What founders and employees with private equity need to know to defer taxes from exercising stock options.
Given my experience in working with business owners I would like to assist you in understanding what the IRC Section 83(i) Election is and how it may benefit you as a founder or employee with company stock options.
What is the section 83(i) Election?
The Section 83(i) election is intended to allow employees to defer paying tax on stock awards for up to five years, although there are events like an IPO (Initial Public Offering) that would cause employees to owe the tax sooner. In theory, an employee could exercise early, and then not have to pay the tax bill until there’s a liquidity event, avoiding the problem some face now.
As an employer it’s great that you want to provide for your loyal employees from a future sale of your business. There are many options available such as restricted stock, phantom stock and stock appreciation rights, that can be used to reward and or retain loyal employees. After weighing up the pros and cons, most employers decide they don’t want all employees to become actual shareholders in the company with the statutory rights that go with it and opt for a phantom arrangement providing for the employees to receive cash only as if they were a shareholder or due to change in control.
Tax Cuts & Jobs Act
With the tax reform under the Tax Cuts and Jobs Act, there is a tool that can alleviate the tax burden of employees receiving compensatory stock by giving them up to five (5) years to pay the tax on the receipt of the stock. If a qualified employee receives qualified stock from a qualified corporation as a result of exercising a non-statutory stock option (NSO) or settling a Restricted Stock Unit (RSU), the qualified employee can file an “83(i) election” to defer the tax for five (5) years unless a disqualifying event occurs in the interim.
An NSO is any stock option granted by a qualified employer that is not an incentive stock option (or statutory stock option) or provided under an Employee Stock Purchase Plan that qualifies for special tax treatment under Code Section 422. An RSU is the right to receive stock in the future.
Generally, without an 83(i) election, employees are subject to income tax on the difference between the fair market value of the stock on the date of exercise of the option less the exercise price, if any. Likewise, employees are subject to income tax from receiving stock on the settling of an RSU on the fair market value of the stock on settlement less any amount the employee paid for the RSU. A Section 83(i) election allows the qualified employee to defer the tax for five (5) years.
A Few Definitions
A qualified employee is a U.S. based employee that regularly works more than thirty (30) hours per week that is not: already an owner of at least 1% of the stock of the corporation; an employee that is or has ever been the CEO or CFO; a spouse, child, grandchild or parent of a 1% owner, CEO or CFO; or among the four (4) highest paid officers of the corporation.
Qualified stock is stock in the employer corporation received by a qualified employee in connection with the exercise of an NSO or settlement of an RSU in exchange for services to the employer during a year when the employer was an eligible corporation.
An eligible corporation is one that during the calendar year in which the NSO or RSU was granted: No stock of the corporation is readily tradeable on an established securities market during any preceding calendar year and the corporation has a written plan under which at least 80% of all U.S. based full-time qualified employees are granted NSOs or RSUs with the same rights and privileges to receive more than a de minimis amount of qualified stock.
Upon receipt of the stock, the qualified employee has thirty (30) days to make the 83(i) election by filing it with the IRS and giving a copy to the employer. If made, the tax that would have been incurred will not be taxed until five (5) years from the year it would have been taxable without the election unless one of the following intervening events occurs earlier:
- The first date stock of the employer becomes publicly traded;
- The date the employee ceases to be a qualified employee;
- The date the qualified stock becomes transferable including to the employer;
- The date the employee revokes the 83(i) election.
- The intent of Section 83(i) is to help with the “phantom income” problem that employees of private corporations have when being compensated with stock. Without the Section 83(i) election, the employee is taxed on the exercise of an NSO on the difference between the fair market value of stock on exercise and the exercise price. The income is considered wages subject to income tax withholding and employment taxes.
- Likewise, upon receiving stock from the settling of the RSU the employee is taxed on the fair market value of the stock on the date of settlement. Both situations cause phantom income because while the employee has taxable income, he/she has not received any cash to pay the additional tax or withholding which must come from other income. Additionally, unlike employees of public corporations, the employee of a private corporation cannot just sell some of the stock received on the open market to get cash to pay the tax.
Recommendation for startups?
The smartest thing startups can do is have a plan for how to treat equity well in advance of any possible liquidity event, and to make sure employees understand the tax impact of exercising options.
Companies should also take the time to determine whether an 83(i) election is right for them. Companies need to consider the potential administrative burden before moving forward. The new tax law is complicated, and changes in one area can have a ripple effect throughout the tax liability of both the company and individuals. Mapping out the impact of these changes is critical to informing any tax strategy moving forward.
I encourage you to speak with a tax professional to assess if the 83(i) election makes sense for your situation. I regularly work in concert with my client’s tax advisors as all the work we do is related.
Thank you for reading!