Many businesses use equity-based compensation plans to attract and retain employees. Historically, employees who received nonqualified stock options or restricted stock as compensation for services from their private-company employer faced a dilemma when they exercised those options or when the restricted stock vested: The resulting income tax was imposed, and withholding became due. Because the stock was not publicly traded or the corporation restricted the transfer of its stock, the employee was not generally able to sell a portion of the stock to generate the cash needed to pay that withholding. Instead, the employee was required to find another cash source or allow the options to lapse, making the receipt of the options or stock less of a positive incentive.
The TCJA added a new provision that allows a “qualified employee” to elect to defer the income and the income tax withholding on qualified stock for up to five years if the corporation is an “eligible corporation.” Note that if the election is made, FICA and FUTA taxes are not similarly deferred and must be withheld and/or submitted under the normal rules for such taxes.
A “qualified employee” is one who:
- Does not/did not own 1% of the corporation during the taxable year or at any time during the 10 prior calendar years or is a family member of such a person.
- Is not the current or former CEO or CFO of the corporation or a family member of such a person.
- Is not/was not one of the four highest-compensated officers of the corporation during the taxable year or for any of the 10 preceding taxable years.
A corporation is an “eligible corporation” if:
- None of its stock (or the stock of a predecessor) was readily tradable on an established securities market during any preceding calendar year.
- The corporation has a written plan under which not less than 80% of all employees in the United States are granted stock options or restricted stock units.
A corporation that transfers qualified stock to a qualified employee is required to notify the employee, at or before the stock becomes vested, that the stock is qualified, that the employee may elect to defer the income, and that the income subject to tax and withholding at the end of the deferral period is based on the value of the stock at the time the stock became substantially vested.
The employee must make what is known as the “inclusion deferral election” under Sec. 83(i) within 30 days after the stock becomes substantially vested. In addition, if the employee makes the election to defer the income, the employer’s tax deduction is deferred until the deferred income is actually included in the employee’s taxable income.
The deferral period ends on the earliest of the following dates:
- When the employee is no longer a qualified employee
- When any stock of the employer becomes publicly traded
- When the stock becomes transferable, including to the employer
- The date the employee revokes their election
- Five years after the employee’s right to the stock is substantially vested
Although this provision is not going to be applicable to most corporations, it may, as a result of the 80% requirement, be of significant interest to startup technology companies that often utilize stock options and restricted stock to attract and retain employees because of such employers’ limited cash availability.