Ten Things to Know About Qualified Equity Grants

On December 7, the IRS issued Notice 2018-97, to provide much-needed guidance on qualified equity grants under Section 83(i). Before I blog about that guidance, I thought it would be helpful to review what qualified equity grants are.

The Tax Cuts and Jobs Act added Section 83(i) to the Internal Revenue Code, which allows privately held companies to grant a new type of vehicle called “qualified equity grants.” Here are ten things to know about qualified equity grants:

1. Employees who receive qualified equity grants can file an election with the IRS to defer taxation for a maximum of five years. Note that the deferral period might be shorter than five years if certain events happen, such as if the company goes public or the stock becomes transferable.
2. Both stock options and RSUs can be qualified equity grants.  Even ISOs can be qualified equity grants, but if an employee files a deferral election under Section 83(i), the ISO converts to an NQSO.
3. For options or RSUs to be qualified equity grants, the company must grant the same vehicle to at least 80% of its employees, and all grant recipients must have equal rights and privileges (except that the number of shares granted can differ by employee).
4. Not all employees can make deferral elections under Section 83(i). Anyone who has ever served as the company’s CEO or CFO is ineligible, as are family members of these individuals. Likewise, anyone who is or has been (during the past ten years) a 1% shareholder or one of the top four highest paid employees is also ineligible.
5. The election must be made within 30 days after the date the employee’s rights to the stock are first transferable or no longer subject to a substantial risk of forfeiture, whichever occurs earliest.
6. The election doesn’t defer taxation for FICA purposes, just for income tax purposes.
7. At the end of the deferral period, the employee must pay tax on the gain that existed when the employee’s rights to the stock were first transferable or no longer subject to a substantial risk of forfeiture, even if the stock has since declined in value. The company must withhold federal income tax at the maximum individual tax rate.
8. Why do I keep saying “when the employee’s rights to the stock are first transferable or no longer subject to a substantial risk of forfeiture” instead of referring to the exercise/vest date? Because that’s the language used in the code and I’m not entirely sure what it means in the context of stock options. Hopefully we’ll get some guidance on this in the future. Until then, draw your own conclusions—in consultation with your tax advisors, of course.
9. Deferral elections aren’t permissible if the company has repurchased its own stock in the past year except in certain circumstances—the rules here are complicated.
10. Companies that have issued qualified equity grants are required to provide a notice to the grant holders, informing them of their right to defer income on the grants.

So that’s what qualified equity grants are in less than 500 words. For more information, check out these alerts by Trucker Huss and Wilson Sonsini.

P.S.—You may be wondering what pocketwatches have to do with Section 83(i). I don't know: time, deferral, time value of money, etc.? Mostly I just think the picture looks cool. The idea of tax deferral is apparently not something stock photographers are aware of. Not only are there zero photos for the search term "tax deferral" but Adobe Stock suggested I must have spelled my search term wrong.