IRS clarifies new qualified equity grants

Income recognition from exercise or settlement of employer stock options and RSUs may be deferred for up to five years.
By Sally P. Schreiber, J.D.

In response to requests from taxpayers and employers, the IRS issued Notice 2018-97 to provide initial guidance on new Sec. 83(i), which was added to the Code by the law known as the Tax Cuts and Jobs Act, P.L. 115-97. Sec. 83(i) permits eligible private company employees to elect to defer for up to five years the recognition of income from private company stock acquired by exercising a stock option or settling a restricted stock unit (RSU) that was granted for performing services during a calendar year in which the employer corporation was an eligible corporation. The income-deferral election applies to stock received due to options exercised or RSUs settled after Dec. 31, 2017.

THE 80% COVERAGE REQUIREMENT

The IRS stated it received questions about a requirement that a qualified equity grant must be issued by the employer according to a written plan under which, in that calendar year, not less than 80% of all U.S.-based employees who provide services to that corporation receive grants of stock options or RSUs with the same rights and privileges to receive qualified stock.

One such question was whether the 80% requirement applies on a cumulative basis so that employers can take into account stock options issued in previous years. The IRS said it believes that the statutory language requires employers to meet the 80% requirement in the calendar year in which the stock options or RSUs are issued. Counting options issued in previous years cumulatively with options granted in the current calendar year is contrary to the statutory language and not a reasonable, good-faith interpretation of the 80% requirement, the notice stated.

EMPLOYEE NOTICE REQUIREMENTS

Sec. 83(i)(6) also requires corporations to notify employees when qualified stock would be first includible in their gross income and of their eligibility to make a Sec. 83(i) election to defer the income, along with certain specified consequences of making the election. Failures to provide such notifications are penalized at $100 per failure, up to $50,000 per year. The statute provides transition relief with respect to the notice requirements, which the IRS reiterated in the notice.

WITHHOLDING REQUIREMENTS

The IRS said it also received questions on the federal income tax withholding requirements for the deferred income related to the qualified stock in the year a qualified stock option or RSU is includible in the employee's income.

The notice provides that the employer should withhold at the maximum rate of tax in effect under Sec. 1. By Jan. 31 of the year following exercise or settlement, the employer must determine the actual value of the deferral stock on the date it is includible in the employee's income and report that amount and the withholding on Form W-2Wage and Tax Statement, and Form 941, Employer's Quarterly Federal Tax Return. If the employer pays the income tax withholding for the deferral stock from its own funds, it may recover that withholding from the employee until April 1 of the year following the calendar year in which the wages were paid.

A qualified employee making a Sec. 83(i) election with respect to qualified stock must agree in the election that all deferral stock will be held in an escrow arrangement, the terms of which must meet certain requirements specified in the notice that are intended to ensure the employer corporation meets its income tax withholding requirements.

OPTING OUT

Finally, the IRS provided that employers may opt out of permitting employees to elect deferred tax treatment by either declining to provide an escrow arrangement for deferral stock or otherwise creating conditions that will not allow an employee to make the Sec. 83(i) election. If the corporation intends to do this, the terms of a stock option or RSU may provide that no election under Sec. 83(i) will be available for stock received upon the exercise of the stock option or the settlement of the RSU. This would inform employees that no Sec. 83(i) election may be made for stock received upon exercise of the option or settlement of the RSU even if the stock is qualified stock.

EFFECTIVE DATE

The IRS stated in the notice it expected to issue proposed regulations that, with respect to issues addressed in the notice, will apply to any tax year ending on or after Dec. 7, 2018. Any future guidance, including regulations, addressing the issues covered by the notice, such as the establishment of more restrictive mechanisms to ensure a corporation's income tax withholding requirements are satisfied, will apply prospectively only.

For more, see "Tax Clinic: Qualified Equity Grants: A Welcome Alternative for Startup Companies," The Tax Adviser, May 2018.

  • Notice 2018-97

— By Sally P. Schreiber, J.D., a JofA senior editor.

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