IRS provides initial guidance on qualified equity grants

Tax Hot Topics newsletterThe IRS provided initial guidance in Notice 2018-97 on the application of Section 83(i) regarding qualified equity grants. The Tax Cuts and Jobs Act (TCJA) amended Section 83 by adding new Section 83(i) to allow certain employees of a private company that grants stock options or RSUs to at least 80% of full-time employees (taking into account all employees in a controlled group) to defer recognition of income beyond the time when income is recognized under current law.

Generally, current law provides that employees who hold nonstatutory stock options or RSUs will recognize compensation income when the underlying stock is transferred to them and is vested. Full-time employees are employees who work an average of 30 or more hours per week. For purposes of the 80% requirement, employees can receive varying amounts of options or RSUs, but all of them must receive the same type of award (either options or RSUs) and must receive more than a de minimis amount.

The election to defer income recognition must be made within 30 days of vesting. However, this special tax treatment is not available if the employee has the right immediately upon vesting to either sell the stock to the employer or settle the award in cash. If the election is made, income recognition is deferred until the earliest of the following dates:

  • Five years from the date the right in the stock becomes vested
  • The stock becomes transferrable, including to the employer
  • The stock becomes publicly traded
  • The employee becomes an excluded employee
  • The employee revokes the Section 83(i) election

Upon the occurrence of one of the five above events, the employee recognizes compensation income equal to the stock value at the time the stock is transferred and is vested, less any amount paid for the stock by the employee. Any further increase in value is capital gain. The employer receives a deduction at the same time the employee recognizes income, and the deduction amount equals the employee’s income.

Excluded employees include the following individuals:

  • Any individuals who have ever been the CEO or CFO (including their family members)
  • Any individuals who have owned more than 1% of stock in their employer in the current year or any of the previous 10 calendar years
  • Any individuals who have been among the four highest-paid employees in the current year or any of the previous 10 calendar years.

Notice 2018-97 details some important distinctions regarding the above rules for qualified equity grants. First, the IRS emphasized that the 80% requirement for granting employees stock options or RSUs is determined on a calendar year basis. The requirement cannot be applied on a cumulative basis by taking into account stock options or RSUs granted in prior calendar years. Therefore, corporations must meet it for each calendar year that a Section 83(i) election is to be made by their employees.

The addition of qualified equity grants to Section 83 also changed the income tax withholding for stock received pursuant to a Section 83(i) election. However, the TCJA made no changes for FICA tax withholding for Section 83(i) purposes. Newly-enacted Section 3401(i) provides that qualified stock (as defined under Section 83(i)) with respect to which an election is made under Section 83(i) is treated as wages received on the earliest of the above five dates and in an amount equal to the amount included in income for the taxable year. The income tax withholding rate must be the maximum rate in effect (37% for 2018) and such stock received by the employee is treated as a noncash fringe benefit. Until further guidance is issued, the notice provides that the stock received pursuant to a Section 83(i) election is generally subject to the guidelines for withholding, paying, and reporting employment tax on taxable noncash fringe benefits pursuant to Announcement 85-113.

Furthermore, in order for the Section 83(i) election to apply, stock options and RSUs deferred by a Section 83(i) election must be held in an escrow arrangement and cannot be removed until income tax is withheld, along with certain other requirements. However, some companies that have otherwise satisfied all the requirements for the Section 83(i) election have expressed interest in electing out of Section 83(i). Although there is no formal method for electing out of Section 83(i), the IRS clarified in the notice that a corporation can preclude its employees from making a Section 83(i) election by declining to establish an escrow arrangement pursuant to the requirements in the notice. This effectively is a way for corporations to avoid the application of Section 83(i).

Overall, Section 83(i) applies to stock attributable to stock options exercised, or RSUs settled, after Dec. 31, 2017. Guidance in Notice 2018-97 will be incorporated into future regulations (with respect to issues addressed in the notice) that will apply to any taxable year ending on or after Dec. 7, 2018. Any future guidance, including regulations, addressing issues covered in the notice will be applied on a prospective basis only. Comments may be submitted through Feb. 5, 2019.

Jeff Martin
Washington National Tax Office
T +1 202 521 1526

Keith Mong
Managing Director
Washington National Tax Office
T +1 202 521 1554

James Sanchez
Senior Associate
Washington National Tax Office
T +1 202 861 4107

Tax professional standards statement
This content supports Grant Thornton LLP’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this content is not intended by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

The information contained herein is general in nature and is based on authorities that are subject to change. It is not, and should not be construed as, accounting, legal or tax advice provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs and may require consideration of tax and nontax factors not described herein. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Grant Thornton LLP assumes no obligation to inform the reader of any such changes. All references to “Section,” “Sec.,” or “§” refer to the Internal Revenue Code of 1986, as amended.