IRS provides guidance on new deferral option for certain stock-based compensation

Notice 2018-97, 2018-52 IRB; IR 2018-246, 12/7/2018

IRS has issued a Notice and accompanying news release providing initial guidance on Code Sec. 83(i), as added by the Tax Cuts and Jobs Act (TCJA; P.L. 115-97, 12/22/2017), which allows certain employee to elect to defer recognition of income attributable to the receipt or vesting of qualified stock. Specific issues addressed in the Notice include the satisfaction of the “80% requirement” under Code Sec. 83(i)(2)(C) for determining whether a corporation is an eligible corporation, and issues relating to income tax withholding on stock for which a Code Sec. 83(i) election has been made.

Background.  Code Sec. 83 generally provides for the federal income tax treatment of property transferred in connection with the performance of services.

Code Sec. 83(i), added by the TCJA, allows “qualified employees” who receive stock from an “eligible employer” on the exercise of a stock option or in settlement of a restricted stock unit (RSU) to elect to defer the inclusion of income from the stock for up to five years from the date that the employee’s rights in the stock are transferable or aren’t subject to a substantial risk of forfeiture (referred to simply as “an election” or “the election”). A “qualified employee” is  any individual who is not an “excluded employee” (e.g., 1% owners, CEO) and who agrees to certain withholding, etc. requirements with respect to the qualified stock. (Code Sec. 83(i)(3)(A))

Under Code Sec. 83(i)(1)(A), if “qualified stock” (below) is transferred to a qualified employee who makes an election with respect to such stock, the amount determined under Code Sec. 83(a) with respect to such stock will be included in income in the tax year of the employee which includes the earliest of:

1. the first date such qualified stock becomes transferable (including, for this purpose, to the employer);
2. the date the employee first becomes an “excluded employee”;
3. the date on which any stock of the issuing corporation becomes readily tradable on an established securities market;
4. five years after the date the rights of the employee in such stock are either transferable or not subject to a substantial risk of forfeiture, whichever occurs earlier; or
5. the date on which the employee revokes the election. (Code Sec. 83(i)(1)(B))

“Qualified stock” is, in general, any stock in a corporation that is the employer of a qualified employee, if such stock is received (i) in connection with the exercise of a stock option or in settlement of an RSU, and (ii) such stock option or RSU was granted in connection with the performance of services as an employee and during a calendar year that the employer corporation was an “eligible corporation.” (Code Sec. 83(i)(2)(A)) In turn, an “eligible corporation” is any corporation that, with respect to any calendar year, (i) has none of its (or any predecessor’s) stock readily tradable on an established securities market during any preceding calendar year, and (ii) has a written plan under which, in such calendar year, not less than 80% of all employees (excluding certain part-time employees) who provide services to the corporation in the U.S. (or any possession thereof) are granted stock options, or are granted RSUs, with the same rights and privileges to receive qualified stock (the “80% requirement”). (Code Sec. 83(i)(2)(C)(i))

The election must be made no later than 30 days after the first date the rights of the employee in such stock are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier. Stock for which an election has been made is referred to as “deferral stock.” (Code Sec. 83(i)(4)(C))

New notice and reporting requirements also apply under Code Sec. 83(i)(6). Specifically,  any corporation which transfers qualified stock to a qualified employee must, at the time an amount attributable to such stock would first be includible in the gross income of such employee (or a reasonable time before), certify to the employee that the stock is qualified stock, and notify the employee that he or she may be eligible to defer income on such stock under Code Sec. 83(i). The employer also must notify the employee of certain tax consequences of the election. Failure to provide the requisite notices under Code Sec. 83(i)(6) can give rise to penalties under Code Sec. 6652(p) of $100 per failure, up to $50,000 per calendar year, unless the employer establishes that the failure is due to reasonable cause and not willful neglect.

The TCJA provided a transition rule under which, until IRS issues regs or other guidance implementing the 80% requirement under Code Sec. 83(i)(2)(C)(i)(II) or the notice requirements of Code Sec. 83(i)(6), a corporation will be treated as in compliance with those requirements if it complies with a reasonable, good faith interpretation of them.

New guidance—application of 80% requirement.  Notice 2018-97 provides that a corporation’s qualification as an “eligible corporation” is determined on a calendar year basis. This includes, among other things, satisfaction of the 80% requirement.

Therefore, whether the corporation has satisfied the 80% requirement is based solely on the stock options or the RSUs granted in that calendar year to employees who provide services to the corporation in the U.S. (or any possession thereof). In calculating whether the 80% requirement is satisfied, the corporation must take into account the total number of individuals employed at any time during the year in question as well as the total number of employees receiving grants during the year (in each case, without regard to excluded employees or part-time employees described in Code Sec. 4980E(d)(4)), regardless of whether the employees were employed by the corporation at the beginning of the calendar year or the end of the calendar year.

IRS determined that interpreting the 80% requirement on a cumulative basis, i.e., taking into account stock options or RSUs granted in prior calendar years, is contrary to the language of the statute and thus isn’t a good faith interpretation of the 80% requirement. So, the transition rule described above doesn’t apply to such an interpretation. (Notice 2018-97, Sec. III.A)

Income tax withholding. The TCJA also amended the income tax withholding provisions—Code Sec. 3401 and Code Sec. 3402—with respect to deferral stock in order to conform to the income tax rules applicable to deferral stock.

Code Sec. 3401(i), added by the TCJA, treats deferral stock as “wages,” subject to employer withholding under Code Sec. 3402, that are (1) received on the earliest date described in Code Sec. 83(i)(1)(B), and (2) in an amount equal to the amount included in income under Code Sec. 83 for the tax year which includes such date.  When the wages are treated as paid under Code Sec. 3401(i), the employer must make a reasonable estimate of the value of the stock and make deposits of the amount of income tax withholding liability based on that estimate.

Under Code Sec. 3402(t), also added by the TCJA, in the case of any deferral stock: (1) the rate of tax under Code Sec. 3402(a) must not be less than the maximum rate in effect under Code Sec. 1 (37% in 2018), and (2) such stock is treated for purposes of Code Sec. 3501(b) in the same manner as a noncash fringe benefit. Code Sec. 3501(b) provides that the taxes imposed by Subtitle C with respect to noncash fringe benefits must be collected (or paid) by the employer at the time and in the manner in regs.

IRS expects that proposed regs providing further guidance on Code Sec. 83(i) will provide that withholding on deferral stock is applied (1) without reference to any payment of regular wages, (2) without allowance for the number of allowances or other dollar amounts claimed by the employee on Form W-4, Employee’s Withholding Allowance Certificate, (3) without regard to whether the employee has requested additional withholding, and (4) without regard to the withholding method used by the employer.

Escrow arrangement. Pursuant to IRS’s authority under Code Sec. 83(i)(3)(A)(II) to impose requirements it determines necessary to ensure that the withholding requirements are met, in order to be a qualified employee, an employee must agree in the election that all deferral stock will be held in an escrow arrangement, the terms of which are consistent with the following requirements:

1. The deferral stock must be deposited into escrow before the end of the calendar year during which the election is made and must remain in escrow until removed in accordance with clause (ii), below, or the corporation has otherwise recovered from the employee an amount equal to the income tax withholding obligation under Code Sec. 3401(i) for the tax year.
2. At any time between the date of income inclusion under Code Sec. 83(i)(1)(B) and March 31 of the following calendar year, the corporation may remove from escrow and retain the number of shares of deferral stock with a fair market value equal (as specifically determined) to the income tax withholding obligation that has not been recovered from the employee by other means.
3. Any remaining shares held in escrow after the corporation’s income tax withholding obligation has been met, whether by retention of shares in accordance with clause (ii) or otherwise, must be delivered to the employee as soon as reasonably practicable thereafter.

IRS noted in Notice 2018-97 that it is aware that the above requirement has the effect of allowing a corporation to preclude its employees from making elections by declining to establish an escrow arrangement as described above, and that future guidance on Code Sec. 83(i)(3)(A)(ii) may establish alternative or substitute mechanisms to ensure a corporation’s income tax withholding requirements are satisfied. (Notice 2018-97, Sec. III.B.2)

Designation of stock as not eligible for election. Some stakeholders indicated to IRS that a corporation may wish to compensate its employees with equity-based compensation for which no election may be made. IRS noted that, since a corporation can simply not establish an escrow arrangement as described above, a corporation does not need to be concerned that it would inadvertently create the requisite conditions for its employees to make the election or be required to comply with the notice requirement of Code Sec. 83(i)(6).

Effective date.  Code Sec. 83(i) applies to stock attributable to stock options exercised, or RSUs settled, after Dec. 31, 2017. IRS anticipates that the guidance in Notice 2018-97 will be incorporated into future regs that will apply to any tax year ending on or after Dec. 7, 2018; but that any future guidance addressing these issues (e.g., the establishment of more restrictive mechanisms to ensure a corporation’s compliance with the income tax withholding requirements) will apply prospectively only. (Notice 2018-97, Sec. IV)

References: For the Code Sec. 83(i) election, see FTC 2d/FIN ¶H-2900 et seq.; United States Tax Reporter ¶ 834.075 et seq.