THE GIFT OF TIME: U.S. TAX RELIEF FOR EQUITY AWARDS OF PRIVATE COMPANIES:
New Code Section 83(i)
By Sandra W. Cohen
The 2017 Tax Cuts and Jobs Act included a gift in the form of tax deferrals to holders of equity grants in private companies. Previously, private company equity holders faced a big problem of taxation without liquidity on settlement of incentive awards without a market for sale of this stock. Ordinarily under U.S. tax law, the intrinsic value received upon exercise of a non-qualified stock option or settlement of a restricted stock unit (RSU) is includible in ordinary income and subject to tax withholding by the employer.
Under the new Internal Revenue Code Section 83(i), eligible employees of qualified issuers who acquired a right to the stock under a broad-based stock plan (a written plan that covers at least 80% of the employees in the employer’s controlled group) have the opportunity to elect to defer the gain on the option exercise or settlement of the RSU until the earliest of:
• Fifth anniversary of the deferral election,
• The date the employee becomes an excluded employee,
• The stock becomes readily tradeable on an established securities market,
• The stock becomes transferable, including because the employer offers to repurchase the stock (subject to other limitations);
Taxation of Deferral Stock Under Section 83(i):
Even though the taxable year has been deferred, the amount that will be included in income is the value of the deferred stock on the original date of exercise/settlement, regardless of whether the stock has declined or increased in value since then. The deferral stock under the new Section 83(i) is excluded from the rules on non-qualified deferred compensation under Section 409A.
Important Limitations on Use of Deferral Stock Under Section 83(i):
- Some executives are excluded from this deferral opportunity: 1-percent equity owners or executives who are among the top four highest paid officers at any time during the ten preceding calendar years, the chief executive officer or the chief financial officer of the corporation or any of their related parties are not eligible employees.
- There are administrative burdens on the employer: it must inform the equity holder that the stock is eligible for a deferral election and explain how and when it will be taxed. In addition, the employer must comply with IRS reporting requirements.
- Stock redemptions, where the employer can repurchase the deferral stock of an equity holder, are very limited.
- Stock purchased on exercise of an ISO or ESPP (Section 423 Plan) is excluded from deferral stock. These purchases are already tax-favored.
- Practitioner Note: The taxable event relating to “transferability” needs regulatory clarification, because if the private stock is vested and unrestricted (other than due to lack of liquidity for private company shareholders) then this requirement is met instantly and this requirement of “transferable” deletes the tax deferral opportunity. Employers who are establishing plans to take advantage of this new Section 83(i) deferral should ensure that there are sufficient restrictions on transfer of the stock resulting on exercise.