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New Guidance for Stock Options and Restricted Stock Units

New Guidance for Stock Options and Restricted Stock Units

One of the changes contained in the Tax Cut and Jobs Act of 2017 (TCJA) was the introduction of a new provision that allows employees to defer taxation that would otherwise follow the receipt or vesting of employer stock if certain conditions are satisfied. In response to a number of questions from stakeholders concerning how to qualify for these new tax-deferral benefits, the Department of the Treasury and Internal Revenue Service (IRS) recently issued guidance that is intended to provide greater clarity around the particular requirements under the new law.



Section 83(i) added by the TCJA allows certain employees to elect within 30 days of vesting to defer the amount that would have been included in income due to the receipt of stock upon the exercise of a stock option or settlement of a restricted stock unit (RSU) for up to five years (potentially earlier in certain cases) provided certain requirements are met. Two key requirements under 83(i) are that (1) qualified stock must be transferred to (2) a qualified employee. 

Qualified stock of an “eligible corporation” includes any stock of the employing corporation if: the stock is received pursuant to the exercise of an option or settlement of an RSU and the stock was granted in connection with the performance of services as an employee. An eligible corporation means a corporation whose stock is not readily tradeable and has a written plan under which no fewer than 80 percent of all employees working in the U.S. are granted stock options or RSUs. In general, a qualified employee is an employee other than: a 1 percent shareholder; CEO or CFO, or related persons; or one of four highest compensated officers for the preceding 10 years.


Recent guidance

Notice 2018-97 (Notice) was published in response to requests for details concerning: the rule that no fewer than 80 percent of all employees receive grants; federal income tax withholding; and, the ability of employers to opt out of permitting employees to elect deferred tax treatment even if the requirements have otherwise been met.


The 80 percent requirement 

The Notice explains that the determination of whether a corporation meets the 80 percent requirement is made on a calendar basis and not on a cumulative basis. Therefore, to qualify as an eligible corporation for the calendar year it must grant options or RSUs in that calendar year to 80 percent of the employees who provide services. In making this calculation, corporations must take into account the total number of individuals employed at any time during the calendar year as well as the employees receiving grants without regard to excluded or part-time employees and regardless of whether they were employed at the beginning or end of the year.


Income tax witholding 

With respect to income tax withholding, the amount of the deferral stock is included as income and treated as wages for withholding purposes at the end of the deferral period (no later than five years after vesting). The Treasury Department expects to provide proposed regulations that the rate of income tax to be used for withholding must equal the maximum rate (currently 37 percent). This rate is applied without regard to the payment of regular wages, allowances or dollar amounts claimed on Form W-4, requests for additional withholding or withholding method used by the employer.

Employers must make a reasonable estimate of the value of the stock when treated as wages and make deposits of income tax withholding based on that estimate. By January 31 of the following year the employer must determine the actual value of the deferral stock on the date it is to be included in income and report the amount and withholding on Form W-2 and 941. If an employer pays the withholding from its own funds it may recover the amount from the employee until April 1 of the following year. An employer that fails to deduct and withhold federal income tax is liable for the tax.

It’s important to point out that unlike income tax withholding provisions, the application of FICA (payroll tax) and FUTA (unemployment tax) rules are unaffected and the timing and application of these taxes has not changed.


Escrow arrangements 

In order to ensure that the income tax withholding requirements are met, the Notice requires that the employee making the election to defer income recognition under 83(i) must agree in the election that all deferral stock will be held in escrow. If the corporation and employee do not agree to deposit the deferred stock in escrow the employee is not a qualified employee and the deferral election is invalid.


Final Thoughts 

For private corporations and their employees, the benefits associated with deferring income recognition related to stock option gains and RSUs under 83(i) could be compelling depending on the facts. Understanding the rules and how to comply is important in order for employees to take advantage of the potential financial benefits. For employers wishing to preclude employees from making 83(i) elections they can accomplish this by declining to establish an escrow arrangement or provide in the terms of the options or RSUs that no election under 83(i) may be made even if the stock is qualified stock. 


Talk to a Gallagher consultant today to discuss how we can partner with you to develop compensation programs that will fit your business strategy, improve your recruitment, retention, and employee engagement, and drive better business outcomes.

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