation is taxed at capital gains rates). However, many employees who receive equity grants do not have the funds to make this election and cover the tax liability, especially with respect to companies where the stock is not readily tradeable (i.e., the employee cannot sell the stock to help pay the taxes).
IRC Section 83(i) allows employees who receive these specific types of equity grants to elect to defer taxation for five years after the stock vests.
Planning Point: Essentially, this can be helpful to employees when the stock that will be transferred to them is not readily tradeable, making it potentially difficult to pay the associated taxes immediately.
The election must be made within 30 days after the date upon which the employee’s rights in the stock are transferable or are no longer subject to a substantial risk of forfeiture (whichever is earlier). The election must be filed with the IRS and the employee must also provide a copy to the employer.2 The employer is required to provide notice of the potential to defer income to the employee receiving the grant. If a deferral election is made with respect to an incentive stock option, that option is treated as a nonqualified stock option for FICA tax purposes.3
Planning Point: Only income taxes are deferred during the deferral period. Employment taxes (Social Security and Medicare taxes) still must be paid.
At the end of the deferral period, the employee recognizes income based upon the value of the stock on the vesting date (regardless of whether the value has decreased during the deferral period).
Planning Point: While the eventual tax paid is based on the value of the stock at vesting, the holding period for long-term capital gains treatment will begin to run during the deferral period. Therefore, if the stock value increases during the deferral period, ordinary income tax rates will only apply to the stock value at the start of the deferral period. The remainder will be taxed at the lower long-term capital gains rates if the stock is not sold for at least one year.
Income must be recognized for the first taxable year that includes one of the following (1) the first date the qualified stock becomes transferable (including transferable to the employer), (2) the date the employee becomes an “excluded employee,” (3) the date on which any of the stock becomes readily tradeable on an established securities market, (4) five years after the first date the employee’s right to the stock becomes substantially vested or (5) the date upon which the employee revokes the deferral election.4
Planning Point: Under the rules that have been provided thus far, it does not appear that termination of employment with the employer will cause the deferral period to end.
“Excluded employees” include any individual (1) who was a one-percent owner of the corporation at any time during the 10 previous calendar years, (2) who is, or has ever been, CEO or CFO of the company (or has acted in that capacity), (3) who is a family member of an individual described in (1) or (2), or (4) who has been one of the four most highly compensated officers of the company for any of the 10 previous tax years.5 Employees must also agree to an escrow provision in order to take advantage of the new deferral option. All deferral stock must be held in an escrow arrangement established by the employer to qualify.6
Planning Point: Failure to establish an escrow account to hold the deferral stock provides employers with the option to compensate employees with stock, but preclude them from making the new Section 83(i) election. The terms of the stock option or RSU can also provide that no Section 83(i) election will be available.
The election is only available with respect to qualified stock, which means stock in an employee’s employer that is (1) received in connection with the exercise of an option or in settlement of an RSU and (2) granted in connection with services that are being performed by the employee. The stock will no longer be qualified if the employee may sell the stock, or otherwise receive cash in lieu of the stock from, the corporation.7
To issue equity grants that qualify for the Section 83(i) deferral election, the employer must be a private company that has a written plan in place stating that at least 80 percent of the employer’s full-time U.S. employees will be granted stock options or RSUs on substantially the same terms. The number of shares granted to each employee need not be equal, so long as each employee is entitled to a more than de minimis amount. Rights and privileges with respect to the exercise of a stock option are not treated for this purpose as the same as rights and privileges with respect to the settlement of an RSU.8
Planning Point: The IRS has released guidance clarifying that this 80 percent requirement is based only on stock options or RSUs granted in a particular calendar year. Further, the employer is required to take the total number of employees employed at any time during the year into account in calculating the 80 percent requirement, as well as all of the employees receiving grants, regardless of whether the person was employed at the beginning or the end of the year in question.9
All related entities are considered in determining whether the 80 percent requirement is satisfied. The definition of controlled group under IRC Section 414(b) applies for purposes of determining corporations that are members of a controlled group (and are thus treated as a single corporation).10 Further, only corporations that make grants to employees are eligible under this provision (LLCs that elect partnership taxation are excluded).