22 Feb Good News for Startup Employees: The Tax Code has a New Deferral Election for Stock Options and RSUs
To understand the benefits of the new deferral election for stock options and Restricted Stock Units (“RSUs”) under section 83(i) of the Internal Revenue Code (the “Code”), it is important to first understand how options granted in exchange for the performance of services are taxed under the traditional approach pursuant to Code section 83:
1. Traditional treatment of stock options and RSUs under Code section 83
A. Stock Subject to Vesting (Restricted Stock)
Section 83(e)(3) provides that an untraded option is not taxed at grant, but rather taxed on the date of exercise of the option. However, if the stock received upon exercise is restricted (i.e., subject to a substantial risk of forfeiture and transferability restrictions), then the taxable event is delayed until those restrictions lapse (because the employee does not own the stock yet), unless the employee made an 83(b) election.
B. 83(b) Election
If the stock acquired at exercise is restricted stock, then the employee can make an 83(b) election. Once the employee has made an 83(b) election, any spread at exercise is ordinary income to the employee, while the stock’s appreciation in value is converted into potential capital gain income, which would be recognized when the employee sells the stock. An employee can make an 83(b) election even though no spread exists on the date of exercise. The 83(b) election must be made within 30 days after the transfer of the property.
C. Ordinary Income and Capital Gain Tax Rates
Under the traditional treatment of options and RSUs, an employee will not be treated as the owner of the employer’s stock until it vests. Thus, any stock appreciation between the date of an equity grant and the date of vesting will be taxed as ordinary income to the employee at a higher tax rate (e.g., the new top federal income tax rate is 37%) compared to the long-term capital gain rate (e.g., the top federal rate is 20%). Therefore, employees who receive stock subject to a substantial risk of forfeiture and transferability restrictions upon exercise have the economic incentive to make an 83(b) election to convert all future appreciation of the stock into potential capital gain income. However, such a tax benefit comes with a price, namely, the employee must pay ordinary income tax on the spread (i.e., the FMV of the stock less the aggregate exercise price) at a time when the vested stock may not even be tradable on an established securities market (which is another common case for startups). As a result, such an immediate tax may be harsh for some option holders.
To address this problem, Congress added a new deferral election under section 83(i) of the Code for options and RSUs:
2. New deferral election for stock options and RSUs under Code section 83(i)
A. Qualified Employee
A qualified employee is defined in the Code as not being an “excluded employee.” An excluded employee includes the (1) CEO or CFO, or an individual acting in either capacity (and related individuals); (2) any 1% owner during the calendar year or during the 10 preceding calendar years (and related individuals); and (3) the top 4 highest paid officers during the calendar year or during the 10 preceding calendar years (based on SEC disclosure rules if they had applied).
B. Qualified Stock
Qualified stock is defined in the Code as the following:
(1) stock of an eligible corporation that is granted in connection with the exercise of an option, or in settlement of a restricted stock unit;
(3) shall not include any stock if the employee may sell such stock to, or otherwise receive cash in lieu of stock from, the corporation at the time that the rights of the employee in such stock first become transferable or not subject to a substantial risk of forfeiture.
C. Qualified Corporation
A qualified corporation is defined in the Code as a corporation in which:
(1) stock not readily tradeable; and
(2) such corporation has a written plan under which, in such calendar year, not less than 80 percent of all employees who provide services to such corporation in the United States (or any possession of the United States) are granted stock options, or are granted restricted stock units, with the same rights and privileges to receive qualified stock.
The new deferral election allows employees to defer for up to five years the income taxes that would be due on the date the stock vests under the traditional approach, while still allowing the long-term capital gain holding period to run concurrently with the deferral period. However, there are some downside issues to consider when making such an election:
- Although the income tax due on the stock is deferred, the tax is also fixed according to the FMV of the stock when the 83(i) election is made. Thus, the employee may suffer a loss if the startup fails or its stock goes down in value.
- Such an election may not be that attractive to unsophisticated employees who is unfamiliar with equity and far removed from a potential liquidity event of the company.
- The 83(i) election only defers income taxes; it does not defer employment taxes. Thus, an employee may still encounter a cash short situation.
 Treas. Reg. § 1.83-2(a).
 I.R.C. § 83(b)(2).
 I.R.C. § 83(i)(3).
 I.R.C. § 83(i)(2).
 I.R.C. § 83(i)(2)(C).
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