Can You Defer Taxes With NSO Election?

Can you defer taxes with an NSO election?

The IRS introduced Code Section 83(i) as a part of the Tax Cuts and Jobs Act 2017. Based on this code, the staff of private companies that receive NSOs (non-statutory stock options) or RSUs (restricted stock units) can elect to defer on Federal Income Tax. This will only occur if they satisfy certain requirements. They can defer on RSU settlement or NSO exercise for about 5 years.

To help companies that seek to make their employees enjoy this election, the IRS released the IRS Notice 2018-97. Interestingly, companies may only find very little advantage when they offer their employees this opportunity. This is mostly because of the cost required to satisfy the requirements of Section 83(i). Along with these are the benefits accruing from different equity compensation alternatives carrying tax advantages. A typical example is incentive stock options.

Defer Taxes with an NSO Election

How do you defer taxes with an NSO 83(i) election? When a qualified employee receives qualified stock from an eligible corporation, they can defer the income taxes on that stock’s value. The election has to be within 30 days of the RSU settlement or NSO exercise. Also, the stock’s value is determined during the settlement or exercise.

This should be before:

  • The day that stock attains transferability status (it includes when it becomes transferable to the employer).
  • The day that the employee attains an “excluded” status.
  • The day that any of the stocks of the company gets traded on any established securities market.
  • Five years after the RSU settlement or NSO exercise (it doesn’t matter if the stock is tradable at the time or not).
  • The day that the employee in question revokes or terminates the election.

Background

Here are some definitions to help you:

Eligible Corporation: This is a private company that has adopted a plan to grant a minimum of 80% of all its employees in the US RSUs or NSOs in a calendar year.

Qualified Stock: This is a stock in an eligible corporation that employs a qualified employee (or the employee’s parent). The stock must satisfy the following requirements:

  • It should be connected to the NSO exercise or RSU settlement.
  • It should be received when the RSU or NSO is granted based on an employee’s performance in a calendar year. The company must already be an “eligible corporation” within this period.

It is important to note that Section 83(i) does not apply to incentive stock options. This is because Federal Income Tax is never due at the time of exercising the incentive stock option. 

Qualified Employee: This is an employee that meets the stated requirements the IRS has established to collect withholding taxes. In simpler terms, a qualified employee isn’t an excluded employee. 

By excluded employee, we mean an employee that:

  • Owns 1% at any period of the calendar year or in the 10 years preceding the current calendar year. Note that family attribution rules are applicable here.
  • Was or is a Chief Financial Officer or Chief Executive Officer of the company at any time. Family attribution rules are also applicable here.
  • Is among the 4 officers of the corporation with the highest compensation for that taxable year. It is the same for an employee that falls into this category for any of the 10 preceding years.

What this means is that the qualified employee shouldn’t be a consultant or director. Instead, they should be an employee through and through.

The 80 Percent Requirement

Determining whether an employee is eligible for the 80 percent requirement should be done every calendar year. Such determination should not take into consideration whether the individual has received any grants in previous years or not. The employer should consider every employee that was employed at any point during the said calendar year. It is important to note that this doesn’t include “excluded employees” or “part-time employees.” 

The employee must also determine if a minimum of this 80 percent received NSOs or RSUs. There are separate tests for each of these. As such, 80 percent have received NSOs or 80 percent have received RSUs. Below are the implications of the 80 percent requirement.

  • Employees cannot know if the organization qualifies as an eligible corporation until the end of the current calendar year. This means that they are not aware if they meet the 80 percent requirement or not.
  • Employers should provide most of their employees with annual refresh awards. This should be done instead of giving these awards after nearly or fully vesting the initial new hire awards.
  • Alternatively, the employers may decide to alter their grant practices. So instead of large initial new hire awards, they can grant smaller annual awards. The effect of this is higher exercise prices for the subsequent awards. It could end up impacting the process of hiring or retaining employees.

There are certain things startups must do to get them ready for their tax season. Click here to find out.

Withholding Requirements

The only taxes deferred under the 83(i) election are federal income taxes. This means that FUTA and FICA taxes remain due and are unaffected during the NSO exercise or RSU settlement. Of course, this covers both the employer and their employees.

According to the notice, the stock or deferral stock should be included in the income tax. This is necessary for federal income tax withholding based on the final date of the deferral period. This period should end on the earliest date of the 30-day period discussed above.

What this means is that the employer should remit the federal income tax withholding directly to the IRS. This must be done for the awards based on the dictates of the 83(i) election following the deferral period. Again, the income from an RSU or NSO under an 83(i) election must be subject to federal income tax withholding. This must be at a maximum marginal income tax rate and it should be without regard to any withholding exemptions or allowances. 

The employer can recover the funds that they paid to the employer. This is based on two conditions. The first is that they made the payment for the withholding amounts from their funds. Secondly, it can only be recovered between when it was paid and the 1st day of April in the year that follows the current calendar year. 

We should state that some States require the employer to receive authorization before they withhold any amounts from the employee’s compensation. The IRS requires each 83(i) election to include a share escrow arrangement. This is necessary to ensure that companies satisfy the statutory obligations of income tax withholding. Such an arrangement requires qualified employees to maintain any deferral stock in an escrow with their employer. This should be in place until when the withholding tax is due or there is an arrangement to pay the tax.

When the deferral period elapses, the employer can deduct the stock from the share escrow account. They will use this amount to pay up the withholding tax while releasing the remaining stock to their employee. Theoretically, this account is designed to protect the employer. However, private companies must still spend cash on withholding tax since the IRS cannot accept their shares as payment. Note that should the election reduce in value, the company and its employee retains the risk of loss.

Opportunity to Opt-Out

According to the notice, a corporation can opt-out if they don’t establish the stock escrow arrangement explained above. What this means is that the company is no longer required to comply with Section 83(i) and its requirements. This is as long as they had unconsciously satisfied the requirements for the deferral eligibility and don’t want to make it available.

FAQs

Who Can Make Qualified Equity Grants?

  • It is the eligible corporation that can make qualified equity grants. To learn more about this and tax issues a startup should avoid, click here.

What Is the Effect of Making an 83(i) Election?

  • When an 83(i) election is made, the employees can defer federal income taxes based on the stock they receive. However, this must be within 30 days of an NSO exercise or RSU settlement.

How to Make an 83(i) Election

Based on the provisions of the notice, companies have a better understanding of the 80 percent requirement. It also helps to explain the tenets of the escrow arrangement and how to secure withholding tax. To have a better understanding of this, startups need the help of an accounting solution with experience in startup tax law. We suggest that you reach out to Founder’s CPA to solve all problems related to an 83(i) election.

Curt Mastio

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