United States: Enough To Get Exercised About?

Tax Reform Offers Limited Deferral on Certain Private Company Equity Compensation

On December 22, 2017, the President signed into law the tax reform bill (the "Act"), informally referred to as the Tax Cuts and Jobs Act. The Act contains a new provision, Section 83(i) of the Internal Revenue Code of 1986, as amended (the "Code"),1 that would allow eligible employees of certain private companies to elect to defer U.S. Federal income tax with respect to "qualified equity grants" for up to five years. The change to the potential tax treatment of stock transferred upon exercise of a stock option or settlement of a restricted stock unit ("RSU") applies to stock options exercised, or RSUs settled, after December 31, 2017.

The provision is ostensibly targeted to start-up and other venture stage companies, and designed to promote broad-based employee ownership and "upside" in such new companies. Notably, the provision is clear that the election (or ability to elect) to defer under Section 83(i) does not result in the arrangement becoming nonqualified deferred compensation under Section 409A of the Code. To qualify for the deferral opportunity under Section 83(i), several limitations and requirements must be met. Put simply, the deferral opportunity is limited to "qualified stock" transferred to "qualified employees" of "eligible corporations."

First, to be a "qualified employee" the employee needs to be employed by a private company, and cannot be (i) the chief executive officer or chief financial officer of the company (either at the time of the election or at any time prior); (ii) one of the four highest compensated officers for the taxable year (or any of the prior ten years); or (iii) a one percent owner of the company in the calendar year (or any of the prior ten years).

Second, to meet the requirements of "qualified stock" the stock must be received upon exercise of a stock option or settlement of a RSU and the stock option or RSU must have been granted in connection with the performance of services by an eligible corporation. In addition, if the employee can sell the stock to (or otherwise receive cash in lieu of stock from) the employer at the time the stock first becomes transferable or is not subject to a substantial risk of forfeiture, the stock will not constitute qualified stock.

Third, the election is not available if the company has repurchased its stock in the preceding year unless at least 25 percent of the dollar amount of such repurchased stock had previously been deferred by employees pursuant to the provision.

Fourth, the election can only be made if the company's stock is not readily tradeable on an established securities market — either at the time of the election or at any time prior to such election — and the company has a written plan under which, in the applicable year, not less than 80 percent of its full time employees in the United States (or a possession of the United States) are granted stock options or RSUs (with the same rights and privileges – and, it seems, either RSUs or options, but not both). The "same rights and privileges" requirement is tested in accordance with the rules for employee stock purchase plans under Section 423(b)(5) of the Code. Although Section 83(i) allows grants of different amounts to different qualified employees, each employee that is intended to count for the 80 percent test must receive more than a "de minimis" amount. Further, these requirements are applied on a controlled group basis (as determined under Section 414(b) of the Code).

A qualified employee who receives an award of stock options or RSUs that is eligible under Section 83(i), can elect within 30 days of exercise or settlement, as applicable, to defer U.S. Federal income tax that would otherwise have been due upon exercise or settlement. The deferral is generally for five years, or, if earlier, the date the underlying stock is (or becomes) readily tradeable on an established securities market, the stock becomes transferrable (including to the company), the employee is no longer eligible for the deferral or the employee revokes the election. Note that the provision calls merely for a deferral of U.S. Federal income tax that would have been recognized at the time of exercise of the option or delivery of the RSU: the value of the amount to be recognized does not "float" with the value of the shares underlying such awards during the deferral period. The employer's deduction follows the employee's inclusion, so that the employee's revocation of the deferral will then trigger the deduction from the employer.

Employers are required to provide notice to qualified employees who receive such qualified stock of their ability to elect to defer income under Section 83(i). Failure to provide such notice, unless due to reasonable cause, will subject companies to a fine of $100 per failure (not to exceed $50,000 in a calendar year).

With all of the limitations and restrictions contained in the provision, it remains to be seen how many employees will be able to take advantage of this new deferral feature. In addition to the tax related issues, companies will also need to consider any U.S. Federal (and State) securities requirements and applicable exemptions. Depending on the size of the employee base and the amounts at stake in respect of stock option and RSUs, some companies may have additional challenges in complying with these conditions, particularly if the employees are not "accredited investors," the company has limited assets, and/or a substantial portion of the shares underlying such awards are in fact granted to employees.


1 Curiously, the Conference Report notes that "[t]he provision clarifies that Section 83 (other than the provision), including subsection (b), shall not apply to RSUs. Therefore, RSUs are not eligible for a section 83(b) election. This is because, absent this provision, RSUs are nonqualified deferred compensation and therefore subject to the rules that apply to nonqualified deferred compensation."

Most (if not all) practitioners have traditionally regarded RSUs as unfunded, unsecured promises to deliver shares (or their equivalent) on a date specified in the underlying governing documents of the award. Because traditional tax principles under Section 83 have indicated that neither cash nor the mere promise to pay at a point in the future are considered "property" within the meaning of Section 83, it is uncertain what this language was intended to add.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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