Understanding the New IRC 83

Understanding the New IRC 83

If you are a private business owner looking to provide additional compensation benefits to your employees, the new 83(i) is worth looking into. Created under the 2017 Tax Cuts and Jobs Act, Section 83(i) is available for a small group of employees whose employers have adopted an 83(i) plan and if used correctly, can provide a significant tax benefit.

Internal Revenue Code Section 83 states that if an employee is granted company stock in connection for services performed, the value of such stock shall be treated as ordinary income in the first taxable year in which the stock is considered transferable and not subject to a risk of forfeiture. In plan English, if an employer grants an employee stock options that only vest after the employee works for the company for the next 3 years…the employee isn’t taxed on the value of the stock until he/she receives the stock in 3 years. The ordinary income the employee will pay tax on will be the value of the stock when the stock is actually received, not when granted.

When the stock is received, the employee will have to pay to the employer his/her share of withholding taxes. You read that correctly, the employee will have to pay the employer since the value of the stock will be included on your W2, withholding for such income needs to be made. This can be troublesome for most taxpayers who do not have the funds to pay the taxes now.

This is where Section 83(i) comes in. First, the employer needs to set up a written plan that follows all of the 83(i) rules: the company is private (stock isn’t sold on a public securities exchange) and in the applicable calendar year at least 80% of US qualified employees will receive grants. To be a qualified employee, you must be: employed full time, are not the CEO or CFO, are not a 1% or more owner preceding the stock option, and are not one of the four highest compensated officers. If all of the above applies, and the stock will be received from an option exercise or a settlement/vesting of restricted stock that cannot immediately be sold back to the company, it may be wise to file an 83(i) election.

If a timely 83(i) election is filed, the withholding/income taxes owed are deferred for up to 5 years. This is a significant amount of time for the employee to save for the taxes due.

While an 83(i) election happens after the stock is vested, an 83(b) election occurs when the grant happens and is typically best used for start-ups with low valuations. For example, if an employee went to work for a promising start-up that was unable to pay a reasonable salary, the employer might offer to grant unvested, restricted stock that vests if the employee works for the company for 4 years. Since the company is a start-up, it might make sense to file an 83(b) election and pay the ordinary income tax when the grant was made as opposed to when the stock vests in 4 years (assuming the stock appreciates). If the value of the company is $1 per share now and might grow to be $100 per share in 4 years, paying the tax now seems like an easy answer. Lastly, 83(b) can be elected by any employee, CEO and CFO included.

An 83(i) and 83(b) election must be filed within 30 days of the vesting or grant, respectfully. Also, you cannot make both elections. Once an 83(b) is made, an 83(i) election is no longer available.

Both concepts are extremely technical and should be heavily analyzed with a team of advisors before an election is made. Please reach out to me if you have additional questions.