Private Company Grants Of Stock Options & RSUs: IRS Guidance Provides Limited Support

Equity compensation in privately held companies is tricky for both employers and employees because the companies’ stock is not publicly traded and is therefore illiquid. Introduced by a complex provision of the Tax Cuts & Jobs Act (“tax reform”), which took effect this year, a new section of the tax code, Section 83(i), seeks to make equity comp more appealing to private companies. It lets them make grants of nonqualified stock options (NQSOs) or restricted stock units (RSUs) in which the recipient can defer income taxes for up to five years from NQSO exercise or RSU vesting as long as the grants meet certain conditions. These are called “qualified equity grants.”

However, the initial reaction by private companies to this new opportunity has been cautious and cool. Before plunging in, many have awaited clarification and guidance from the IRS on the many technical requirements and details of the new grant type. In Notice 2018-97, the IRS finally issued guidance for companies on qualified equity grants, with more to come, but it may do little to enhance the appeal of these grants for smaller startups.

The Tax Problem Congress Wanted To Solve But Only Made More Complicated

While stock options and restricted stock units are popular at startups and other pre-IPO companies, employees cannot sell stock at exercise or vesting, even to pay the taxes owed on the income. The IRS confirmed in regulations issued during 2014 that the tax measurement date (at exercise for options and at vesting for restricted stock) is not delayed by any lack of liquidity or securities law restrictions on resales of stock.

The fact that the tax treatment for stock grants at pre-IPO and large publicly traded companies is identical seems oddly unfair when you consider the vastly differing liquidity situations of private and public company employees. While private companies want to use equity grants to motivate, retain, and create employee-shareholders, they do not want to obligate their employees to pay taxes on shares they cannot sell. Seeking to ease this conundrum, Congress first considered the Empowering Employees Through Stock Ownership Act. That bill eventually transformed into part of the Tax Cuts & Jobs Act. To provide for qualified equity awards, it added Section 83(i) to the Internal Revenue Code.

Qualified Equity Grants: Outline Of New Tax Deferral

Instead of automatically delaying when taxation occurs after employees receive illiquid private company stock as compensation, Section 83(i) imposes elaborate rules on what types of grants qualify, what types of employees qualify for these grants, employee deferral elections, and procedures companies must follow. The table below summarizes some of the main features of the new Section 83(i).

Key Facts For Tax Deferral Of Private Company Stock Grants

Eligible types of stock compensation	NQSOs and RSUs
Tax deferred	Federal income tax
Deferral period	Five years, unless triggered earlier
Election required	83(i) election within 30 days of exercise or vesting
Company requirements	Numerous, including grants to 80% of employees

For more details on this tax code provision, see our related article: Private Company Stock Options And RSUs: 10 Facts To Know About The New Tax-Deferral Opportunity.

Three Topics IRS Guidance Addresses

In Notice 2018-97, the IRS clarifies and creates rules in three areas that are evidently the most pressing for companies.

1. Time requirement for the 80% rule. To make qualified equity grants, the company must issue grants to at least 80% of employees in a single calendar year. The law does not provide for a cumulative basis that considers grants from prior years. Apparently, the IRS felt it had to go with the statutory language.

Potential impact: This makes it more difficult for early-stage startups, as they primarily make new-hire grants, not annual grants that can more easily fit into a calendar year. For example, imagine a 10-employee startup in which everyone gets meaningful grants at hire. Next year, the company hires two more employees, who also get meaningful grants. Although 100% of employees have equity awards, the company made grants to only 20% in that year, and therefore those grants cannot be tax-qualified. Don’t blame the IRS for this outcome until Congress amends the law.

Big private companies, such as the Unicorns (e.g. Uber, Airbnb), along with other large late-stage pre-IPO companies that make broad-based grants, will find it easier to meet the 80% rule. Their grant practices have probably evolved to become more regular, with annual and bonus grants.

2. Tax withholding. Companies must set up a procedure to escrow the deferred shares employees receive at exercise with options or vesting with RSUs. They then use some of the shares to pay the withholding tax that is eventually due after five years or a liquidity event. Employees must agree to this arrangement at the time of their deferral election.

Potential impact: This new requirement, not stated in the new law, addresses company and IRS concerns about how the taxes will be paid. This becomes a big issue if no liquidity event occurs or when ex-employees cannot be located. The approach does add more costs, procedures, and communications to what companies are obligated to implement.

The requirement makes qualified equity grants more appealing to well-established private companies that are likely to go public or get acquired. They have the resources to set up this type of arrangement. Their employees also assume less risk and thus more potential benefit with the deferral, as they are acquiring stock that has demonstrated value and the potential for liquidity within the five-year deferral period.

3. An opt-out: Companies can designate grants that are ineligible for the employee deferral election. They do this by not setting up the share escrow arrangement or not following other conditions for qualified equity grants.

Potential impact: Companies were concerned that they could unintentionally meet the conditions allowing employees to make a deferral election, potentially causing the company to be penalized for not following the new law’s requirements for employee notices and communications. While the IRS guidance clarifies how companies can opt out of the provision, the pressing need for IRS guidance on how to opt out suggests companies are not eager to make these type of stock grants. Early-exercise stock options or vesting conditions that require an IPO or acquisition will probably remain more popular ways to specially structure stock grants at private companies.

For more information about the taxation of stock options and restricted stock/RSUs, see the Tax Center at myStockOptions.com. The website’s section on pre-IPO companies covers topics related to stock grants at private companies.