Small business owners who’ve incorporated may be reluctant to share ownership with staff. However, the National Center for Employee Ownership lists a number of compelling reasons why it may make sense to give employees some ownership, even for very small companies. Doing so is a way to retain employees as well as to increase their productivity and caring about the business. The Tax Cuts and Jobs Act included a provision that allows for the deferral of income by employees who receive an equity interest through a “qualified equity grant” (explained below). Here’s an overview of the new rule and what it means taxwise to employees and the company. It’s not easy stuff to understand because there are so many aspects to it.
New deferral option
The grant of stock options (in technical terms are ones that are nonstatutory stock options and not incentive stock options) usually are not taxed until the exercise of the options, and restricted stock units (RSUs) usually are not taxed until the stock becomes vested. However, under new law for stock attributable to stock options exercised or restricted stock units (RSUs) settled after December 31, 2017, there’s a potential further delay in taxation as a result of a new rule, called a Sec. 83(i) election.
Employees of privately-held corporations can elect to defer income for up to 5 years on the value of stock acquired by exercising qualified stock options and RSUs granted to them by their employers. Let me give you an example of how all of the possible taxation rules apply:
Say in 2018 an employee gets options to acquire stock that will vest in 2022. Assume the stock is worth $1X in 2018 and $5X in 2022. Under the basic rule, the employee is taxed in 2022 on $5X; this is ordinary income. But the employee can make a Sec. 83(b) election within 30 days of receiving the restricted stock pursuant to the options, which means reporting $1X of ordinary income in 2018 (all future appreciation becomes capital gains). Now, instead if the employee (assuming he or she is a qualified employee as explained below) makes a Sec. 83(i) election in 2022, the $5X of ordinary income does not have to be reported until 2027. The $5X value is the reportable amount in 2027 even if the stock’s value has appreciated beyond this amount.
The Sec. 83(i) election applies only to stock acquired as part of a “qualified equity grant.” This is a written plan that, in any calendar year in which grants are made, not less than 80% of all employees in the U.S. receive them. However, only a “qualified employee” can make the election. This is an employee who is not excluded from doing so. Those excluded include certain executives, highly-compensated officers, those owning more than 1% of the corporation’s stock, and a family member of any of these individuals.
The Sec. 83(i) election must be made within 30 days of the employee’s right to the stock becomes substantially vested or transferrable, whichever is earlier. The IRS has said that the election is made in a manner similar to the Sec. 83(b) election that has existed for years. A sample form is available from the IRS.
Before making the election, consider the risk: If the value of the stock declines between the time of the election and 5 years, the ordinary income reportable is still the stock’s value at the time of the election. And the ordinary income tax rates applicable 5 years hence will apply and they could be higher than they are now.
If an employee makes the election, then the employee must agree to allow the deferral stock to be held in escrow. The stock remains in escrow until the employee’s income tax withholding (explained below) has been satisfied.
While employees make the deferral election, it’s up to their corporations to make this possible by creating qualified equity grants and doing other things. Corporations must tell employees about the Sec. 83(i) election if they are eligible for it. They must also tell employees that amount of income recognized at the end of the deferral period will be based on the value of the stock at the time at which the rights of the employee first become transferable or not subject to a risk of forfeiture, even if the value of the stock has declined during the deferral period and that this amount is subject to income tax withholding in the year in which this amount is includible in their gross income. The failure to provide the required notice can result in a $100 penalty for the corporation for each failure (up to a maximum of $50,000 in a calendar year), unless there is reasonable cause for the failure.
Withholding is done at the highest individual tax rate in effect at the time (e.g., the rate is 37% now). This is so regardless of an employee’s W-4 allowances. Payment of this withholding is just like it is for any other noncash fringe benefit.
Employers must determine the actual value of the stock includible in the employee’s income no later than January 1 of the following year (a reasonable estimate may be made on the date the fringe benefit is paid in order to meet timely tax deposit requirements). Determining the actual value is necessary so that it can be reported on the employee’s W-2 as well as the employer’s Form 941. The IRS has guidance on what happens if there’s a difference in the estimate and actual value, and if the employee has been underwithheld.
Even though income tax can be deferred, there is no deferral option for FICA and FUTA purposes. Nonqualified stock options exercised and RSUs settled by employees are subject to FICA and FUTA taxes.
Corporations can bar employees from opting to defer income for 5 years in 2 ways:
- Not provide an escrow arrangement.
- Not meet qualified equity grant conditions (e.g., only issue grants to 50% of employees rather than the 80% requirement).
If a corporation does either of these things, then any grants to employees must make it clear that the Sec. 83(i) election is not available to them.
Instead of giving equity interests directly, corporations might consider using Employee Stock Ownership Plans (ESOPs) to give employees equity positions. Talk with your legal and tax advisers to see whether qualified equity grants or ESOPs make sense in your situation.