The U.S. tax reform law took effect on February 1, 2018. It, includes, among other tax incentives, a beneficial election regarding taxation of non-qualified stock options (NQSOs) and restricted stock units (RSUs). This circular summarizes the main changes to treatment of such equity grants as provided by section 83(i).
Taxation of NQSO and RSU – General
Under existing law, the grant of an NQSO or RSU is not a taxable event.
Section 83(b) election is not available for a NQSO grant. Rather, the election is available at the time of exercise if the option is exercisable for unvested stock. NQSOs are also not taxed at vesting. NQSOs are taxed at an ordinary income tax rate, upon exercise, on the income that is the difference between the fair market value of the stock issued upon exercise and the exercise price paid by the option holder. The capital gain holding period starts as of the exercise.
Section 83(b) election is available for RSUs. The RSU holder is entitled to make an 83(b) election (within 30 days from the date of grant) and pay ordinary income tax rate on the fair market value of the restricted stock reduced by any amount of exercise price (which is normally zero for RSUs). If no 83(b) election has been made, RSUs are taxed at vesting at an ordinary income tax rate. The capital gain holding period starts as of vesting.
New Section 83(i) Election
In addition to the existing tax rules described above, a qualified employee may elect to defer, for up to five years, the income recognition event associated with stock options or RSUs received in connection with the performance of services. The deferral is available only to qualified employees and only if the issuing company is an eligible corporation. The 83(i) election provides that instead of including income at exercise of a stock option (assuming fully vested stock is received) or at delivery of fully-vested stock, then the employee will be subject to income tax at the earlier of the following to occur:
- The date the stock has ceased to be subject to restrictions on transferability;
- The date the employee becomes an excluded employee;
- The date on which any stock of the issuer becomes publicly traded;
- The date that is five years after the employee’s right to the stock is vested; or
- The date the employee revokes the election.
A corporation is an eligible corporation with respect to a calendar year if the following conditions are met:
- no stock of the corporation is tradable in a securities market; and
- the corporation has a written plan pursuant to which not less than 80% of all employees who provide services to the corporation in the United States are granted stock options or RSUs with the same rights and privileges to receive qualified stock (the “80-percent requirement”).
The employee must take an 83(i) election no later than 30 days after the first date the employee’s right to the stock is vested or is transferable, whichever is earlier. The employee makes an 83(i) election in the same manner as an 83(b) election. An election may be made on ISOs or options granted under an employee stock purchase plan, but if the 83(i) election is made with respect to an ISO, then the option is not subject to the standard ISO rules.
If an employee makes an 83(i) election, the employer’s deduction is deferred until the employer’s taxable year in which or with which the amount is included in the employee’s income. The Internal Revenue Code includes certain employee notice requirements. Specifically, a corporation that transfers qualified stock to a qualified employee must provide notice to the employee at, or a reasonable period of time prior to, the date the qualified stock becomes substantially vested. It is the responsibility of the employer to notify the employee with respect to the following:
- That the employee may (if eligible) elect to defer income inclusion with respect to the stock;
- If the employee makes an 83(i) election, the income inclusion amount at the end of the deferral period will be based on the value of the stock at the time the employee’s right to the stock first becomes vested, notwithstanding whether the value of the stock has declined during the deferral period; and
- That the amount of income to be included at the end of the deferral period will be subject to withholding.
Failure to provide the notice to the employee, may result in the imposition of a penalty of $100 for each failure, subject to a maximum penalty of $50,000 for all failures during any calendar year. The provision is generally applicable to options exercised, or restricted stock units granted, in 2018 and later taxable years.