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Private-Company-Equity-Grants-New-Tax-Deferral-Opportunity-for-Employees

Private Company Equity Grantsโ€”New Tax Deferral Opportunity for Employees

by Joe Steffan, CPA, MBT

Generally, an employee receiving employer equity grants, such as restricted stock units (RSUs) or shares of their employerโ€™s stock from exercising employer stock options,  must include in taxable income the value of the shares of stock received (less amounts paid) once the rights in that stock are transferable or not subject to a substantial risk of forfeiture. For privately held companies, this means their employees receiving equity grants end up paying income tax on shares of stock that do not have a readily available market in which to sell the shares.

There is now an opportunity under Section 83(i) for these employees to defer for up to five years the income taxes on the equity grants by making an election with the IRS. However, there are limitations on the types of equity grant plans eligible to be included in this election.

The Section 83(i) election is limited to employees of privately held corporations with a written plan granting stock options or RSUs to at least 80% of โ€œqualifiedโ€ employees as compensation for services. โ€œQualifiedโ€ employees cannot include:

  • The corporationโ€™s CEO or CFO;
  • Individuals who have owned more than 1% of the corporation in any of the past 10 years, including the current year;
  • A family member of an individual described above; or
  • Individuals who have been one of the four highest-paid members of the organization in any of the past 10 years, including the present year.

The employee who chooses to make a Section 83(i) election must file within 30 days after the first date the employeeโ€™s right to the shares of stock is substantially vested or is transferableโ€”whichever is earlier.

After the Section 83(i) election is filed, the employee will be subject to income tax at the earlier of the following dates:

  • The date the qualified stock is transferrable;
  • The date the employee is no longer a โ€œqualifiedโ€ employee (e.g. becomes a 1% owner of the corporation);
  • The date on which any stock of the employer becomes publicly traded;
  • Five years after the employeeโ€™s right to the stock is substantially vested; or
  • The date on which the employee revokes the Section 83(i) election.

The Section 83(i) election to defer income tax does not defer the timing of FICA tax. The exercise of employer stock options or settlement of RSUs will remain taxable for FICA purposes in the year the stock is transferable or not subject to a substantial risk of forfeiture. Also, the employerโ€™s deduction will be deferred until the year the exercise of employer stock options or settlement of RSUs is included in the employeeโ€™s taxable income.

Due to the complex rules and the requirement to include at least 80% of employees in a plan that does not benefit the corporationโ€™s senior executives, it does not seem likely that many privately held corporations would choose to implement an equity grant plan that qualifies for a Section 83(i) election. 

However, a corporation planning an IPO or the sale of the corporation within five years from when the equity grants would be taxable to its employees, and that wants to share some of the proceeds with substantially all of its employees should consider setting up a qualifying equity grant plan. By setting up an equity grant plan that would be eligible for the Section 83(i) election the corporationโ€™s employees would be able to defer the payment of income taxes until the year of the IPO or the sale of the corporation.

Hopefully, affected employees will now be able to enjoy the intended benefit of their employer equity grants with this modificationโ€”after all, it was never intended to introduce a new concern.

Joe Steffan, CPA, MBT

Joe Steffan, CPA, MBT

Joe Steffan, CPA, MBT's experiences include working with clients in a variety of industries, including technology, retail, and service. This background has allowed him to specialize in tax compliance and consulting services for closely-held businesses and their owners.