The adoption of Internal Revenue Code Section 83(i) under recent US tax reform will allow certain private company employees to defer federal income tax on eligible stock options and restricted stock units for up to five years following their respective exercise or settlement. While additional clarification from the Internal Revenue Service is still needed, and there are a number of technical requirements under Section 83(i) that must be satisfied, Section 83(i) could be useful for bridging the gap between when an employee is subject to income tax and when the employee's shares can be liquidated.
The Tax Cuts and Jobs Act of 2017 (PL 115-97) added new Section 83(i) to the US Internal Revenue Code, which allows eligible employees of private companies the opportunity to defer US federal income taxation on eligible stock options and restricted stock units (RSUs) for up to five years following exercise of the stock options or settlement of the RSUs. The deferral treatment applies to a stock option that is exercised and RSUs that are settled after December 31, 2017.
Under current tax law, a nonqualified stock option is generally taxed upon exercise of the stock option and RSUs are generally taxed upon settlement of the RSUs. Stock of a private company cannot be readily sold by employees to cover taxes. Accordingly, Section 83(i) could be useful for bridging the gap between when an employee is subject to income tax and when the employee's shares can be liquidated. However, given the technical requirements of the new rule and some of the clarifications needed from the Internal Revenue Service (IRS), it is unclear how widely Section 83(i) will be used. On the other hand, it appears that companies cannot opt out of Section 83(i), in which case companies will have to determine whether their stock options or RSUs might be granted to enough employees to meet the 80% eligibility test described below, and then ensure that they do not inadvertently fail to comply with the requirements of Section 83(i), which could result in penalties to the company.
What Is the Tax Deferral Period?
Section 83(i) allows certain eligible employees the opportunity to defer federal income taxation attributable to "qualified stock" until the earliest of
five years after an employee's right in the stock is transferable or not subject to a substantial risk of forfeiture (generally, meaning five years after exercise of a stock option (for a vested option) or the settlement date of RSUs);...