Qualified employees at private companies who are granted non-qualified stock options (NSOs) or restricted stock units (RSUs) and who later receive stock upon exercise of the option or upon settlement of the RSU may elect to defer the recognition of income for federal income tax purposes for up to 5 years if certain requirements are met. This is the new IRS Section 83(i) election to defer income tax on stock grants. These rules apply to stock attributable to options exercised, or RSUs settled, after December 31, 2017.
By combining an 83(i) election and an ESO advance of the taxes you need up front, you are essentially getting the float on a loan for 5 years until you actually forward the money to the IRS. Moreover, you are avoiding the risk of the stock’s value collapsing or not yet being public but still having to pay the IRS at the end of 5 years.
How can an employee exercise an NSO and defer the recognition of income for federal income tax purposes for up to 5 years without being subject to immediate withholding?
The 83(i) election is made in a manner similar to that for an 83(b) election. The election must be made no later than 30 days after the options are exercised and no longer subject to vesting. The employee must file the 83(i) election form with the Internal Revenue Service by certified mail and provide the employer with a copy of the 83(i) election form. (83iForm) An 83(i) election cannot be made if an 83(b) election was made.
Can ISO exercises benefit from any kind of 5-year AMT deferral under this provision?
No, the 83(i) election is not applicable to ISOs. If an 83(i) election is made for an option exercise, then that option will not be considered an ISO and will not receive ISO tax treatment.
Will I benefit from the lower Long Term Capital Gains Tax rate?
Both NSOs and RSUs are still subject to tax at the ordinary income tax rates based on their Fair Market Value at the point they become shares of stock. However, any additional gain in value above the FMV is eligible for the lower long term capital gains tax rate if the shares are held for at least one year before they are sold. An 83(i) election makes this benefit less burdensome by deferring taxes for 5 years, but be aware that tax based on the FMV will still be due in 5 years regardless of whether your final sale price is higher or lower than the FMV.
Can existing stock option plans benefit from the 83(i) election?
An existing plan under which, in the calendar year, not less than 80 percent of all employees who provide services to the corporation in the United States (or any U.S. possession) are granted stock options, or RSUs, with the same rights and privileges to receive qualified stock, can benefit from the new 83(i) election.In general, the determination of rights and privileges with respect to stock is determined in a manner similar to the employee stock purchase plan rules. The requirement that 80 percent of all applicable employees be granted stock options or RSUs with the same rights and privileges cannot be satisfied in a tax year by granting a combination of stock options and RSUs, and instead all such employees must either be granted stock options or be granted restricted stock units for that year.
What does the company need to do in order to in order to comply with the new rules?
Notice Requirement. Employers are required to provide notice to their employees that they are eligible for the 83(i) election at the time (or a reasonable period before) the employee’s right to the qualified stock is substantially vested (and income attributable to the stock would first be includible absent an 83(i) election). Noncompliance can result in a fine of $100 for each failure, not to exceed $50,000.
Reporting Requirement. For each employee, employers must report in Form W-2, box 12, code GG the amount included in income in the calendar year from qualified equity grants under IRC Section 83(i), and in code HH the total amount of income deferred under IRC Section 83(i) determined as of the close of the calendar year. Then the employer must provide to the electing employee a written statement showing (1) the amount includible in gross income for the tax year when a statutory inclusion event occurs, and (2) the aggregate income amount that is being deferred under an 83i election, as of the close of the calendar year.
Deferred Employer’s Deduction. If an employee makes an 83(i) election, the employer’s deduction is deferred until the employer’s tax year in which or with which ends the tax year of the employee for which the amount is included in the employee’s income.
Withholding Requirement. The employer must withhold federal income tax at 37% in the tax year that the amount deferred is included in the employee’s income.
What if an exit occurs before the end of the 5 year deferral period or if the real exit is for a valuation lower than the valuation at the time of the 83i election?
If an employee makes the election, the amount of income required to be included at the end of the deferral period, or when a statutory inclusion event occurs, such as the transfer or sale of the stock, will be based on the value of the stock at the time the employee’s right to the stock first becomes substantially vested, notwithstanding that the stock’s value may have declined during the deferral period (and even if the stock’s value has declined below the employee’s tax liability with respect to such stock).
Will my state of residence also defer the recognition of income?
States may, but are not required to, conform to federal tax laws. For example, California does not generally conform to the federal income tax law, while New York generally conforms to most federal income tax provisions. As a result, California and New York may adopt different rules regarding the recognition of income upon making the new 83i election. Please consult with a Certified Public Accountant (CPA) in your state of residence, if you have not already done so, to determine the state income tax treatment of the option exercise and 83i election.
Where can I find an 83(i) election form?
ESO cannot guarantee the validity of the sample 83iForm against the ever-changing tax code. As such, it is your responsibility to contact a tax professional.
For more information on how the ESO Fund can help you with taxes on your NSO exercise, please contact us. (email@example.com)