Section 83(i) Election

A Section 83(i) election is an election under Internal Revenue Code section 83(i), headed "Qualified equity grants," by which a qualified employee defers the income that would otherwise be recognized when qualified stock is transferred to them. Instead of including the value in the year the stock vests or is delivered, the employee includes it in the year that contains the earliest of five events, up to five years later. The election is made in a manner similar to an election under section 83(b), and the deadline is the same clock: no later than 30 days after the first date the employee's rights in the stock are transferable or are not subject to a substantial risk of forfeiture, whichever happens earlier.

Qualified stock means stock in the employer received either on the exercise of an option or in settlement of a restricted stock unit, where the option or unit was granted for services during a year in which the employer was an eligible corporation. An eligible corporation is one whose stock has never been readily tradable on an established securities market in any preceding calendar year and which has a written plan granting, in that year, stock options or restricted stock units with the same rights and privileges to not less than 80 percent of its employees providing services in the United States. The consequence of that test, covered on the restricted stock units entry, is that the election is a private-company mechanism and does not reach a public company.

One relationship is worth stating directly because it reads backwards at first. Section 83(i)(7) provides that section 83, "other than this subsection," including any election under subsection (b), does not apply to restricted stock units. So an 83(b) election on a restricted stock unit is impossible, while an 83(i) election on one is expressly contemplated. The two elections are not variants of each other: 83(b) pulls tax forward to grant, and 83(i) pushes it back from vesting.

Five events end the deferral, and only one of them is the employee's own choice. Inclusion happens in the taxable year containing the earliest of: the first date the qualified stock becomes transferable, including transferable to the employer; the date the employee first becomes an excluded employee; the first date any stock of the issuing corporation becomes readily tradable on an established securities market; the date five years after the rights first became transferable or ceased to be subject to a substantial risk of forfeiture; or the date the employee revokes the election. A promotion into the corner office, an initial public offering, or an acquisition that makes the shares transferable will all end the deferral early.

The excluded-employee test bars the people most likely to want this. Under 83(i)(3)(B), an excluded employee is anyone who is or has been at any time during the calendar year, or in the 10 preceding calendar years, a 1-percent owner of the corporation within the meaning of section 416(i)(1)(B)(ii), the key employee provision. It also captures anyone who is or has ever been the chief executive officer or chief financial officer, or who acted in either capacity; anyone bearing a family relationship described in section 318(a)(1) to such a person, which reaches spouses, children, grandchildren and parents; and anyone who is one of the four highest compensated officers of the corporation for the taxable year or was for any of the 10 preceding years, determined using the shareholder disclosure rules under the Securities Exchange Act of 1934 as if they applied to a private company. This is a look-back test, so a person who has left an executive role does not become eligible by doing so.

Two further limitations sit in 83(i)(4)(B), and the third is unusual. No election may be made if the employee has already made an 83(b) election on the same stock, or if any stock of the corporation was readily tradable at any time before the election is made. The third is a company-level anti-abuse rule aimed at tender offers: if the corporation purchased any of its own outstanding stock in the calendar year before the year containing the vesting date, no new election may be made unless at least 25 percent of the total dollar amount of stock so purchased was deferral stock, meaning stock already covered by an 83(i) election, and the choice of whose deferral stock was bought was made on a reasonable basis. The requirement is treated as met if the purchase swept up all the outstanding deferral stock. A corporation with deferral stock outstanding that buys back any of its shares during a year must report the total dollar amount purchased on its own return.

The value is fixed at vesting, and that is the risk the election creates. Section 83(i)(6) requires the corporation to certify that the stock is qualified stock and to notify the employee that the election is available, and it specifies what the notice must say. Among the required warnings: that the amount of income recognized at the end of the deferral period will be based on the value of the stock at the time the employee's rights first became transferable or ceased to be subject to a substantial risk of forfeiture, "notwithstanding whether the value of the stock has declined during the deferral period," and that the income will be subject to withholding at the rate determined under section 3402(t). The deferral is of the timing, not of the measurement. An employee who elects and then watches the company's valuation fall will be taxed on a number the shares no longer support, on shares that may still be unsellable.

Two narrower points. Stock is not qualified stock if the employee may sell it back to the corporation, or otherwise take cash instead of stock from the corporation, at the time their rights first become transferable or cease to be subject to a substantial risk of forfeiture, since in that case the liquidity problem the provision addresses does not exist. And all members of a controlled group under section 414(b) are treated as one corporation for the whole subsection, so the 80-percent plan test and the excluded-employee test cannot be managed by splitting a business into entities.

1. Confirm the stock is qualified stock. It must come from exercising an option or settling a restricted stock unit granted for services in a year the employer was an eligible corporation, and the employee must not be able to take cash from the corporation instead at vesting.

2. Confirm the employer was eligible in the grant year: no publicly traded stock in any prior year, and a written plan granting options or units with the same rights and privileges to at least 80 percent of its U.S. employees that year.

3. Confirm the employee is not an excluded employee, checking the current year and the 10 preceding ones for 1-percent ownership, service as chief executive or chief financial officer, a qualifying family relationship to one, or membership of the four highest paid officers.

4. Watch the 30-day clock, which starts on the first date the rights become transferable or stop being subject to a substantial risk of forfeiture, whichever is earlier.

5. File the election in a manner similar to an 83(b) election, and expect the employer's certification and notice.

6. Track the five ending events, and remember the amount was fixed on the vesting date.

Suppose, with invented figures, that Aisha exercises options on 4,000 shares of a private employer. Her strike price is $2.00 a share and the fair market value at exercise is $12.00, so the spread is 4,000 x ($12.00 - $2.00) = $40,000 of ordinary compensation income that would otherwise be taxable that year. There is no market for the shares, so paying the tax means finding the cash somewhere else.

She files a Section 83(i) election within 30 days. Nothing goes on that year's return. Five years later the company is still private, still has not been acquired, and a recent financing has repriced the common stock at $3.00 a share. The five-year event arrives and Aisha must include the $40,000 anyway, because the amount was measured on the vesting date and is not re-measured. Her 4,000 shares are worth 4,000 x $3.00 = $12,000. The election did what it promised, which was to move the timing, and it did not promise to move the number.

What the election is good for

• It addresses a genuine mismatch, where tax is due on private stock that cannot be sold to pay the tax.
• Five years is long enough for many companies to reach a liquidity event, at which point the shares themselves can fund the bill.
• It is the one section 83 election available on a restricted stock unit, since an 83(b) election is ruled out by statute.
• It can be revoked, so an employee who reaches liquidity early is not stuck with the deferral.
• The employer is legally required to tell the employee the election exists and to spell out its main risk in writing.

What it costs, and who cannot use it

• The amount taxed is fixed at the vesting-date value. A decline during the deferral period does not reduce it, and the employee may end up taxed on more than the shares are worth.
• Three events can end the deferral early without the employee choosing it: the stock becoming transferable, any stock of the company becoming publicly tradable, and the employee becoming an excluded employee.
• Owners, current and former chief executives and chief financial officers, their close family and the four highest paid officers are barred, and the bar looks back ten years.
• The employer must have granted equity to at least 80 percent of its U.S. employees that year, which most companies have not done.
• The 30-day deadline is unforgiving and runs from vesting, a date many employees do not notice at the time.
• A company buyback in the previous calendar year can block new elections unless a quarter of the dollars spent went to deferral stock.