Tax Deferral on Stock Compensation for Employees of Private Companies

Since 2017, Congress, followed by the IRS in 2018, is making it easier for employees of closely held corporations to share in the value of their employer’s stock. If you are an employee of a private company, you are likely granted option plans or restricted stock units (“RSUs”), but are burdened with paying income tax on the value of the stock when it is received. Stock in closely held corporations often cannot be easily monetized to provide for tax payments. In option plans, this cash requirement is exacerbated by the need to pay an exercise price to acquire the stock.

To help this situation, IRC Section 83(i) provides a tax deferral which expands your ability to own stock in your employer. The tax deferral lasts until the earliest of five dates:

  • The stock is transferable
  • You are not able to take advantage of the deferral by reason of a promotion or stock ownership
  • The stock first becomes readily tradable on an established securities market
  • You revoke the election to defer taxes on this compensation; or
  • Five years after the stock is not subject to a risk of forfeiture

You are eligible to take advantage of this as long as you are not, with respect to the corporation:

  • A 1% owner at any time during the current or preceding 10 years
  • CEO or CFO during the current year or any prior year or anyone related to them
  • One of the four highest compensated officers for any of the preceding 10 years

The employer must not have had any of its (or a predecessor’s) stock readily tradable on an established securities market in any preceding year, and have a written plan under which at least 80% of all employees (excluding those not eligible to take advantage of this and certain part-time and foreign employees) are offered options or RSUs with the same rights and privileges during the year. The number of shares offered can be based on an individual’s performance, as long as 80% of employees have a right to more than a de minimis number of shares. In addition, the employer must provide employees notice of the right to make the deferral election, and remind employees that the taxable amount recognized at the end of the deferral period is the value of the stock when no longer subject to a substantial risk of forfeiture, even if the value of the stock has declined during the deferral period.

Employees who want to take advantage of this tax deferral opportunity need to elect to do so no later than 30 days after the stock they receive is no longer subject to a substantial risk of forfeiture by sending an election statement to the IRS. In addition, the employee must agree that all stock on which an election to defer the payment of taxes has been made will be deposited in an escrow account, permitting the employer to use the stock to fund income tax withholding amounts when due. The income tax withholding required, 37% of the value of the stock when no longer subject to a substantial risk of forfeiture, is due at the end of the deferral period. Social Security and Medicare taxes cannot be deferred under the election and are due when taxes would otherwise be due, when the stock is no longer subject to a substantial risk of forfeiture.

Many employers expressed concern that they may be subject to the statute, including the notice requirements, and requested that the IRS provide a mechanism to avoid the application of this section for an otherwise eligible employer. The IRS provided that an employer can decline to establish an escrow arrangement as required by IRS Notice 2018-97, thereby preventing employees from making the election and eliminating the employer notice requirement. In addition, the terms of the stock option or RSU can provide that no election under IRC Section 83(i) will be available to employees for this equity compensation.

The statute is specifically designed to benefit start-up companies whose employees want to share in the growth of corporate equity but may not have available cash for tax payments. The tax deferral opportunity is not available to certain officers, shareholders and highly compensated employees, and requires that at least 80% of all other employees be granted options or RSUs during the current year. However, many employers will find the cash flow benefits and opportunities to incentivize employees useful.

If you have questions or concerns about stock compensations or IRC Section 83(i), contact Deb Walker or your Cherry Bekaert professional. Our dedicated team of tax experts can explain the details of specific to your situation and help you determine which actions are best.