The Internal Revenue Service issued Notice 2018-97 on December 7, providing initial guidance for the new Section 83(i) of the Internal Revenue Code (Section 83(i)) enacted by the Tax Cuts and Jobs Act. The notice principally addressed guidance on the 80 percent requirement under the act, a new mandatory withholding tax mechanism and an opt-out opportunity for employers.
Section 83(i) allows certain “qualified employees” of “eligible corporations” an opportunity to elect to defer federal income taxes from the exercise of stock options and/or settlement of restricted stock units (RSUs) for up to five years. By making a Section 83(i) election within 30 days of the exercise of the option or the settlement of the RSU, employees defer federal income taxes with respect to the stock received upon exercise or settlement (deferral stock) until the earliest of the following dates when:
Each date above is referred to as a “payment date.”
Under the Tax Cuts and Jobs Act, a “qualified employee” is any employee of an “eligible corporation” who: (1) is not an “excluded employee” and (2) agrees to certain requirements that ensure that proper withholding of federal income taxes will be met in connection with a Section 83(i) election.
An “excluded employee” is anyone who:
An “eligible corporation” is a private company that has a written equity incentive plan, under which at least 80 percent of all employees who provide services in the U.S. are granted stock options or RSUs in a calendar year, with the same equal rights and privileges.
The notice clarifies that the determination of whether an employer satisfies the 80 percent requirement must be made on a calendar-year basis, without regard to awards granted in prior calendar years. An employer must consider all the employees employed at any time during the calendar year (disregarding part-time employees and excluded employees) and determine whether at least 80 percent of those employees received options or RSUs. The tests for options and RSUs are separate, meaning 80 percent must have received options, or 80 percent must have received RSUs. The test is not whether 80 percent received either options or RSUs.
The notice provides guidance and clarification on the requirements with respect to withholding federal income taxes relating to deferral stock received in connection with a Section 83(i) election:
In an effort to solve the withholding requirements, the IRS is mandating that an employee making a Section 83(i) election agree in the election form that all deferral stock will be held in an escrow arrangement until the employer recovers from the employee the income tax withholding obligation. At any time between the payment date and March 31 of the calendar year following the payment date, the employer may retain a number of shares with a fair market value (FMV) equal to the income tax withholding obligation that has not been recovered from the employee by other means. For this purpose, the FMV is determined using the regulations of Section 409A, as of the date the shares of deferral stock are retained by the employer. This is different than the FMV of the deferral stock used to calculate the amount of income, which is as of the date of the exercise of the option or the settlement of the RSU.
After the income tax withholding obligation has been met, any shares of deferral stock remaining must be delivered by the employer to the employee as soon as reasonably practicable. If the employee does not agree to deposit the deferral stock into the escrow established by the employer, the employee will not meet the requirements of a “qualified employee” and may not make a Section 83(i) election.
Companies that are concerned about the administrative complexities involved with Section 83(i) can now “opt-out.” If the employer does not establish an escrow arrangement, it can preclude its employees from making a Section 83(i) election, even if the employer would otherwise qualify as an “eligible corporation.” An employer may inform its employees that the stock is not eligible for a Section 83(i) election, as a result of not having an escrow arrangement.
We encourage you to reach out to any lawyer in the employee benefits group at Fenwick & West regarding Section 83(i).