6 Months In, Stock Option Deferral Rule Not Catching On

Aug 2, 2018 | Business Organizations / Corporate, Taxation

A provision in the new tax law allowing for tax deferral on some stock options may have been appealing in theory, but six months later, it’s a non-starter for most companies.

IRS guidance could make the provision more attractive, but some of the requirements driving its unpopularity are baked into the statute, according to practitioners.

J. Marc Fosse of Trucker Huss APC told Tax Analysts that he hasn’t seen much interest from clients in offering the deferral election, echoing what other practitioners have been saying for months. Part of that reluctance stems from unanswered questions about the requirements, he said.

Until guidance is issued, the IRS will treat companies as compliant with some of the statutory requirements as long as they make a good-faith effort, but Fosse said employers aren’t reassured. “I don’t know that people will invest the time and resources to figure that out until there’s IRS guidance,” he said.

Fosse remains optimistic that some companies will take an interest if and when the IRS issues favorable clarifications, but he said some of the statute’s tougher requirements — such as the requirement that options be granted to at least 80 percent of employees — will likely remain a deterrent.

Lack of Options

The new deferral election under section 83(i), added by the Tax Cuts and Jobs Act (P.L. 115-97), allows some recipients of stock options and restricted stock units to defer income for up to five years after they would otherwise vest. The concept was introduced in a bipartisan bill called the Empowering Employees Through Stock Ownership Act, a version of which passed the House in 2016.

The deferral option was intended to help employees at private companies who can’t afford the tax consequences of exercising their stock options. While public company employees can exercise options and sell shares to pay their tax bill, private company employees often cannot sell stock to cover the taxes on the excess of the fair market value of the stock, forcing them to forfeit their valuable options.

According to an October 2017 report from the Urban-Brookings Tax Policy Center, the problem has become more common in recent years because successful start-up companies have been staying private longer.

The National Venture Capital Association lobbied for the bill, arguing that stock options are a critical tool for attracting talent to start-ups. “Stock options are particularly important for startups that are often cash strapped and using all resources available to develop and build a novel product,” the group said in a September 2017 letter to Treasury. “But as the U.S. capital markets have become more hostile to small capitalization companies, many startups are opting to stay private longer rather than pursue an [initial public offering].”

All Quiet on the Deferral Front

But the seemingly valuable deferral option has yet to catch on. “One would have thought we’d have seen a clamoring for these plans in January,” Scott P. Spector of Fenwick & West LLP said during a recent American Law Institute Continuing Legal Education webinar. “We’ve seen almost none. . . . I think it’s fascinating that this is out there and no one is taking advantage of it.”

Gerald Audant, also of Fenwick, and Juliano Banuelos of Orrick, Herrington & Sutcliffe LLP, agreed that there’s been little interest. Audant and Banuelos discussed section 83(i) along with Spector at the ALI-CLE event June 14.

Banuelos said section 83(i) is a good idea in concept, but an imperfect solution because the requirements are so restrictive. “It’s pretty unlikely that this is going to see broad-based use, but there will be specialized situations and happenstance situations where it will be used,” Banuelos said.

Fosse agreed, saying that the deferral elections likely will be attractive to only a limited group of private corporations that have a real chance of a liquidity event within a five-year period.

Practitioners appear to agree that the biggest obstacle is the 80 percent requirement, which Fosse said is a particularly high hurdle for larger companies. If part-time employees must be included in the 80 percent calculation, it will be even tougher to meet, Fosse said, but he added that the IRS could find that those employees are excluded.

Another issue is the restriction on a company’s ability to buy back stock. Stock isn’t “qualified” under the statute if the employee can sell it or receive cash in lieu of stock. Therefore, Banuelos said, stock issued with put rights, repurchase rights, or in accordance with net settlement programs is presumably disqualified.

Another problem, according to Fosse, is that the election must be made within 30 days of vesting, but the statute doesn’t say when the option must be exercised and thus when the employee must pay the exercise price. “Because section 83 generally applies only to a transfer of property, it seems logical the option would be exercised in the 30-day period, but Treasury could interpret it differently,” he said.

Guidance Not a Priority?

Potential penalties associated with the statute’s notice requirements are also scaring off employers, Audant said. Employers are required to notify employees that they’re eligible to make a section 83(i) deferral election, and the IRS can assess a $100 fine for each failure to timely provide employee notice, up to $50,000 per year. Audant said the threat of penalties is driving his clients to find ways to make sure they don’t qualify to offer the deferral.

The withholding issue is another major concern that Fosse said needs to be resolved before the provision can be viable. It appears that employers could be on the hook for employees who are unwilling or unable to reimburse the company for withholding obligations, and Fosse said the IRS will need to offer administrative relief to assuage those fears.

“We’re expecting to get further guidance from Treasury that hopefully will make it more user- friendly, but unless some of these substantive provisions . . . are relaxed, I don’t see [section] 83(i) getting a ton of play as intended,” Banuelos said.

Spector expressed doubt that guidance would come soon, noting that section 83(i) wasn’t included in the latest priority guidance plan as one of the projects to implement the TCJA. “I think this will be like the [section] 280G regs, that we’ll see guidance in 14 years,” Spector said. “This is just not on their priority list, and I think that anybody that does this is doing it without guidance.”

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This article was written by Stephanie Cumings and originally published by Tax Analysts. To learn more about the author and Tax Analysts,  please visit http://www.taxanalysts.org 

Stephanie Cumings wrote this article as a result from her attendance at ALI CLE’s Executive Compensation 2018 annual conference. More information about this program can be found here:

www.ali-cle.org/cz019