Notice 2018-97 provides guidance to taxpayers about issues related to IRC §81(i), a provision added by the Tax Cuts and Jobs Act that allows employees in certain situations to defer recognition of income when receiving stock or having an interest in such stock vest.

The Notice as meant to provide some additional clarity in the application of this provision for three areas:

The application of the requirement in section 83(i)(2)(C)(i)(II) that grants be made to not less than 80% of all employees who provide services to the corporation in the United States,
The application of federal income tax withholding to the deferred income related to the qualified stock, and
The ability of an employer to opt out of permitting employees to elect the deferred tax treatment even if the requirements under section 83(i) are otherwise met.

The IRS begins by describing the basic structure of new §83(i):

Section 83(i) allows certain employees to elect to defer inclusion in income of the amount that would otherwise be included under section 83(a) upon the transfer of stock pursuant to the exercise of a stock option or the settlement of a restricted stock unit (RSU). Inclusion of that income may be deferred for up to 5 years as the result of a section 83(i) election, subject to certain limitations…

The notice goes on to describe the effect of the making of a §83(i) election by an employee:

Section 83(i)(1)(A) provides that if qualified stock is transferred to a qualified employee who makes an election under section 83(i) with respect to such stock, the amount determined under section 83(a) with respect to such stock will be included in income in the taxable year determined under section 83(i)(1)(B). Accordingly, such income shall be included in the taxable year of the employee which includes the earliest of:

(i) the first date such qualified stock becomes transferable (including, solely for purposes of this clause, transferable to the employer);

(ii) the date the employee first becomes an excluded employee;

(iii) the first date on which any stock of the issuing corporation becomes readily tradable on an established securities market;

(iv) the date that is 5 years after the first date the rights of the employee in such stock are transferable or not subject to a substantial risk of forfeiture, whichever occurs earlier; or

(v) the date on which the employee revokes the election (at such time and in such manner as the Secretary of the Treasury (Secretary) provides).

Employees who are qualified to make this election are all employees who are not excluded employees. An excluded employee is any individual:

(i) who is a 1 percent owner at any time during the calendar year or who was a 1 percent owner at any time during the 10 preceding calendar years;

(ii) who is or has been at any prior time (I) the chief executive officer (or an individual acting in such capacity) or (II) the chief financial officer (or an individual acting in such capacity);

(iii) who bears a relationship described in section 318(a)(1)[1] to any individual described in subclause (I) or (II) of clause (ii); or

(iv) who is one of the 4 highest compensated officers of the corporation for the taxable year, or was one of the 4 highest compensated officers of such corporation for any of the 10 preceding taxable years, determined on the basis of the shareholder disclosure rules for compensation under the Securities Exchange Act of 1934 (as if such rules applied to such corporation).

The Notice describes eligible stock for which an election can be made:

Section 83(i)(2)(A) defines “qualified stock” as any stock in a corporation that is the employer of a qualified employee, if such stock is received (i) in connection with the exercise of a stock option or in settlement of an RSU, and (ii) such stock option or RSU was granted in connection with the performance of services as an employee and during a calendar year that the employer corporation was an eligible corporation. Section 83(i)(5) provides that, for purposes of this subsection, all persons treated as a single employer under section 414(b) shall be treated as one corporation. Section 83(i)(2)(B) provides that qualified stock does not include any stock if the employee may sell the stock to, or otherwise receive cash in lieu of stock from, the corporation at the time that the employee’s rights to the stock first become transferable or not subject to a substantial risk of forfeiture.

An eligible corporation is described as follows in the Notice:

Section 83(i)(2)(C)(i) defines an “eligible corporation” as any corporation that, with respect to any calendar year, (i) has none of its (or any predecessor’s) stock readily tradable on an established securities market during any preceding calendar year, and (ii) has a written plan under which, in such calendar year, not less than 80% of all employees who provide services to the corporation in the United States (or any possession of the United States) are granted stock options, or are granted RSUs, with the same rights and privileges to receive qualified stock.

The Notice goes on to note that “employees shall not fail to be treated as having the same rights and privileges to receive qualified stock solely because the number of shares available to all employees is not equal in amount, so long as the number of shares available to each employee is more than a de minimis amount.”

As well, “rights and privileges with respect to the exercise of an option shall not be treated as the same as rights and privileges with respect to the settlement of an RSU.”

The election in question must be made in conformity with certain requirements:

…[A]n election with respect to qualified stock shall be made no later than 30 days after the first date the rights of the employee in such stock are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier, and shall be made in a manner similar to the manner in which an election is made under section 83(b).

An election is prohibited in certain circumstances:

… no election may be made under section 83(i) if the qualified employee has made an election under section 83(b) with respect to such qualified stock, or if any stock of the corporation which issued the qualified stock is readily tradable on an established securities market at any time before the election is made. In addition, no election may be made under section 83(i) with respect to any qualified stock if the corporation that issued the stock purchased any of its outstanding stock in the calendar year preceding the calendar year which includes the first date the rights of the employee are transferable or are not subject to a substantial risk of forfeiture, unless (i) not less than 25% of the total dollar amount of the stock so purchased is deferral stock, and (ii) the determination of which individuals from whom deferral stock is purchased is made on a reasonable basis.

Notification must be provided to the employee by a corporation that transfers qualified stock to an employee at the time the value would be includable in income (or a reasonable time before). The employer must also certify that the stock is qualified stock and that the employee may be able to defer recognition of the stock under IRC §83(i).

An employer must provide notice to an employee making an election under IRC §83(i) of the following items:

(i) the amount of income recognized at the end of the deferral period will be based on the value of the stock at the time at which the rights of the employee first become transferable or not subject to a risk of forfeiture, notwithstanding whether the value of the stock has declined during the deferral period;

(ii) the amount of such income recognized at the end of the deferral period will be subject to withholding under section 3401(i) at the rate determined under section 3402(t); and

(iii) the responsibilities of the employee, as determined by the Secretary under section 83(i)(3)(A)(ii), with respect to such withholding.

There is a $100 penalty for the failure to provide each required notice unless the taxpayer can show the failure was due to reasonable cause.[2]

The Notice first addresses the 80% requirement. That requirement is described as follows:

…[S]ection 83(i)(2)(C) defines an “eligible corporation,” in relevant part, as, with respect to any calendar year, any corporation that has a written plan under which, in such calendar year, not less than 80% of all employees who provide services to the corporation in the United States (or any possession of the United States) are granted stock options, or are granted RSUs, with the same rights and privileges to receive qualified stock.

The IRS noted that it had received inquiries regarding whether the 80% requirement for a calendar year is applied on a cumulative basis that takes into account prior calendar years. In response the Notice indicates:

The determination of whether a corporation qualifies as an eligible corporation is made “with respect to any calendar year.” Furthermore, to meet the 80% requirement, the corporation must have granted “in such calendar year” stock options to 80% of its employees or RSUs to 80% of its employees. Therefore, the determination that the corporation is an eligible corporation must be made on a calendar year basis, and whether the corporation has satisfied the 80% requirement is based solely on the stock options or the RSUs granted in that calendar year to employees who provide services to the corporation in the United States (or any possession of the United States). In calculating whether the 80% requirement is satisfied, the corporation must take into account the total number of individuals employed at any time during the year in question as well as the total number of employees receiving grants during the year (in each case, without regard to excluded employees or part-time employees described in section 4980E(d)(4)), regardless of whether the employees were employed by the corporation at the beginning of the calendar year or the end of the calendar year.

The Notice goes on to discuss employment and withholding taxes when a §83(i) election is made. The Notice first notes that TCJA made no changes to FICA or FUTA withholding with respect to such stock.

However, TCJA did modify the income tax withholding provisions applicable to such stock, seeking to conform income tax withholding to the income taxation of such deferral stock. The Notice provides:

…[Q]ualified stock (as defined in section 83(i)) with respect to which an election is made under section 83(i) is treated as wages (1) received on the earliest date described in section 83(i)(1)(B), and (2) in an amount equal to the amount included in income under section 83 for the taxable year which includes such date. Thus, under section 3401(i), the amount of the deferral stock included in gross income is treated as wages subject to federal income tax withholding on the earliest date described in section 83(i)(1)(B), which sets forth the end date of the applicable deferral period.

The Notice goes on to describe the mechanical issues related to withholding, specifically invoking Announcement 85-113’s provisions on issues related to withholding from non-cash fringe benefits.

The Notice provides for the required of an escrow arrangement to hold such stock to ensure that the withholding requirements are met. Such an escrow arrangement must provide for the following terms:

(i) The deferral stock must be deposited into escrow before the end of the calendar year during which the section 83(i) election is made and must remain in escrow until removed in accordance with clause (ii) or the corporation has otherwise recovered from the employee an amount equal to the corresponding income tax withholding obligation under section 3401(i) for the taxable year determined in accordance with section 83(i)(1)(B).

(ii) At any time between the date of income inclusion under section 83(i)(1)(B) and March 31 of the following calendar year, the corporation may remove from escrow and retain the number of shares of deferral stock with a fair market value equal to the income tax withholding obligation that has not been recovered from the employee by other means. The fair market value of the shares must be determined pursuant to the rules in § 1.409A-1(b)(5)(iv). The fair market value used for purposes of this calculation is the fair market value of the shares at the time the corporation retains shares held in escrow to satisfy the income tax withholding obligation.

(iii) Any remaining shares held in escrow after the corporation’s income tax withholding obligation has been met, whether by retention of shares in accordance with clause (ii) or otherwise, must be delivered to the employee as soon as reasonably practicable thereafter.

The Notice observes that:

If the corporation and the employee do not agree to deposit the deferral stock into an escrow arrangement consistent with the terms outlined above, the employee is not a “qualified employee” within the meaning of section 83(i)(3). The Treasury Department and the IRS are aware that this has the effect of allowing a corporation to preclude its employees from making section 83(i) elections by declining to establish an escrow arrangement consistent with the terms outlined above.

The IRS goes on to point out that because the stock cannot qualify for the election unless the employer agrees to establish the escrow arrangement, an employer that does not wish to establish such a program will not accidentally create such a program.

[1] The described relationships are a spouse, child, grandchild or parent.

[2] IRC §6652