Stock Option Counsel, P.C. - Legal Services for Individuals. Attorney Mary Russell counsels individuals on equity grants, executive compensation design, employment agreements and acquisition terms. She also counsels founders on their personal interests at incorporation, financings and exit events. Please see this FAQ about her services or contact her at (650) 326-3412 or by email.
The final Tax Cuts and Jobs Act of 2017 added a new Section 83(i) to the Code intending to allow holders of RSUs and options to defer tax on those benefits until they are able to sell the shares to cover their tax bills. Its drafting makes it unlikely to apply in practice at most startups, but where it applies it can defer taxation for up to five years from the date of option exercise or RSU vesting.
Many issues related to the Section 83(i) Election are unclear from the legislation and will need to be clarified by IRS guidance. So this is the best of my understanding as of today. This is not tax advice for readers, so please consult with your own accountant or CPA.
Option Exercises & Section 83(i) Election
Because well-designed startup RSUs are already structured to defer taxation until liquidity, the benefits of tax deferral under Section 83(i) are most needed for option exercises.
For eligible option exercises, a timely election under Section 83(i) will defer income at exercise until the earlier of the (i) IPO; (ii) the first date the stock becomes transferable (including to the employer), (iii) five years from exercise, (iv) the first date the employee becomes an “excluded employee,” or (v) the date the election is revoked. The 83(i) Election must be made within a 30-day period after exercise.
These are some of the eligibility requirements:
1. The company must have offered stock options on terms that provide the same rights and privileges (other than the number of shares) in the calendar year of grant to at least 80% of its U.S. employees. Since most startups do not make annual grants of stock options, this would be unlikely to apply except in years of very high growth in staff size, or to the occasional startup that gives broad-based annual refresh grants.
2. The individual must not be a significant owner or executive of the company. The ownership test is met by 1% ownership. The executive test relates to role, such as CEO and CFO, as well as total compensation, as it applies to the four most highly compensated officers of the company. Both definitions have historical applicability, such as a 10-year look back, as well as future applicability, so that if one of the definitions is met after the Section 83(i) Election, the individual becomes an “excluded employee” and the tax deferral ends.
Section 83(i) Notice
Companies are required to provide a Section 83(i) Notice to eligible employees at the time (or a reasonable period before) they become eligible to make the Section 83(i) Election. However, not all eligible employees will be aware of their eligibility, as some companies may still be in the process of assessing eligibility. Therefore, those considering option exercises at private companies may want to inquire as follows:
I understand that the new tax bill created a Section 83(i) Election to allow deferral of taxation at option exercise until the earlier of 5 years from exercise or liquidity. But there are certain rules that have to be met for an option to be eligible, including related to the company’s option grant practices, my own ownership percentage and other requirements. Can you please confirm whether, if I exercise this option, I will be eligible to make a Section 83(i) Election on the stock I purchase?
Making the Section 83(i) Election Decision
Individuals who are eligible to make the Section 83(i) Election will want to consider the pros and cons based on the tax consequences and their investment plans. For example, exercising options and filing the Section 83(i) Election will not solve the pre-liquidity taxation problem if there is not a liquidity event before the five-year (or earlier) deadline. And the Section 83(i) Election converts ISOs into NQSO, so any favorable tax treatment associated with ISOs would be lost. Since the alternative minimum tax exemptions have increased so dramatically, ISOs are more likely to be AMT-free at exercise. Such an ISO exercise may ultimately result in more favorable tax treatment than the Section 83(i) Election, if the shares are held for the full ISO holding periods. And, as in any option exercise, paying the exercise price itself is an investment risk and having a tax-deferred exercise does not make the exercise risk-free.
Negotiating New Offers
All well-negotiated startup equity offers include planning for investment timing, tax timing and tax rates. While the Section 83(i) Election is a new tool in that toolbox, it is not likely to be the most advantageous planning method for new grants. See this post for some examples of my favorite structures for equity offer negotiations.