The hope of the Section 83(i) election
I wrote a short-ish primer on the Section 83(i) election that was enacted as part of the Tax Cuts and Jobs Act. It isn’t meant to be published so writing isn’t great, but it’s meant to be a quick introduction for a project I’m working on. I’ll keep things vague for now and post if this ever goes live, but figured I share what I wrote.
The TL;DR is that the 83(i) has the right intent which is to allow private company employees to defer taxes, but is not practical due to the heavy restrictions for the company and limited benefits for the employee.
Here you go:
A Section 83(i) election has a lot of potential benefits that may be appealing to start-up employees. On the surface, it allows an employee with non-qualified stock options (NSOs) to exercise their options, and defer the ordinary income tax bill associated with exercising to as long as 5 years. However, the benefits to the employee are severely limited and could pose potential issues.
The election only defers regular taxable income which would be for employees who hold non-qualified stock options (NSOs). For employees granted ISOs, you cannot defer the alternative minimum tax (AMT) liability. If you hold ISOs, you can still take the election, but you lose all tax benefits of having ISOs making it unattractive for ISO holders.
Employees still have to pay this back in a maximum of 5 years if the company still hasn’t exited. Although it buys you time to save for the tax bill, you’re still at risk to pay the tax bill down the road and be in the same position you were in today.
Employees are still liable for paying income tax on the value of the equity at the time of exercise. If the value of the stock drops after the 5 year period is up, they will be paying a higher amount putting them worse off than they would have been if they had waited.
Furthermore, after the IRS released guidance on Section 83(i) in Notice 2018-97, it is clear that not only are the benefits for the employee limited, but the administrative burden for companies to offer the 83(i) election is heavy.
There is a rule that requires employers to make grants of options or RSUs to 80% of it’s employees. Employers must always calculate how many options or RSUs were granted to their employees every year to ensure it meets the 80% rule. Furthermore, there are restrictions on who qualifies to be part of that 80%.
An employer must hold the stock in which the 83(i) election was made in an escrow account until the end of the deferral period when the employee fulfills the withholding requirement by paying the income tax.
An employer must provide notice of availability of Section 83(i) election. This likely means that employers will need to amend their equity plans to say whether they are making the 83(i) election, and if so, meet at stringent requirements every year.
The intention of the bill is on the right track but after reviewing the fine print, it is difficult to see many employers offering this for the employees given the administrative burden and relatively limited upside for the employee. Small start-ups are focused on building a company and likely would not want to be burdened with additional work managing a 83(i) offering for their employees. Unfortunately, this is just another example of the clear disconnect in Congress on the issues that stock option holders and start-up employees face.