[co-author: Maggie Caldwell]

The Tax Cuts and Jobs Act of 2017 (“The Act”) is just over a year old and tax practitioners, taxpayers and commentators are still working to digest the actual effect of many of its sweeping changes. While one of the central notions of this legislation was to lower the income tax burden on working people, much debate in the business and political press remains as to whether The Act achieved this goal, in whole or in part. The authors believe that the enactment of new Code § 83(i)[1] was a good step in this direction.

This provision, we believe, simply intends to allow the tax benefits of receiving upside in the fruits of the labor of working people that inure to a private company’s growth in equity value to those individuals targeted by the legislation beyond their basic compensation measured by salary, bonus and employee benefits—similar to that usually afforded only to senior executives and directors. This is achieved by generally deferring the income recognition (and payment of cash income tax) on the receipt of corporate stock (not partnership interests) in private companies to the earlier of a cash monetization event (such as an Initial Public Offering or a cash buyout by a public entity or a private equity firm) when they have the cash to pay the tax, or five years. This is a favorable development because the taxation of the receipt in this form of compensation has been historically challenging to measure and process through payroll systems. Additionally, it is often difficult to administer and credibly explain to a working class that is often devoid of the benefit of sophisticated tax and legal advice available to senior executives and investors.

What’s So Hard About the Income Tax Treatment of Receiving Equity in a Private Company?

Code §§ 61 and 83 generally treat the receipt of renumeration of any kind as taxable compensation at that time. The income tax withholding rules[2] (including the Federal Insurance Contributions Act, Federal Unemployment Tax Act, etc.) also require employers to withhold and remit those taxes at the time, based upon a percentage of the amount of compensation paid, and failure to withhold penalties[3] are harsh and can become very “personal” to the officers overseeing the withholding process. The first issue to address when stock or stock rights are granted is valuation. This is quite difficult in many cases for private companies because these entities have valuation challenges brought on largely due to the lack of measurable liquidity data points due to their private (and non-traded) nature and limited market for their equity.

Secondly, there is a cash flow issue: how does one withhold cash income taxes on a non-monetary transaction (i.e., a stock option grant)? The cash for withholding tax on a non-monetary event must come from somewhere as withholding it out of their salary is rarely acceptable to anyone. Next, for even a benevolent owner, this cash flow issue remains in that even if one can value the non-traded equity, to keep the working employee whole from a tax return/cash standpoint, often the tax gross-up becomes more than the successful entrepreneur wishes to invest in this effort. Additionally, from our experience, explaining this notion to working people often becomes a challenge when remaining creditable in maintaining their loyalty and essential efforts due to the complexity and dollars involved as most working people aren’t exactly fond of doing things that affect their relationship with the Internal Revenue Service (IRS) or a state tax authority.

OK, So Who’s In & Who’s Not on Section 83(i)[4] (Known as the Inclusion Deferral Election)?

Eligible Entities: Private C corporations; no public successors.

Out: The CEO, the CFO, the (otherwise) top four compensated individuals (with a 10-year lookback period) and certain people related[5] to them, as well as existing 1% owners.

In: Qualified Employees. Simply, anyone who’s not out.

Eligible Stock & Rights:

Transfers of stock pursuant to the exercise of options or the settlement of restricted stock units after December 31, 2017. However, employees making otherwise allowable § 83(b) income inclusion elections under current law are prohibited from making an Inclusion Deferral election under this sub-section on the same property. Also, certain escrow arrangements are allowable[6] to facilitate this program.

When Does the Party End?

Liquidity Event[7] or five years from the grant.

When Should I Consider This?

Eligible, expanding private company, or a post-restructuring entity that is not a public successor.

How Does One Make the Inclusion Deferral Election?

The issuing corporation must first notify the service provider (employee) that the property (deferral stock) granted is subject to this treatment at the employee’s election. If the employee wishes to elect this treatment, it must do so within 30 days of the grant of the property, similar to present-law § 83(b) requirements. This election is made by the employee and involves notifications to both the IRS and the issuer-employer.

Tax Treatment by Issuer

Like present-law § 83(h) in that a deduction is available when service providers report the underlying compensation income in the same amount as they report as income. Watch out for fiscal year issuers as the deduction matures on December 31 (the employee’s likely tax year-end) and not on the specific date the compensation is recognized[8]. As mentioned earlier, cash income tax withholding and deposit requirements apply at income recognition dates, which require treasury planning and solid communication with affected employees.

Likely Financial Accounting

ASC Topic 718-740 guidance for existing non-qualified stock option arrangements seems adequate. From our experience, some private companies tend to be challenged with the technical requirements of this accounting guidance when converting to SEC GAAP in S-1 preparation processes.

Possible Pitfalls

Advice needed on plan adoption:

• Legal
• Tax
• Accounting
• Valuation
• Practical
• Fair Market Value (FMV) of the property at grant seems to drive IRS’ view; thus, if no liquidity event occurs in five years, issuers have to deal with the consequences of a non-cash taxable maturity.
• FMV at grant may be greater than the FMV at maturity

Conclusion

Growing private companies should consider the new § 83(i) mechanism to reward those hard-working employees that contributed to company growth and wealth creation for their founders.

References

• Internal Revenue Code § 83(i)
• House of Representatives Committee Report (sec. 3803 of the House bill, sec. 13603 of the Senate amendment, and secs. 83, 3401, and 6051 of the Code) [Pub. L. No. 115-97; H.R. Rep. No. 115-466, I.I., Compensation]
• IRS Notice 2018-97

[1] All statutory references herein are to the Internal Revenue Code of 1986 as amended and as in effect as of the date of this article.

[2] § 3402(a), etc.

[3] § 6672

[4] Additional helpful insight was provided by the Internal Revenue Service (the Service) in Notice 2018-97.

[5] § 318, and there are complex rules for beneficiaries of trusts, partners, etc., that are beyond the scope of this Insight.

[6] § 83(i)3)(A)(ii).

[7] Such as an Initial Public Offering, merger with a public company, or a private equity purchase.

[8] For example, if compensation under this section is recognized on May 1 20x1 for a corporate issuer with a June 30 tax year end, this compensation deduction (if otherwise allowable) would be recognized in the issuer’s tax year ending June 30, 20x2, which is the tax year that includes the service provider’s tax year of recognition: December 31, 20x1.