On December 7, the IRS issued Notice 2018-97, to provide much-needed guidance on qualified equity grants under Section 83(i). In this blog entry, I highlight the key areas of guidance covered in the notice.
To refresh your memory, new Section 83(i) allows employees of private companies to defer income recognition for up to five years for stock options and RSUs that meet specified requirements. Still don’t have any idea what I’m talking about? See my prior blog entry “Ten Things to Know About Qualified Equity Grants.”
Notice 2018-97 provides guidance on the following key areas.
Section 83(i)(2)(C)(i)(II) specifically states that for options and RSUs to qualify for deferral elections, the granting corporation must have “a written plan under which, in such calendar year, not less than 80 percent of all employees who provide services to such corporation in the United States (or any possession of the United States) are granted stock options, or are granted restricted stock units…” [emphasis added].
Despite this language, there has been some confusion as to whether 80% of the company’s employees have to be issued grants in the calendar year that the Section 83(i) grants are issued or whether it is sufficient for 80% of the employees to hold outstanding grants, some of which may have been granted in prior years.
Notice 2018-97 clarifies that in the calendar year that Section 83(i) qualified options or RSUs are granted, the company must grant the same type of vehicle to at least 80% of its employees.
Notice 2018-97 clarifies that deferral elections under Section 83(i) have no effect on taxation of options and awards for FICA and FUTA purposes. The notice also clarifies that income taxes must be withheld at the maximum individual tax rate in effect at the close of the deferral period. The language in the legislation seems clear on these points as well, but I guess some people had hoped for a different outcome.
Where employees have made deferral elections under Section 83(i), companies are obligated to withhold federal income tax at the close of the deferral period. Moreover, the taxable income attributable to the grant is based on the spread that existed when the event triggering the election occurred, even if the stock has since declined in value.
This withholding requirement presents some obvious challenges for companies. Most notably, if the stock has declined in value, employees may be disinclined to pay tax on the higher value. This could make it difficult for companies to fulfill their withholding obligations.
To address this, Notice 2018-97 requires companies to establish an escrow arrangement for all options and RSUs that are to be treated as qualified equity grants under Section 83(i). Any stock subject to a deferral election under Section 83(i) must be deposited into the escrow account until the end of the deferral period. If employees fail to pay over the withholding taxes, the company can withhold shares to cover the tax payment.
I haven’t encountered any companies that want to issue Section 83(i) grants; most private companies I’ve spoken with are primarily concerned with whether they will be forced to comply with the notice requirements and allow employees to make deferral elections if their options and RSUs unintentionally meet the requirements of Section 83(i).
Notice 2018-97 is good news in this regard. First, even where private companies grant broadly (not at all uncommon for private companies) most don’t issue grants to 80% or more of their employees annually. Employees receive grants upon hire and then maybe every few years, as their prior grants near their full vesting date. Thus, many private companies don’t currently fulfill the 80% requirement.
Where companies find that they unintentionally comply with all of the requirements under Section 83(i), they can easily disqualify their options and RSUs simply by failing to set up the required escrow arrangements.
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