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Six Reasons Why Section 83(i) Is a Trap

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January 15, 2019 | Barbara Baksa

Six Reasons Why Section 83(i) Is a Trap

One of the many challenges private companies face when offering stock compensation to their employees is that, whether in the form of stock options or awards, the grants may be subject to tax before the company goes public. Section 83(i), which allows employees to defer taxation of stock options and restricted stock units that meet the requirements to be considered qualified equity grants, was intended to address this challenge. I think it misses the mark in a big way. (If you have no idea what I’m talking about, see my prior blogs on Section 83(i): “Ten Things to Know About Qualified Equity Grants” and “IRS Notice 2018-97 Provides Guidance on Section 83(i).”)

For my last blog entry in my series on Section 83(i), I present six reasons why I think Section 83(i) is a trap for employers.

1. Five Years Isn’t Long Enough. Tom Petty once said that “love is a long, long road” and the same can be said of the path to an IPO. The maximum deferral period under Section 83(i) is five years. For many pre-IPO companies, that just isn’t long enough. As a result, qualified equity grants that are subject to deferral are still likely to be subject to tax before the company’s IPO. All Section 83(i) does is delay the problem; a delayed problem is still a problem.

2. The Horse-Out-of-the-Barn Problem. When private companies grant NQSOs, they generally don’t allow employees to exercise the options unless they’ve made arrangements to pay over the tax withholding due upon exercise. This strategy provides the carrot necessary to ensure that employees reimburse the company for the taxes it has to pay over to the IRS on their behalf. Section 83(i) takes away this carrot. At the end of the five-year period, the company has few, if any, tools at its disposal to encourage the employee to pay over the tax withholding, yet the company is responsible for collecting the withholding and depositing it with the IRS even if it is unable to collect the funds from employees.

3. The Company Could be Left Holding the Bag. The taxable income the employee owes tax on at the end of the five-year period is equal to the spread that existed at the time of the event that triggered the deferral, even if the stock has declined in value. If the stock has declined in value, many employees would likely choose to walk away from the stock rather than pay the taxes that are due, leaving the company holding the bag.

4. Good Luck Finding Everyone. It’s likely that some employees who make deferral elections will terminate during that five-year period. This could make them difficult to find when it’s time to collect their tax payment.

5. Escrow Arrangements Solve the IRS’s Problem But Not the Company’s. In Notice 2018-97, the IRS addresses numbers 2, 3, and 4 above by requiring the company to hold the shares in escrow until the end of the deferral period and prohibiting the company from releasing the shares from escrow until the taxes have been paid.  This ensures that the company can hold back a portion of the shares and apply the value of those shares to the tax payment if the company is unable to collect the tax withholding from the employees. This would be a great solution for a cash-rich public company.  But for cash-poor private companies, it’s likely not a solution at all.

6. Do You Want That Super-Sized? To further exacerbate the problem, at the end of the deferral period, federal income tax has to be withheld at the maximum individual tax rate.

To issue qualified equity grants, a company has to grant the same type of equity award (either options or RSUs) with the same terms to at least 80% of its employees in the same calendar year. Thus, 80% or more of the company’s employees will hold options or awards that were granted in the same year and that vest in the same year. Which means many employees are likely to file their deferral elections in the same year and will eventually be subject to tax in the same year. This could easily put a strain on a private company’s cash reserves. In a worst-case scenario, it might force a company to seek additional financing.

- Barbara

P.S.—I'm super stoked that this blog entry gave me an excuse to post a cat pic. Get it? Section 83(i) is a trap and the cat is about to trap the mouse. 

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