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January 2, 2019

IRS Clarifies the New Deferral Election for Stock Compensation (article)

The IRS has issued Notice 2018-97 clarifying some important aspects of the Section 83(i) deferral election which was introduced as part of the 2017 Tax Act, commonly known as the Tax Cuts and Jobs Act (TCJA).

Recap of the IRC Section 83(i) Election

The TCJA allowed employees to elect to defer income from the receipt or vesting of certain stock compensation. The provision applies to employees of a small business that is a corporation not traded on an established securities market. The stock compensation subject to this provision consists of income resulting from the exercise of a stock option or on the stock settlement of a restricted stock unit (RSU). The deferral period can last up to five years. Without the new election under the TCJA, an employee would generally be subject to tax upon exercise of the option or upon settlement of the RSU, at which time a potentially cash-strapped employee would have to fund payment of the tax, generally by selling some of the stock where no market may exist. The new election attempts to remedy this dilemma by permitting deferral of the income.

However, several barriers come with this new deferral opportunity. For instance, the five-year deferral period will be cut short if any of the following events occur sooner:

  • The employee becomes eligible to sell the stock back to the employer or to anyone else;
  • The stock becomes readily tradeable on an established securities market;
  • The employee revokes the election under IRS rules; or
  • The employee becomes an “excluded employee.”

An excluded employee is:

  • A 1-percent or greater owner, or who was a 1-percent owner within the prior 10 calendar years;
  • The business’ CEO or CFO, even if only acting in either of those capacities, or anyone who is a spouse, child, parent, or grandparent of a current or former CEO or CFO; or
  • One of the four highest compensated employees during the tax year or during any one of the preceding 10 calendar years.

By becoming an excluded employee, a taxpayer not only terminates an existing election, he becomes ineligible to make any future election.

Another barrier (discussed in a previous article) is that the business must grant eligible stock rights or RSUs to at least 80 percent of its full-time employees. Because incentives like these are often reserved to incentivize management, this is expected to drastically limit the number of businesses willing to entertain such a program. Furthermore, the stock granted to all employees must offer the same rights and privileges, though amounts granted may differ. These restrictions have blunted the reach of the new election.

Clarifying the 80% Rule

Businesses undeterred by these barriers had questions regarding the details of these restrictions. Chief among these was whether the 80 percent requirement took into account stock option or RSU grants that occurred in a prior calendar year. The IRS clarified in the notice that the 80 percent test only applies to activity transpiring on a year-by-year basis. This alleviates the concern that prior year grants would make it more difficult, if not impossible, to meet the 80 percent threshold. It also presents a planning opportunity to businesses that have historically made grants to small numbers of employees. Instead of granting these options or RSUs to small groups, the business could redefine the criteria for its grants to “bunch” them. For example, if a corporation with 100 non-excluded employees typically makes grants to employees upon reaching certain milestones (such as years of service), it could redefine the grant criteria for these employees to bunch the total grants during a particular year where there may be only minor adjustments needed to the timing of such grants.

The notice also clarifies that the 80 percent test is calculated by dividing the number of employees who were issued the grant by the total number of employees who were employed by the business at any time of the year. So if a corporation had 100 cumulative employees during the year but only had 50 at the time of grant, it would not meet the 80 percent requirement even if all 50 employees were granted the stock. Note that when counting cumulative employees and employees granted the stock, all employees classified as excluded employees are disregarded, which preserves the ability of the business to provide grants to its owners, top executives, and highest paid employees without affecting the 80 percent test. However, grants with different rights and privileges cannot be added together to meet the 80 percent test. For example, the business could not grant voting stock to 30 of its top performers and non-voting stock to the next 50 best-performing employees to meet the 80 percent threshold, because the same rights and privileges would not exist in this case.

Withholding and Employment Taxes

Another question concerned the timing of withholding on income and employment taxes associated with the grant. In the notice, the IRS clarifies that the election does not affect the timing of FICA and FUTA taxation of the stock compensation; therefore, the employer must withhold and pay the taxes when the employee makes the election.

On the other hand, the election provides new withholding rules for income taxes. First, the IRS provides in the notice that income tax withholding is calculated at the maximum applicable rate (currently 37 percent), without regard to the taxpayer’s regular wages, withholding allowances, or any additional withholding requested by the taxpayer, and without regard to the withholding method used by the employer. Importantly, this withholding liability is not due until the termination of the deferral period. The income upon which withholding is required is based on the value of the stock at the time of the election, not when the deferral period ends. This can be detrimental to an employer if the stock has declined in value or become worthless since the original election date.

Escrow Arrangement

The deferred income tax withholding arrangement leaves open a possibility that the company may have insufficient funds to satisfy the liability, or may no longer exist at that time. To manage this concern, the IRS established that the deferral stock must be held in an escrow arrangement. The notice provides that the stock must be deposited into escrow before the end of the calendar year in which it was granted. Further, it must continue to be held in escrow until the employer has recovered from the employee the income tax withholding amount. An exception to this rule is that the employer may withdraw stock from escrow in an amount (using the FMV of the stock) needed to satisfy the income tax withholding obligation, if it cannot be recovered by other means. Once the withholding has been recovered, the employer must take steps to distribute the stock as soon as is reasonably practicable.

The benefit of the escrow account provision is that it allows the employer to make a grant without having to pay income tax withholding during the deferral period. The escrow provision also gives the employer more control over when stock is eligible for the election, as the employer can make the stock ineligible by simply not establishing the escrow account. However, the employer must use a third party to fulfill the escrow duties, which will come with its own added administration costs.


The guidance provided by the IRS in Notice 2018-97 provides important information for employers who wish to offer Section 83(i) eligible stock grants to employees. It clarifies the 80 percent rule, which is seen by many as one of the larger barriers to such grants. It also provides a clear process for withholding and a taxpayer-friendly escrow mechanism, though the escrow account does add some administrative complexity. For more information on this provision and planning to make it effective for your workforce, please contact your local CBIZ MHM tax professional.

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Copyright © 2019, CBIZ, Inc. All rights reserved. Contents of this publication may not be reproduced without the express written consent of CBIZ. This publication is distributed with the understanding that CBIZ is not rendering legal, accounting or other professional advice. The reader is advised to contact a tax professional prior to taking any action based upon this information. CBIZ assumes no liability whatsoever in connection with the use of this information and assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.

CBIZ MHM is the brand name for CBIZ MHM, LLC, a national professional services company providing tax, financial advisory and consulting services to individuals, tax-exempt organizations and a wide range of publicly-traded and privately-held companies. CBIZ MHM, LLC is a fully owned subsidiary of CBIZ, Inc. (NYSE: CBZ).

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